Bank Lawyer's Blog

Requiescat in pace

Due to a death in the family, I will not be posting for at least the next couple of weeks.

Derivatives, Practically Speaking

The Third Edition of “Practical Derivatives, A Transactional Approach” edited by London-based Mayer Brown attorneys Edmund Parker and Marcin Prezanowski and published by Globe Law and Business (www.globelawandbusiness.com), is the third book related to derivatives with which these two attorneys have been associated and reviews of which have appeared on this blog. The first, “Equity Derivatives,” I reviewed in 2009. The second, “Credit Derivatives: Understanding and Working with the 20014 ISDA Credit Definitions,” was reviewed by Shapiro Bieging Barber Otteson LLP partner Kurt Leeper earlier this year. The following latest review is by Mr. Leeper and SBBO partner Christian Otteson.

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There have been many changes to the derivatives market since the Second Edition of “Practical Derivatives” was published seven years ago. In addition to the regulatory changes (which necessitated the addition of substantial new material in the latest edition), there have been major changes in documentation, including the 2014 ISDA Credit Derivatives Definitions (also discussed in detail in a separate book, the review of which is linked above). There have also been newly developed documentation for cleared over-the-counter (OTC) derivatives and other industry standard forms, all of which are addressed in the Third Edition.

As the editors state in their preface, “the purpose of this book is to provide a practical introduction and overview of all current trends in derivatives, including–in particular—their transactional, regulatory and documentation-related aspects.” We think that they have succeeded admirably. However, because the book covers a wider breadth of ground than the other two books previously reviewed on this blog, and, as stated, the book is intended to be an “introduction and overview” to derivatives, to borrow from an observation in an earlier review of “Equity Derivatives,” this would be an excellent book to give any associate or in-house counsel who is intent on learning what derivatives are, as an -in-depth introduction to such transactions. It should also function as a handy reference for those practitioners who might occasionally get bogged down in the details of negotiating the documentation of a particular transaction and need to step back and “see the forest for the trees.”

The book is broken down broadly into three sections: (1) the regulatory and governance aspects of derivatives; (2) documenting and designing derivatives; and (3) derivative asset classes and corresponding industry documentation. The discussion by Paul Ali of the relation of derivatives to corporate governance, as well as the different considerations and rules that govern corporate end users versus institutional investors, is particularly pertinent in the wake of the recent financial crisis and its aftermath. Ruth Frederick’s chapter on the current regulatory framework of EU regulation, while not intended as a comprehensive guide to all OTC derivatives regulation, provides a good introductory review of EU regulation. As US-based attorneys who represent, for the most part, US-based clients, we would also have appreciated an overview of the US regulatory framework. The final chapter of the initial section, in which Kunnel Tanna discusses the concept of close out netting and how it works under the ISDA master netting agreements, is a useful analysis of a concept that is fundamental to understanding the derivatives process. While US law, especially bankruptcy law, is discussed in relation to the enforceability of netting agreements, the emphasis is on UK law. Notwithstanding that fact, US lawyers who do not already have a firm grasp of close out netting will benefit from the discussion.

The documentation section of the book begins with an overview, by Guy Usher, that covers the types and evolution of ISDA documentation, including, as well, a brief review of SIFMA and ISLA documents, and does discuss some US and English variations. A chapter by John D. Finnerty and Rachel W. Park on designing derivatives structures is an excellent summary of the types and basic structures of various derivatives. As was noted in the review of “Equity Derivatives,” the use of charts and other visual aids helps those of us who are “visual learners.” Because we do not practice law in Germany, we did not review the chapter “Introduction to German derivatives documentation” by Patrick Scholl. Similarly, his chapter on cleared OTC derivatives focuses on EU law and regulation and, to that extent, may be less valuable to US lawyers who do not engage in derivative transactions governed by EU law.

The final section on asset classes and corresponding industry documentation is divided into chapters on commodity derivatives, equity derivatives, credit derivatives, and “other derivatives” (which include interest rate, foreign exchange, and property derivatives). Although the author of this blog a number of years ago reviewed “Equity Derivatives,” inasmuch as the authors of this review represent clients in derivatives transactions primarily related to credit and interest rates, we will confine our remarks to those chapters.

The two chapters authored by Edmund Parker that cover an introduction to credit derivatives and an overview of the 2014 ISDA credit derivatives documents lead you step-by-step through the types and structures of each subtype of credit derivative, the difference between OTC and cleared derivatives (options, forwards, and swaps), structured and exchange-traded products, and standard documentation. While citing primarily EU regulation, the discussion of regulatory capital treatment and various types of risks is sufficiently broad to be of value to a US attorney who desires to understand these basic issues. Mr. Parker’s chapter on the 2014 ISDA Credit Derivatives documentation is designed to give the reader a basic understanding of the documentation, but not the in-depth treatment he offers in his separate book on the 2014 ISDA credit definitions, a link to a review of which is included above. Still, in the 73 pages of this lengthy chapter, there is plenty of meat on the bones.

Natalie Ashford and Vincent K.P. Sum give a brief overview of interest rate derivatives. As they note, these are “complex financial instruments,” and an in-depth discussion would require more than the brief overview provided in nine pages. Nevertheless, if a reader is interested in gaining a basic understanding of the types, uses, risks, and documentation of interest rate derivatives, he or she can obtain it. The chapter also contains a brief overview of the regulatory environment in the wake of the 2008 financial meltdown, and the authors address separately (albeit in summary fashion) the environments in the US, EU and Asia Pacific.

Overall, we think the book is a well-written and informative introduction to derivatives transactions, and would be a useful resource for those interested in learning about derivatives, on whichever side of a derivatives transaction the reader may sit.

Arbitrate This!

Last week's issuance of a final arbitration rule by the CFPB provoked various reactions throughout the financial services world. Among the more amusing were those of long-time BLB favorite, Dorsey & Whitney partner Joe Lynyak. In a client alert, Joe asserted that there was both good news and bad news in the wake of the rule.

First, the bad news—this is litigation hell for just about everyone providing or supporting consumer financial services.  Essentially (and subject to very limited exceptions), the Rule applies to practically any person or entity that provides loans, deposit accounts, services, collection assistance, or credit reporting consumer products and services.  As of the effective date of the Rule (60 days after publication in the Federal Register plus an additional 180 days), so-called “providers” must modify arbitration agreements to ban pre-dispute limitations on class actions—and update old agreements as new products and services are obtained.  Among other things, the Rule contains draft provisions whereby bans on class actions contained in older agreements are to be supplied to consumers to notify consumers that class actions within the arbitration context are no longer applicable.

Joe also discussed the enhanced reporting obligations placed on consumer financial services companies by the rule, and in summary, asserted that the rule "creates a new procedural and compliance nightmare. Commencing in the latter part of the first quarter of 2018, providers will be required to amend consumer disclosures on a go-forward basis. In regard to existing (i.e., pre-Rule consumer agreements), providers will be required to monitor contracts to update arbitration provisions that become subject to the requirements of the Rule. And finally, complex policies and procedures must be developed to identify and report arbitrations subject to the Rule to the CFPB."

Luckily, I had plenty of craft beer on hand while reading the bad news, so I made it through the weekend in relatively sane (if not sober) condition.

"So, what possibly could be the good news?" you ask. Joe's glad you did, because he's found the silver lining in this dark cloud.

Now, the good news—repeat after me—the Congressional Review Act or “CRA.” It provides Congress with the ability to rescind a regulatory action, which the GOP-controlled Congress has already employed following the last election.

Importantly, the CRA is not subject to a requirement that 60 votes be obtained in the Senate—a mere majority in both Houses is all that is required. Moreover, once passed and signed by the President, the affected agency is prohibited from revisiting the subject regulation for an extended period of time.

While the acronym "CRA" often causes financial institutions to spit up a little in their mouths, in this case it brings with it the aroma of freshly baked bread or, better yet, freshly skewered bureaucrat roasting over an open pit.

Some found placing hope in the CRA akin to the captain of the Titanic placing hope in global warming melting all North Atlantic icebergs before they make it to the shipping lanes. The CRA requires that Congress act within a set time period following adoption of a rule, and this Congress has, thus far, proven itself to be filled with an excess of only one quality: inertia. It's been as dysfunctional as the Corleone family. Thus, I get the skepticism. On the other hand, there's nothing like something favored by Elizabeth Warren, the Washington Post, the New York Times, and the Los Angeles Times to unite the warring factions of the tribe known as the Republican Party around a common, destructive cause.

There are other avenues open to destroy the rule, from litigation (an ironic method for those seeking to deny recourse to the courts for consumers) to simply waiting until Richie Cordray's term is over next year and replacing him with consumer-friendly Chris Christie (who's recently demonstrated his utter contempt for the common man when he's not running for elective office), who would rescind the rule while sunning himself on a beach that's off-limits to plebians. However, waiting until next July forces affected businesses to, at the very least, spend a lot of money on lawyers to update agreements. Nobody wants that, do they?

While the Los Angeles Times lauds the fact that the CFPB is "going out with a bang," less ideologically motivated observers wonder why the CFPB decided to tug on Superman's cape. Joe, for example.

Already, the questions are being asked why the CFPB issued the Rule with knowledge that the employment of the CRA is not only possible, but probable.

My guess is hubris.

"Hubris." That's a word I once used to describe King Richard himself, and it's appropriate for the agency as a whole. On the other hand, as far as recognizing that quality in itself, I assume that it's all Greek to the CFPB.

A Ruling That Raises As Many Questions As It Answers

For those readers who've been following the saga of Colorado's Fourth Corner Credit Union, a state-chartered credit union that was formed to serve marijuana businesses operating "legally" under Colorado law (albeit illegally under federal criminal law), we commented last year on the dismissal with prejudice by a federal district court in Denver of the credit union's petition for an injunction that would overturn a decision by the Federal Reserve Bank of Kansas City to deny the credit union a "master account" with the Federal Reserve Bank, an account that is necessary for the credit union to have access to the federal reserve's banking system and services. The acquisition of a master account is a condition of state approval of the credit union's charter. The FRB had denied the application for the master account for a number of reasons, but the most prominent was the fact that the credit union's business plan involved violating federal laws that prohibit participation in or facilitating the manufacture, sale, or distribution of marijuana. The district court refused to compel the FRB to take an action that would authorize the violation of federal law.

The credit union appealed the district court's ruling to the 10th Circuit US Court of Appeals, and recently, a three judge panel issued three separate opinions and one order that prompted one (anonymous) attorney to question whether I thought the appeals court justices might have been affected by either primary or secondary smoke inhalation. I'm sure that question was rhetorical and on that basis, I refuse to answer it. Nevertheless, the outcome was unusual, to say the least.

The primary fact that seems to split the three is that during the proceedings at the district court level, the credit union amended its complaint filed with the court (but not its application for the master account filed with the FRB) to state that it would serve marijuana related businesses "only if authorized by state and federal law." Otherwise, it would only serve members who engaged in the advocacy of legalization of marijuana. The application filed with the FRB and the original complaint stated that the credit union would serve only those marijuana related business authorized by Colorado law. Two justices determined that serving marijuana related businesses would be illegal under current federal law. One of those justices, agreeing with the district court judge, didn't believe the credit union's assertion that it would not serve federally-illegal marijuana related businesses and one of the other justices did believe the credit union's assertion (in fact, he stated that the court was obligated to accept at face value those assertions in this respect that were set forth in the amended complaint). The justice who believed the credit union voted to overturn the district court's decision and grant the credit union's request for injunctive relief (in other words, order the FRB to grant it a master account). The "unbeliever" voted to affirm the district court's determination that the credit union's complaint should be dismissed "with prejudice."  The third justice thought that the credit union's claims were not yet "ripe" for judicial review because the FRB had not had an opportunity to consider an amended application for a master account from the credit union that contained the modified position of the credit union regarding its serving only those marijuana related businesses that are legal under state and federal law. The third justice voted to dismiss the credit union's complaint "without prejudice," so that the credit union could file an amended application with the FRB that contained such a modified position and, if the FRB once again denied the application, to seek relief again in the federal court system. The other two justices thought that there were enough facts to make the credit union's claim "ripe," and that sending it back down for another try with the FRB was a waste of time.

Because of the diversity of opinions, and the fact that two of the three justices, in essence, voted to let the credit union "proceed with its claims," the only way to effectuate that majority result was to reverse the district court's dismissal of the credit union's complaint with prejudice and remand the decision with instructions to the district court to dismiss the amended complaint "without prejudice." The credit union can file an amended application with the FRB and, if the FRB denies the amended application, the credit union can start the slow slog through the court system again. According to one subsequent press report, the credit union intends to do just that "sooner than later." I have not read reports as to whether the FRB intends to petition for a hearing by the full court of appeals. One Colorado attorney opined that this is not the type of case that is likely to be taken up by the US Supreme Court, and I agree with him. Nevertheless, pursuing a full court review would be an effective tactic if your goal is to wage a war of attrition and to hope that you outlast your opponent.

A spokesperson for the credit union told a Denver reporter that "[t]he ruling doesn’t just establish that the Federal Reserve Bank of Kansas City does not have the discretion to deny issuance of a master account as long as the applicant meets its standards, ... [i]t also frees Fourth Corner to pursue its business plan serving the burgeoning marijuana industry." As to the first point, only one of the three justices reached that conclusion. The other two did not address the issue at all, so that interpretation of relevant federal law regarding the FRB's discretion in granting mater accounts, and whether a master account is or is not a "right," was not settled by the decision. As to the latter point, the spokesperson later backtracks by admitting that currently, "the burgeoning marijuana industry" it is permitted to service "would be limited to marijuana industry supporters such as nonprofits and advocates as long as marijuana remained illegal on the federal level." Moreover, "[i]t’s not yet clear as to whether the business restriction could extend to ancillary businesses — those that provide services and products to the marijuana industry but don’t directly handle the plants..."

One of the justice's opinions indicates that the FRB stated a number of reasons, in addition to illegality, upon which iit based its decision to deny the credit union's application for a master account. As the next phase of this litigation parade slogs on, I expect the courts to have another crack at construing whether any of those reasons may be used by the FRB to deny a master account, or what otherwise is the extent of the FRB's discretion on this matter. I would expect them also to give further guidance on the issue of "obstacle preemption" of federal law in this area. The one 10th Circuit Court of Appeals judge to rule on these issues clipped the FRB's wings, but since the three judges varied widely on so many issues, and two of them did not address these issues at all, I would not cite that opinion as binding precedent or an indication of which way the wind would blow in the future.

One of the linked articles also notes that the NCUA denied the credit union's application for insurance of accounts and that there is ongoing litigation between the NCUA and the credit union over that denial. While the FDIC and NCUA have statutory standards that guide them in their decision to approve or deny such applications, they have traditionally been granted wide discretion by the courts in interpreting those standards. In that respect, while the spokesperson for the credit union asserts that it was always in the credit union's business plan to service marijuana legalization advocates, I suspect that that business plan weighed heavily on the side of serving marijuana related business other than merely "legalization advocates." By agreeing to serve only a limited type of marijuana related business until the "big earners" (such as licensed pot shops) are legalized under federal law, will that give the NCUA ammunition for its decision to deny insurance of accounts? I do not know the answer, I'm merely raising the issue. I'm also observing that the master account from the FRB is only one high hurdle that the credit must still jump on the path to opening its doors (which it originally planned to open a couple of years ago). Insurance of accounts is another, and the modified business plan, while potentially helping it jump one hurdle, may hinder it in jumping another.

You have to hand it to the organizers of Fourth Corner. They certainly possess persistence. However, they're going to need to continue to possess that quality, as well as the financial resources to continue to pursue litigation, because to me, this battle doesn't seem like it's anywhere close to being over. 

Luetkemeyer Still After Operation Choke Point

Notwithstanding the departure of Eric Holder and his merry band of miscreants in the Justice Department who concocted the infamous "Operation Choke Point" (with the willing, if covert, cooperation of the federal bank regulatory agencies) and their replacement by a raft of new characters personally selected and/or blessed by he who occupies the White House (aka "The Swamp Drainer"), Republican representative Blaine Luetkemeyer of Missouri has, in 20017, has again attempted to plant his perennial Choke Point-killing piece of legislation known popularly as the "Choke The Chicken Choker Act." The last time we checked on this effort a couple of years ago, it failed to move very far in Congress, perhaps because at that time, the Republicans did not control both houses of Congress and the White House. Last year it passed in the House but went nowhere in the Senate. Now that the Republicans control all three branches, Luetkemeyer apparently believes that the time to drive a stake through the heart of Operation Choke Point for eternity (or until the Democrats regain control of Congress and the White House, which ever comes first) has finally arrived.

As a quick refresher course for readers who've been hibernating in a cave for the last few years, Operation Choke Point was a scheme by Holder and certain senior federal regulators to deny access to the banking system to certain businesses deemed "unsavory" according to the tenets of a moral code based, we have determined after serious investigation and discussion and theologians, on the teachings of a defrocked Hobbesian-Malthusian-Venusian monk named "Bob." Bob taught that those who engaged in such activities as payday lending, tobacco chewing (unless the chewer swallows and does not expectorate), firearms sales, prono purveying, online Christian dating, and collecting fossilized insect exoskeletons, should be denied the right of access to oxygen. Based upon these strict value judgments, the creators of Choke Point did whatever they could to "encourage" financial institutions not to provide financial services to business that engaged in these activities, or others that Bob from time to time might, out of the clear blue of a midday sky, after a dozen Jello Shots, decide were "anathema." The encouragement might take the form of a behind-the-scenes severe talking to, a beating with rubber hoses that left no tell-tale marks, or a regulatory enforcement or other civil action that intimidated the victim into terminating, with extreme prejudice, the poisonous business as a customer of the insitution. Denied access to the nation's financial system, the nefarious business would be choked off from the money they needed to remain in business.

Of course, the perpetrators of this scheme initially publicly denied that any such scheme existed. Instead, the federal government was merely concerned by the risk to the nation's financial institutions posed by banking "risky business." Since the regulators included "reputational risk" as being one of the principal risks, and defined "reputational risk" as anything the regulators said it was, well, the whole program was merely focused on the safety and soundness of financial institutions, not on the regulators' views of "good" and "bad" in terms of business models.

Luetkemeyer believed the banks who complained, not the Obama administration officials and the bank regulators who explained, and his legislation was the result. Recently, one of the creators of the scheme admitted not only his participation, but that the scheme might just have had unintended consequences. Of course, that individual is now cashing out of government service and heading to big law, where he may get paid by some of the same businesses he tried to kill. That's the D.C. way.

Luetkemeyer's legislation would require regulators to have a material reason for requiring a bank to terminate a business relationship with a customer, and such a reason could not be based solely on "reputational risk." The act is part of the Financial Choice Act passed by the House recently but currently squatting immobile like Jabba the Hut in the Senate. To hedge his bets while he's got the votes, Luetkemeyer has also reintroduced the bill as a separate bill, in case the version of whatever version (if any) of the Financial Choice Act that emerges from the Senate does not contain it. This time around, the prospect of sending Operation Choke Point to dustbin of history looks promising.