U.S. Treasury Department Issues White Paper on Online Marketplace Lending Industry

On May 10, 2016, the Department of the Treasury issued a white paper on online marketplace lending that maps the current market landscape, reviews industry insights and offers policy proposals for the road ahead.  Based on approximately 100 responses from online marketplace lenders, financial institutions, investors and other key industry figures, the Treasury, in consultation with the CFPB, FDIC, Federal Reserve Board, FTC, OCC, SBA and SEC, made several notable recommendations and observations.

The white paper explores policies that would expand regulatory oversight, including standardized representations and warranties in securitizations, pricing methodology standards, the implementation of a registry for tracking data on transactions and the reporting of loan-level performance, among others.  In addition, the Treasury mentions potential cybersecurity threats, anti-money laundering, the uneven protections and regulations in place for small business borrowers and the growth of the mortgage and auto loan markets as some of the emerging trends to monitor.  The Treasury is also considering the role of federal agencies in regulating these areas, including the formation of an interagency working group for online market place lending.  Press ReleaseWhite Paper.

The SEC is Seeking Comment on a Joint Agency Proposed Rule Relating to Incentive-based Compensation Arrangements

On May 6, 2016, the Office of the Comptroller of the Currency, Treasury (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), Federal Housing Finance Agency (FHFA), the National Credit Union Administration (NCUA), and the U.S. Securities and Exchange Commission (SEC) issued and sought comment on a joint proposed rule to implement section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) relating to the prohibition on and the disclosure of information of incentive-based compensation arrangements.  The deadline for comments is July 22, 2016.  Notice of Proposed Rulemaking and Request for Comment.

Agencies Propose Net Stable Funding Ratio Rule

On May 3, 2016, the Federal Deposit Insurance Corporation, the Federal Reserve and the Office of the Comptroller of the Currency proposed a rule, the net stable funding ratio (the “NSFR”), to strengthen banks by requiring them to maintain a minimum level of stable funding relative to the liquidity of their assets, derivatives and commitments over a one-year period.  The most stringent of the NSFR’s requirements would apply to, among others, banking organizations with $250 billion or more in total consolidated assets.  The NSFR would become effective January 1, 2018.  ReleaseProposed Rule.

The FDIC Rescinds De Novo Time Period Extension

On April 6, 2016, the Federal Deposit Insurance Corporation (the “FDIC”) rescinded Financial Institution Letter (FIL) 50-2009, Enhanced Supervisory Procedures for Newly Insured FDIC-Supervised Depository Institutions.  The Financial Institution Letter extended the de novo period from three to seven years for newly organized, state nonmember institutions for examinations, capital maintenance and other requirements.  Release.

Joint Interim Final Rule Published Relating to Expanded Examination Cycle Eligibility

On March 24, 2016, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) issued and are requesting public comment on an interim final rule that will allow more community banks to be eligible for the 18-month on-site examination cycle. The rule expands eligibility to qualifying insured depository institutions with less than $1 billion in total assets. Press Release. Interim Final Bill.

Covered Broker-Dealer Provisions Under Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act

On February 17, the Securities and Exchange Commission and the Federal Deposit Insurance Corporation “jointly propos[ed] a rule to implement provisions applicable to the orderly liquidation of covered brokers and dealers under Title II of the Dodd-Frank Act[.]”  The two government agencies issued the proposed rule pursuant to the Dodd-Frank Act, which specifically empowers them to regulate the liquidation of specific large financial entities.  Release.

Morgan Stanley Settles RMBS Litigation with FDIC for $63M

On January 29, Morgan Stanley and the Federal Deposit Insurance Corporation agreed to settle five suits encompassing state and federal claims alleging that Morgan Stanley made misrepresentations in offering residential mortgage-backed securities to three now-defunct banks.  Morgan Stanley will pay $63 million to the FDIC, as receiver for Colonial Bank of Montgomery, Alabama, Security Savings Bank of Henderson, New York, and United Western Bank of Denver, Colorado.  Morgan Stanley denied all liability regarding the claims, and the settlement agreement specified that the parties settled in order to avoid further litigation.  The settlement was reached in coordination with the Department of Justice.  Settlement and Release Agreement.

Preparing for Potential Inquiries into Designated Lender Counsel in PE Sponsored Syndicated Loans

Recent media reports have expressed alarm at the use of “designated lender counsel” in private equity-sponsored leveraged loan transactions.[1]  The phrase refers to the practice of a private equity firm instructing the investment bank arranging its syndicated loan as to which law firm the private equity firm would like the investment bank to use as the bank’s counsel.  According to the press reports, the practice (also known as “sponsor designated counsel”) has become prevalent in the syndicated loan market.  The question raised in the press is whether this practice creates a material conflict of interest, because the law firm representing the investment bank arguably generates fees based on the strength of its relationship with the private equity firm across the table.  If it does, the next question is whether that conflict could be argued to adversely affect the lending arrangement, with potential negative consequences for investors in the loan.

The attention this issue is attracting in the media will likely spark regulatory interest as well as interest among participants in the syndicated loan market.  Prominent lead arrangers in the syndicated loan market should expect inquiries from any number of potential government authorities, including the Federal Reserve, the Office of the Comptroller of the Currency (the “OCC“), the Federal Deposit Insurance Corporation (the “FDIC“) and state authorities such as attorneys general and financial supervisory agencies.  Below we offer guidance for preparing for potential inquiries and responding to any inquiries made.

Potential Regulatory Issues and Inquiries from Market Participants

Over the past several years, the most prominent regulatory guidance in the leveraged loan market has been the Interagency Guidance on Leveraged Lending that the OCC, the Federal Reserve and the FDIC jointly issued in March 2013 (the “Leveraged Lending Guidelines“), as well as various interpretative updates published by the agencies since then.[2]  The Leveraged Lending Guidelines urge banks to implement “a risk management framework that has an intensive and frequent review and monitoring process.”[3]  The general purpose of the Leveraged Lending Guidelines is to keep regulated financial institutions from “unnecessarily heighten[ing] risks by originating poorly underwritten loans,”[4] which could result in risks that “find their way into a wide variety of investment instruments and exacerbate systemic risks within the general economy.”[5]

Although the Leveraged Lending Guidelines do not address the practice described in the press reports, they do instruct regulated financial institutions to put in place policies and procedures that define conflicts of interest, provide risk management controls, permit employees to report conflicts without fear of reprisals, ensure compliance with relevant laws and provide for adequate employee training in this area.[6]   For this reason, regulated lead arrangers of syndicated loans may expect the Federal Reserve, the OCC and the FDIC to inquire whether the practice of sponsor designated counsel creates a conflict and, if so, whether the institution managed that conflict in compliance with the Leveraged Lending Guidelines.

Outside of Federal banking regulators, other government actors – particularly state attorneys general and financial supervisory agencies – might choose to focus on the practice as well. State regulators, for instance, might opt to investigate whether the practice described in the press constitutes a deceptive trade practice. New York’s statute prohibiting deceptive business practices, for example, makes unlawful “deceptive acts or practices in the conduct of any business” and authorizes the attorney general to bring an action to enjoin such acts and to “obtain restitution of any moneys or property obtained”.[7] The statute does not define “deceptive acts or practices,” so all that is necessary is that the attorney general “believe from evidence satisfactory to him” that a deceptive act or practice has occurred. (Federal and other states’ statutes have similar language.) This broad authority would permit such a government authority to launch an investigation following this media driven story.

In addition to regulatory scrutiny, lead arrangers should prepare for potential inquiries from syndicated loan purchasers, who may read the press stories and want to know whether the loans they purchased from the financial institution were reviewed by sponsor designated counsel.

Internal Review

Against this backdrop, there are certain considerations that a financial institution acting as lead arranger for syndicated loans should contemplate in order to address any questions that the institution’s various constituencies may raise and to ensure the institution employs best practices going forward.

  • The press reports fail to distinguish between “left lead arrangers” and other investment banks involved in syndicated loans, but substantially all loan market participants know that on any particular transaction, the “left lead arranger” assumes primary responsibility for the negotiation of loan documents with legal counsel.  As a result, financial institutions should focus their review primarily on transactions where they served as “left lead arranger” and thus directed the relationship with outside counsel.    
  • The press reports allege that a designated law firm might be serving two masters when designated by a private equity sponsor. However, if a designated law firm has a strong, historical relationship with the financial institution, the allegation is difficult to sustain. For example, if Law Firm X generates three times more revenue from its overall relationship with the financial institution than it does from its relationship with the private equity firm, the allegation that the law firm would prioritize the private equity firm’s interests over the bank’s on any particular transaction is implausible.
  • The conflict of interest being alleged is principally the law firm’s and not that of the financial institution.  Financial institutions should consider whether each law firm involved can be reasonably relied upon to manage responsibly any conflicts that may arise, taking into account the firm’s reputation and the financial institution’s own historical experience with, and knowledge of, the firm.
  • A financial institution should also review whether it has ever rejected a sponsor’s designated counsel, or hired “shadow counsel” to review the designated counsel’s documents for any reason.  If so, this would indicate that the financial institution was monitoring the risk alleged by the press articles and mitigating that risk where appropriate.
  • Although time intensive, a financial institution might wish to take a sample of recent top tier sponsor transactions where designated counsel was used and compare the loan documentation in that sample to a similar group of top tier sponsor transactions where outside counsel was not designated.  A finding that the respective sets of loan documents did not differ substantially in lender protection would go a long way toward proving the press allegations spurious.
  • Financial institutions should assess whether appropriate internal constituencies were apprised of this practice, had considered any associated risks and were monitoring on an ongoing basis whether those risks remained contained.   In a financial institution with a product group overseeing leveraged lending, one would want to know whether that group and its associated legal and supervisory functions were monitoring and mitigating those risks on an ongoing basis.

[1] Andrew Ross Sorkin, A Growing Conflict in Wall St. Buyouts, N.Y. Times, Jan. 5, 2016, http://www.nytimes.com/2016/01/05/business/dealbook/a-growing-conflict-in-wall-st-buyouts.html?ref=dealbook;

see also Dan Primack, A Private Equity Conflict Grows on Wall Street, Fortune, Jan. 5, 2016, http://fortune.com/2016/01/05/a-private-equity-conflict-grows-on-wall-street/

[2] 78 Fed. Reg. 17766 (March 22, 2013).

[3] Id. at 17771.

[4] Id.

[5] Id. at 17772.

[6] Id. at 17776.

[7] N.Y. GEN. BUS. LAW § 349(a)-(b).

CFTC Approves Final Rule on Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants

On December 16, 2015, the U.S. Commodity Futures Trading Commission approved a new regulation for uncleared swaps not regulated by the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration or the Federal Housing Finance Agency.  The new rule requires parties to collect margin in order to address concerns of entities taking on excessive risk. Press release.