Securities Mosaic® Blogwatch
August 29, 2016
Bridging the Week: August 22 to 26 and August 29, 2016 (Summarily Barred; False Performance Data; Inadequate Disclosure; The Grass Is Greener)
by Gary DeWaal

Last week, a nonmember was summarily barred from accessing all CME Group exchanges’ markets for 60 days for endeavoring to disguise that he was the controller of five trading accounts that were not in his name. In addition, 13 investment advisers agreed to settle charges brought by the Securities and Exchange Commission that they passed along to their own investors false performance data provided by an independent third party adviser. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Nonmember Banned From Trading All CME Group Products for 60 Days Without a Hearing for Alleged Suspicious Trading Activities (includes Legal Weeds);
  • Multiple Investment Advisers Sanctioned for Passing Along False Performance Claims of Another Adviser;
  • Affiliated Private Equity Fund Advisers Agree to US $52.7 Million Settlement for Inadequate Disclosure Regarding Fees and Loans; and more.

Note: Because of the US Labor Day holiday, the next edition of Bridging the Week will be September 12, 2016.


  • Nonmember Banned From Trading All CME Group Products for 60 Days Without a Hearing for Alleged Suspicious Trading Activities: Andrey Sakharov, a nonmember, was summarily barred from trading any CME Group product for 60 days based on a determination by CME Group’s chief regulatory officer or delegate that such action was necessary to “protect the best interests of the Exchanges and the marketplace.” According to CME Group, on multiple dates since July 1, 2016, Mr. Sakharov allegedly placed orders on Globex in an account not in his name and without an executed power of attorney. Using this account, he placed small quantity orders on one side of the market in August 2016 gold and natural gas futures contracts, and large quantity orders on the other side. He then cancelled both sides of his orders quickly afterwards. CME Group did not claim that any of these orders were placed to effectuate the execution of other orders; however, it claimed that Mr. Sakharov placed trades without any intent that they be executed. CME Group also said that an introducing firm advised it that the account on whose behalf Mr. Sakharov placed these orders had been referred to the Cyprus Securities and Exchange Commission for possible money laundering. In addition, alleged CME Group, Mr. Sakharov placed trades for a least four other accounts not in his name at an unidentified futures commission merchant after advising the same introducing firm that “he did not want to be officially associated with these accounts, since he was concerned that he may be banned from trading following this investigation.” Unrelatedly, three futures commission merchants were fined by the Chicago Mercantile Exchange for violations of rules related to financial requirements and/or requirements pertaining to the segregation of customer funds. The alleged violations appear to be of the nature of recordkeeping or procedural offenses, rather than deficiencies in any amounts required to be maintained. Each of the firms was fined US $50,000. Separately, LPS Futures LLC agreed to pay a fine of US $15,000 to resolve a disciplinary action brought by ICE Futures U.S. that charged it misreported the execution time of a block trade, and failed to report a block trade to the exchange within 15 minutes of execution, as required.

Legal Weeds: Designated contract markets are required by the Commodity Futures Trading Commission rule to have a disciplinary process that includes certain required elements that promote fairness, but may include an emergency process that permits a DCM to “impose a sanction, including suspension, or take other summary action against a person or entity subject to its jurisdiction upon a reasonable belief that such immediate action is necessary to protect the best interest of the marketplace.” (Click here to access the CFTC’s guidance regarding its Core Principle 13 for DCMs – Disciplinary Procedures.) Pursuant to this CFTC authority, DCMs, like CME Group exchanges, have adopted rules to permit summary denial of access to exchanges’ trading facilities “upon a good faith determination that there are substantial reasons to believe that such immediate action is necessary to protect the best interests of the Exchange.” (Click here to access CME Group Rule 413.A. See also ICE Futures U.S. Rule 21.02(f); click here to access.) Under these rules, there is typically a maximum period such summary ban may remain in effect. In the interim, a respondent may request a hearing before a hearing panel. In April 2015, CME Group summarily barred two traders – Nasim Salim and Heet Khara – from trading on any CME Group exchange for 60 days relying on its summary emergency suspension authority because of the respondents’ then current alleged spoofing activities. (Click here to access details in the article, “CME Group Summarily Suspends Trading Privileges of Two Traders Without Hearing for Alleged Spoofing and Non-Cooperation” in the May 3, 2015 edition of Bridging the Week.)

  • Multiple Investment Advisers Sanctioned for Passing Along False Performance Claims of Another Adviser: Thirteen investment advisers settled charges brought by the Securities and Exchange Commission for fines of between US $100,000 and US $500,000, for passing along to their advisory clients false performance data provided by another independent investment advisor. According to the SEC, each of the 13 advisers used performance data provided by F-Squared Investments, Inc., formerly registered with the SEC as an investment adviser from March 2009 through January 2013, to solicit investors for managed trading programs based on F-Squared’s AlphaSector index. However, said the SEC, the performance data provided by F-Squared was false in that, among other things, it claimed it was based on real client performance, when it was not, and the performance results were “substantially overstated.” The SEC charged that none of the 13 advisers took adequate steps to evaluate the legitimacy of F-Squared’s performance claims. The SEC charged each of the 13 advisers with failing to make and keep records necessary to demonstrate the calculation of performance or rate of return it provided to 10 or more persons, as well as distributing advertisements that were false and misleading. In January 2015, the SEC filed and settled charges against F-Squared, claiming it defrauded investors by falsely advertising a successful seven-year track record for its core investment strategy, reflecting actual investments for actual customers, when performance data was actually “materially inflated and hypothetical.” The firm agreed to pay US $35 million to resolves these charges. Separately, Howard Present, the firm’s cofounder and former chief executive officer, was also sued by the SEC for this matter; this matter is still pending. (Click here for details of these SEC enforcement actions in the article, “Investment Company and Former CEO Charged With Defrauding Investors Related to Sale of Index Products Using ETFs; Firm Settles by Payment of US $35 Million” in the January 4, 2015 edition of Bridging the Week.)
  • Affiliated Private Equity Fund Advisers Agree to US $52.7 Million Settlement for Inadequate Disclosure Regarding Fees and Loans: The Securities and Exchange Commission filed and settled charges against Apollo Commodities Management, L.P., a private equity fund adviser, and three other Apollo Management private equity fund advisers (Apollo Management V, VI, and VII, L.P.; collectively, all four entities, “Apollo”) for their inadequate disclosure to investors and a supervision lapse. The SEC charged that, from at least December 2011 through May 2015, Apollo accelerated the assessment of annual monitoring fees due from certain portfolio companies it advised upon the private sale or initial public offering of such companies. However, claimed the SEC, Apollo failed adequately to disclose in advance to the portfolio companies or their limited partners that the payment of such fees might be so accelerated. In addition, the SEC claimed that Apollo Management VI (AMVI) failed adequately to disclose on certain funds’ financial statements that, in connection with loans granted by the funds, an affiliated general partner of AMVI, not the funds, would receive interest payments. Finally, the SEC claimed that after a former Apollo senior partner was determined to have impermissibly charged personal items and services to Apollo-advised funds and the funds’ portfolio companies in 2010 and 2012, Apollo did nothing more than require the partner to reimburse the entities and reprimand the manager. Subsequently, Apollo engaged outside counsel who determined that the partner had charged additional personal expenses to Apollo-advised funds and the funds’ portfolio companies from January 2010 to June 2013. The partner reimbursed the entities for these expenses too and entered into a separation agreement with Apollo. The SEC claimed that Apollo failed “reasonably to supervise” the partner. To resolve the SEC’s allegations, Apollo agreed to disgorge US $40.2 million to compensate investors and to pay a fine of US $12.5 million. In October 2015, the SEC brought and settled similar charges against three affiliated Blackstone Group investment advisers for likewise not disclosing adequately to investors that they might accelerate certain management fees when they ceased advising certain investment companies. (Click here for details of this enforcement action in the article, “SEC Alleges Investment Advisers’ Failure to Disclose Pocketing of Legal Fees Discount Constitutes Conflict of Interest” in the October 11, 2015 edition of Bridging the Week.)

And more briefly:

  • CFTC and FIA Object to CFPB Proposal to Ban Certain Arbitration Agreements to the Extent They Pertain to Commission-Regulated Activities: The Commodity Futures Trading Commission and the Futures Industry Association filed comment letters with the US Bureau of Consumer Financial Protection (CFPB) objecting, in part, to a proposed rule by the CFPB that would prohibit arbitration agreements that barred consumers from filing or participating in class action litigations regarding covered consumer financial products or services. Language in the preamble to the proposed rule would subject the rule’s requirements to “any product or service that is subject to both the Bureau’s and [CFTC’s arbitration rules].” Both the CFTC and FIA pointed out that the CFTC has exclusive jurisdiction over the regulated activities of CFTC registrants, and any CFPB rule may not also regulate such activities.
  • Security-Based Swaps May Be Aggregated in Initial Margin Calculations for Uncleared Swaps Says CFTC Staff: Staff of two divisions of the Commodity Futures Trading Commission issued an interpretation to the International Swaps and Derivatives Association permitting covered swap entities that collect and post margin on a portfolio basis to include both security-based swaps and swaps in their calculations, subject to certain enumerated conditions. Among other things, both the swaps and security-based swaps must be subject to the same eligible master netting agreement and applicable netting portfolio. The two divisions are the Division of Swap Dealer and Intermediary Oversight and the Division of Clearing and Risk.
  • SEC Adopts Rules to Enhance Investment Advisers’ Disclosure, Including Derivatives Exposure, on Form ADV: The Securities and Exchange Commission amended various of its rules under the Investment Advisers Act to require advisers to disclose on their Form ADVs filed with it additional information regarding their separately managed accounts. (Form ADV is used by investment advisers to register with the SEC and state securities authorities; click here for background.) In addition, the amended rules enable private funder adviser entities that operate a single advisory business to register using a single Form ADV. The new amendments will be effective 60 days after they are published in the Federal Register.
  • CFTC Grants SEF Registration to Seed SEF LLC: The Commodity Futures Trading Commission approved Seed SEF LLC as a swap execution facility. Seed’s website indicates that it will offer swap products in “emerging agricultural markets with idiosyncratic production risks.” Apparently, its first swap products will be derivatives based on hemp, a type of cannabis plant.

Totally Irrelevant (But Is It?): I guess buyers and sellers in this marketplace will conclusively get to determine whether the grass is truly greener on the other side. I presume they each hope that is not the case.

August 29, 2016
How New CEOs Use Disclosure to Cut Uncertainty and Boost Their Careers
by Khrystyna Bochkay, Roman Chychyla and Dhananjay Nanda

For chief executive officers, communication is essential. It allows them to help stakeholders understand a company’s strategies and form opinions about the company’s prospects as well as the CEO’s ability to create value. While effective communication is important at every stage of a CEO’s career, it is most salient at times of increased uncertainty around CEO transitions. A new CEO does not get a second chance to make a good first impression on employees, customers and investors, and because a CEO is in the spotlight as the company’s leader, a CEO’s every statement and move are scrutinized for what he or she is planning to do. For example, Marissa Mayer, appointed Yahoo CEO in July 2012, started her first earnings conference call with analysts and investors with a discussion of "the vision and direction for Yahoo moving forward…Our goals are simple: execute faster, return value to our shareholders, attract the best talent and make Yahoo the absolute best place to work."

New CEOs’ disclosures about their firms’ prospects can allay stakeholder uncertainty about their management’s ability: No one likes uncertainty – neither outside stakeholders such as investors and creditors, nor insiders like employees. Investors, creditors, and employees all expect a new leader to show them a credible and promising path even if it is too early for the leader to possess precise information about the outcomes of their strategic plans. A CEO’s message, optimism and confidence can alleviate stakeholders’ concerns by reducing uncertainty about management’s ability and their company’s future. This is especially true for CEOs appointed when their company is performing poorly and for CEOs that lack a history of publicly observable executive experience.

In contrast, CEOs’ future-oriented information disclosures and their optimism potentially increase with their job experience. As they gain on-the-job knowledge, CEOs enhance their expertise so that stakeholders perceive information that they disclose as more credible. The increasing credibility leads investors and creditors to demand that their CEOs enhance their disclosures about their firms’ prospects. Further, a CEO’s job and career security increase over their tenure as they demonstrate superior performance. Consequently, CEOs are increasingly confident and optimistic about their firms’ future.

To test these competing predictions, we analyze the communication styles in quarterly earnings conference calls of 670 newly appointed CEOs who begin their career as CEOs at publicly listed U.S. firms after 2005. Earnings calls connect a company’s top management with participating analysts and investors. Typically, a call starts with a brief introduction of the management team present on the call and a legal disclaimer about forward-looking statements. Then company executives (CEO, CFO, etc.) give an overview of the operating performance for the quarter just ended and provide information on future plans and operations. After the introductory statements by managers, the call is opened to questions from analysts and investors. Since conference calls are periodic events that contain managers’ prepared statements and spontaneous responses to participants’ questions, they provide an ideal setting for examining CEOs’ communication styles.

Using textual analysis techniques on a large sample of quarterly earnings conference calls, we are able to identify CEO-specific statements in earnings conference calls and determine the degree of future-orientation and optimism in CEO disclosures. CEOs who disclose more information about the future and use more positive language in their communications are deemed more open and optimistic about their strategies and plans. We measure executives’ future-oriented language as the number of sentences in a conference call that include future-oriented phrases scaled by the total number of spoken sentences, and their optimism by the relative difference between positive and negative words in their sentences, scaled by the total number of spoken words.

We find that the amount of CEOs’ future-oriented disclosures and their optimism decrease over their tenure – CEOs are more forthcoming and optimistic in their communications with investors and analysts at the beginning of their appointment but both measures decline over time. The average decline in forward-looking information and relative optimism is substantial, 13 percent year over year. Further, we find that the number of positive spoken words by a CEO declines while the number of negative words increases over their tenure. In addition to our primary sample of CEOs who start their appointment after 2005, we find that our identified negative relation between CEOs’ communication styles and their tenure maintains in a sample of successful CEOs – those who maintained their position for at least 18 quarters.


To examine whether our observed relation between CEO tenure and disclosure style is truly CEO driven rather than affected by other changes in company characteristics around executive transitions, we also study the future-orientation and optimism in statements made by firm officers other than the CEOs (e.g., CFO or COO) in each quarterly earnings conference call, over their CEOs’ tenure. We find that the future-oriented disclosures and optimism of non-CEO officers does not change over their CEO’s tenure. That leads us to conclude that the empirically observed relation between CEO disclosure style and CEO tenure is essentially CEO-specific and a result of the temporal decline in the perceived uncertainty about executive ability that alleviates their career concerns.

Since uncertainty surrounding CEO appointments is heightened for CEOs facing greater career concerns and those who are not well known to investors, we separately analyze communication styles of CEOs who are hired following poor company performance, CEOs who are hired from outside the firm, CEOs who are younger and CEOs lacking prior executive experience. We find that externally hired CEOs, those lacking prior executive experience and those appointed following poor firm performance are more forthcoming in disclosing their strategies and prospects. Younger and inexperienced CEOs are more optimistic in their conference call communications. These results further demonstrate that CEOs use their communication styles to mitigate increased corporate uncertainty following their appointment, and that their communication styles are affected by their concerns regarding the executive labor market’s beliefs about their managerial ability.

Overall, our empirical analysis demonstrates the dynamically changing communication styles of CEOs over their tenures in response to the uncertainty about their ability perceived by their firms’ stakeholders. To alleviate stakeholder concerns about firm prospects and to favorably impress outsiders, CEOs disclose more about the future and are more optimistic about their plans in early years of their career. Given that CEOs’ information dissemination attracts a great deal of attention from their firms’ investors, creditors, customers and employees, our study provides important evidence about executives’ motives that affect their disclosing behavior.

This post comes to us from assistant professors Khrystyna Bochkay and Roman Chychyla and Professor Dhananjay Nanda of the University of Miami School of Business Administration. It is based on their paper, "CEO Ability Uncertainty, Career Concerns and Voluntary Disclosure," available here.



August 29, 2016
PwC explains New Margin Rule for Broker-Dealers in To-Be-Announced Transactions
by Dan Ryan, Mike Alix, Adam Gilbert, Grace Vogel and Armen Meyer

On August 15, the Financial Industry Regulatory Authority (FINRA) issued a regulatory notice adopting a requirement that U.S. registered broker-dealers collect margin on To-Be-Announced (TBA) transactions (FINRA Rule 4210).[1] FINRA’s action follows the Securities and Exchange Commission’s approval of FINRA’s earlier proposal[2] which was amended several times.

TBA transactions serve as a significant funding and hedging vehicle for consumer mortgage originations and provide liquidity in the secondary market for mortgage loans. These products have over $184 billion in average daily trading volume, second only to U.S. Treasuries, and have historically not been subject to margin requirements. The Rule is designed to reduce the counterparty credit risk TBAs expose broker-dealers to as a result of TBAs’ long settlement durations.

Under FINRA Rule 4210, broker-dealers will have to collect margin from most customers for the majority of TBA transactions (unless the transaction is centrally cleared through a registered agency, among certain other exceptions). The broker-dealer will also have to deduct from its regulatory net capital any required margin that is not collected by the close of the next business day.

The Rule generally implements recommendations from the Treasury Market Practices Group (TMPG) made in 2012. Several of the largest broker-dealers have been preparing for the Rule since the TMPG issued its recommendation; however, most firms have a great deal to do before the Rule’s upcoming compliance deadlines.

The Rule divides compliance into two phases. The first phase requires that credit risk limits be assigned to each counterparty by December 15, 2016 (consistent with the broker-dealer’s risk policies and procedures). The second phase applies the rest of the Rule’s requirements (e.g., margin and net capital deductions) by December 15, 2017. We suggest that firms begin implementation efforts now, as the rule is complex and likely to present significant operational challenges.

The Rule

The Rule requires FINRA member firms to collect margin from most counterparties for the majority of their TBA transactions. These transactions are forward mortgage-backed security (MBS) trades in which the parties agree to a price and certain characteristics of the MBS (including estimated face value), but the actual MBS that will be delivered to fulfill the trade is not designated until two days before the settlement date. As a result, the broker-dealer is exposed to credit risk for an extended period, often several months.

The Rule first requires that FINRA member firms set and apply a credit risk limit to each counterparty based on the counterparty’s risk, as determined by a credit risk officer or a credit risk committee. These limits are also required for transactions beyond TBAs, as further prescribed by the Rule.

More significant, the Rule requires that member firms collect both maintenance margin and mark-to-market losses (MTM) from smaller counterparties[3] and collect only MTM from most other counterparties.[4] These margins must be posted by the close of business on the next business day after a margin deficiency arises. However, if the margin deficiency is less than a $250,000 de minimis threshold, the broker-dealer may choose not to collect the margin (depending on the broker-dealer’s risk appetite vis-a-vis the counterparty) and may similarly choose not to collect margin for TBAs involving multifamily housing or project loan programs.

Finally, the Rule calls for net capital deductions and concentration limits related to uncollected margin, as further described below. The Appendix to this brief provides a graphic representation of the Rule’s requirements.


The requirement to collect margin will be a heavy lift for firms that have historically booked these transactions in cash and delivery-versus-payment (DVP) accounts because these types of accounts are generally not operationally equipped to deal with margin. The margin requirements will be especially problematic for broker-dealers with investment adviser (IA) counterparties because the broker-dealer will have to "look through" the IA to calculate and collect margin for each of the IA’s underlying customers. However, for the purpose of establishing credit risk limits, the broker-dealer need not "look through" the IA but may assign this limit to the IA as a whole.

MTM is generally required on TBA transactions with broker-dealers, banks, insurance companies, IAs, and private funds (e.g., hedge and private equity funds), or individuals, with financial assets of more than $40 million and a net-worth of more than $45 million, among others.[5] MTM must be calculated daily, and any outstanding MTM calls that exceed the $250,000 de minimis threshold must be collected by the broker-dealer. When calculating outstanding margin, broker-dealers are permitted to net mark-to-market profit and losses within the same counterparty’s account.

Maintenance margin is essentially only required from smaller private funds (e.g., hedge funds and private equity firms), or individuals, with financial assets less than $40 million and a net-worth less than $45 million. As an added wrinkle, maintenance margin must also be collected from mortgage bankers that are not using TBA transactions to hedge loan commitments. This adds another level of operational complexity to firms’ compliance, as the rule puts the onus on broker-dealers to monitor mortgage bankers’ loan pipelines and ensure that TBAs are used for hedging purposes only.

Net capital deductions and concentration

The rule accounts for the possibility that a broker-dealer may fail to immediately collect margin. In such situations, the broker-dealer must then deduct the uncollected amount from its regulatory net capital by the end of the next business day. If the margin remains uncollected after five business days, the broker-dealer must then liquidate the portion of the TBA transaction necessary to meet the margin deficiency, unless the broker-dealer requests and is granted an extension by FINRA.

Broker-dealers must also notify FINRA, and cease engaging in new TBA transactions,[6] if total net capital charges (i.e., uncollected margin) over five business days exceed a "concentration threshold." The concentration threshold is exceeded if the uncollected margin for a single account (or group of commonly controlled accounts) reaches 5 percent of the firm’s tentative net capital or reaches 25 percent of the firm’s tentative net capital for all accounts combined. Any margin deficiencies resulting from the $250,000 de minimis threshold also count towards the concentration threshold,[7] as detailed in the Appendix.

How should firms prepare?

Implementing the processes to calculate and collect margin under the Rule will pose significant challenges to firms. To prepare, broker-dealers should do the following.


Most firms need to enhance their operational capabilities. This effort will require firms to:

  • Determine for each counterparty whether it must collect MTM, or both MTM and maintenance margin (i.e., determine requirements based on whether the counterparty is "exempt" or "non-exempt" as described by the Rule). Proper counterparty coding will be critical.
  • Classify each account managed by an IA-counterparty as "exempt" or "non-exempt" based upon the account’s owner. Consideration should be given to seeking attestation from the IA that all of their accounts meet the definition of an "exempt" counterparty, unless the broker-dealer is informed otherwise.
  • Put in place infrastructure to calculate and collect margin, and to net mark-to-market profit and losses within the same counterparty’s account.
  • Establish a process to capture outstanding margin below the $250,000 de minimis level, in order to determine if margin should be collected and to track it against concentration thresholds.
  • Implement infrastructure to track and code transactions for which margin is not required
    (e.g., centrally cleared transactions, and TBAs involving multi-family housing or project loan programs).

Establish processes to ensure margin is collected within the required five business days, TBAs can be liquidated if needed for margin that goes uncollected beyond five business days, and extensions can be obtained from FINRA as applicable.


Amend existing customer agreements in order to:

  • Ensure agreements include the $250,000 de mimimis
  • Consider obtaining an attestation from each mortgage banker using TBAs to hedge, which states that the securities in their account are used solely for hedging. These attestations should be renewed regularly.


Firms should assign risk limits to each counterparty and actively monitor their credit exposure (even beyond TBA transactions):

  • Designate a credit risk officer or credit risk committee to establish risk limits in accordance with risk policies and procedures.
  • Establish a daily process to ensure limits are not breached.


Firms should update policies and procedures to reflect the Rule’s requirements and also:

  • Enhance processes to incorporate margin deficiencies into daily net capital calculations.
  • Establish a process to monitor and report to FINRA when the Rule’s concentration thresholds are breached (and restrict TBA activity).

Appendix – Is your TBA transaction subject to margin requirements?

The following chart depicts from which counterparties broker-dealers must collect margin and the associated net capital deductions and concentration thresholds. The chart also depicts the types of transactions that obviate the need for collecting margin regardless of counterparty.

Broker-dealer requirements
Counterparty or transaction Maintenance margin? MTM? Net capital deductions? Concentration thresholds? Rule reference
Counterparty-based requirements


Smaller private funds, and individuals, with net-worth < $45mm and financial assets < $40mm

Mortgage bankers not using the TBA to hedge loan commitments

Yes Yes Yes Yes (e)(2)(H)(ii)(e)
Larger private funds, and individuals, with net-worth > $45mm and financial assets > $40mm



Insurance companies

Investment advisers

Investment companies

State/local gov’t entities

Savings associations

Mortgage bankers using the TBA to hedge loan commitments

No Yes Yes Yes (e)(2)(H)(ii)(d)
Counterparties with gross open positions < $10mm, and certain other characteristics No No No Yes (e)(2)(H)(ii)(c).2
Federal banking agencies and similar entities No No No No (e)(2)(H)(ii)(a).1
Transaction-based exceptions De minimis margin outstanding (< $250,000) No No No Yes (e)(2)(H)(ii)(f)
Multi-family housing or project loan programs No No No No (e)(2)(H)(ii)(a).2
Centrally cleared TBAs No No No No (e)(2)(H)(ii)(c).1


[1] In addition to TBAs, FINRA Rule 4210 (or "the Rule") applies to Specified Pool Transactions and Collateralized Mortgage Transactions, which FINRA collectively defines as "Covered Agency Transactions." However, TBAs constitute the majority of Covered Agency Transactions market, so this brief refers to all of these as "TBAs" for simplicity.

[2] See PwC’s Regulatory brief, Mandatory margin on TBAs: TBD, but not for long (July 2014).

[3] The Rule refers to these smaller counterparties as "non-exempt" counterparties. These counterparties must post maintenance margin, in addition to having to post MTM like most other counterparties. These counterparties are generally small private funds (e.g., hedge and private equity funds), or individuals, with financial assets less than $40 million and a net-worth of less than $45 million.

[4] The Rule refers to these other counterparties as "exempt" counterparties because they do not have to post maintenance margin. These counterparties must still post MTM and are described in more detail below (and in the next footnote). However, the Rule explicitly excludes the following entities from any margin requirements: federal banking agencies, central banks, multinational central banks, foreign sovereigns, multilateral development banks, and the Bank for International Settlements. Furthermore, the broker-dealer need not collect margin from counterparties with gross open positions of $10 million or less if (a) the transaction settles and trades in the same month (or settles in the month after it trades) and (b) the counterparty regularly settles its TBAs on a DVP basis or for cash and does not engage in certain financing techniques such as dollar rolls or round robin trades in its TBA transactions with the broker-dealer.

[5] Other "exempt" counterparties (see prior note) that only need to post MTM include savings associations, investment companies, state and local government entities, and mortgage bankers that transact in TBAs for hedging purposes.

[6] If the concentration threshold reaches 5% by a single account, the broker-dealer must cease doing additional business with the account. If the threshold reaches 25% across all accounts, the broker-dealer must put a hold across all accounts on any new TBA transactions.

[7] Deficiencies from daily MTM and maintenance margin requirements for accounts with gross open positions of $10 million or less also count towards the concentration threshold if they generally settle on a DVP basis. See note 4 for further detail.

This post comes to us from PwC. It is based on the firm’s Regulatory Brief for August 2016, which is available here.

August 29, 2016
Blockholders: a Survey of Theory and Evidence
by Alex Edmans, Clifford Holderness
Editor's Note:

Alex Edmans is Professor of Finance at London Business School and Clifford G. Holderness is Professor of Finance at the Boston College Carroll School of Management. This post is based on a recent paper by Professors Edmans and Holderness. Related research from the Program on Corporate Governance includes The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

Our new paper, Blockholders: a Survey of Theory and Evidence, surveys the role of large shareholders in corporate governance. We start by analyzing the underlying property rights of public corporations and blockholders. How are public corporations similar to other forms of private property and how are they different? We then define a blockholder by discussing what distinguishes it from an ordinary shareholder. Next, we present new evidence on the frequency, size, and board representation of blockholders in United States corporations and the resulting association with firm characteristics. We then develop a simple unifying model to present theories of blockholder governance through two channels. The first, traditional channel is direct intervention in a firm’s operations, otherwise known as “voice.” These theories have motivated empirical research on the determinants and consequences of activism. The second, more recent channel is selling one’s shares if the manager underperforms, otherwise known as “exit.” These theories give rise to new empirical studies on the two-way relationship between blockholders and financial markets, linking corporate finance with asset pricing. We survey the empirical evidence on blockholder governance and close with suggestions for future research.

Our major conclusions are as follows:

  • Blockholders are ubiquitous. Virtually every corporation, of every size, in every country has them. It is hard to imagine how firms could survive in a market economy without large shareholders. In short, they are important to study.
  • There is no unambiguous definition of a blockholder. There is no theoretical basis for the commonly used 5% threshold or indeed any threshold. Future research should study blocks below 5% when possible.
  • The dollar value of a block or the concentration of the block in an investor’s portfolio could matter as much as the percentage value of a block. These are much-neglected topics ripe for study.
  • Blockholders are endogenous. We know of no known credible instruments for block ownership. Insistence on clean identification will result in a focus on narrow questions or the avoidance of research on blockholders altogether; studies should be led by economics, not econometrics. Much can be learned by careful analyses of blockholders in different settings using a variety of methods. Descriptive analyses can be illuminating if researchers are careful not to make causal claims.
  • Blockholders are heterogeneous: they include hedge funds, mutual funds, pension funds, individuals, and other corporations. Each has its own determinants, incentives, and consequences. Most research, however, treats all blockholders as homogenous.
  • Blockholders interact. Although existing research often considers blockholders in isolation, the presence of one blockholder can increase or decrease the effectiveness of other blockholders or even smaller shareholders. Moreover, the direction of complementarity likely varies by blockholder type. For example, an activist blockholder may deter the entry of a second activist, but she may be catalyzed by non-activist blockholders who can potentially vote in the same direction.
  • Blockholders are evolving. For example, institutional investors today are more willing to be hostile toward management than they were only 30 years ago.
  • Blockholders can govern through exit, not just through voice. This new way of thinking about blockholders—as informed traders, rather than just as controlling entities—gives rise to new directions for both theoretical and empirical research. Blockholders can both impact and be impacted by financial markets, thereby linking asset pricing with corporate finance.
  • Blockholders can exert governance through the threat of exit and voice, rather than only through actual exit and voice. The absence of these actions, therefore, does not imply the absence of blockholder governance. Identifying such threats and their effect on firm outcomes is challenging but important.

The full paper is available for download here.

August 29, 2016
We Have a Consensus on Fraud on the Market - And It's Wrong
by James Spindler
Editor's Note:

James C. Spindler is Sylvan Lang Professor of Law at University of Texas Law School; and Professor, University of Texas McCombs School of Business. This post is based on a forthcoming article by Professor Spindler. Related research from the Program on Corporate Governance includes Rethinking Basic by Lucian Bebchuk and Allen Ferrell, discussed on the Forum here.

Fraud on the market litigation has faced existential challenges in recent years, fueled by a broad academic policy consensus that it “just doesn’t work.” This consensus has, in large part, focused on two theoretical critiques of private securities litigation, the “diversification critique” and the “circularity critique.” The diversification critique holds that potential fraud losses to investors may be eliminated through diversification: an investor will lose from fraud on some trades, but gain on others, and this ought to even out in the end.[1] The circularity critique argues that, since plaintiffs are typically shareholders of the defendant firm, the fraud on the market remedy amounts to shareholders suing themselves, achieving no meaningful compensation, and merely shifting money from one pocket to the other.[2]

These critiques have flourished among academics, and have found their way into policy papers, court opinions, Congressional testimony, and even the recent Halliburton pleadings. Clearly, if fraud does not harm investors (diversification), and fraud on the market remedies do not compensate them anyhow (circularity), the implications for reform are vast and profound. These critiques are arguably the most important innovations in theoretical securities law of the past quarter century.

However, as discussed in a forthcoming article,[3] the diversification and circularity critiques are themselves fatally flawed. They should be abandoned, and the reform proposals springing from them rethought.

The diversification critique reflects a fundamental mistake as to what diversification can and cannot do: neither expected losses to better-informed traders, nor resources expended to avoid such expropriation, can be diversified away. Consider the case where two investors, a seller and a buyer, are deciding whether to transact a share of stock whose price is uncertain. If neither of the investors has an informational advantage over the other, then each may expect to be a winner as often as a loser—and, indeed, here the diversification critique appears to be correct. However, suppose that one of the investors has the ability to expend resources investigating the share’s true value (“precaution costs” or “search costs”): this will provide her with a better estimate of the firm’s value, and she can refuse to buy/sell when the share is overpriced/underpriced. In this case, she (the “informed trader”) has positive expected gains, and her counterparty (the “uninformed trader”) has positive expected losses. This would be true no matter how many independent iterations of the game occur—that is, even in a diversified setting, the informed trader expects to win on average, and the uninformed expects to lose. Further, the best response of the uninformed trader may be to engage in precaution costs himself: expend resources becoming informed, abstain from trading, or pay a securities professional to manage his money. In reality, these costs are substantial.[4] This is a form of Prisoners’ Dilemma or collective action problem. These precaution costs are socially inefficient, and of course they do not diversify away.

The circularity critique fails because, as it turns out, the fraud on the market remedy is compensatory and, under plausible conditions, is perfectly compensatory. Just as a non-pro-rata dividend transfers wealth among shareholders, so too does the fraud on the market remedy provide a net transfer to the plaintiff class. Further, the fraud on the market remedy accounts for the degree to which plaintiffs fund their own recoveries, and automatically adjusts via the stock price. While the paper derives a complete mathematical solution, consider here the following example: Suppose that of a firm’s 10 shares outstanding, 2 shares are held by a fraud on the market plaintiff. If the fraud inflated the firm’s value by $1, a first cut would estimate a per share recovery of $1 (for $2 total). However, the anticipation of paying out $2 causes all shares (including plaintiff shares) to decline by another $0.20, so that the total payout will be $2.40, which increases the decline, and so on. This process asymptotes to a total payout of $2.50, which restores the plaintiff to the status quo ante.[5] Hence, compensation of defrauded plaintiffs is complete. This is important, not just because the circularity critique is wrong, but because a compensatory remedy reduces or removes the incentive to engage in precaution costs in the first place. Hence, fraud on the market is potentially, in theory, a valid way to avoid a Prisoners’ Dilemma of precaution costs and restore the social optimum.

What are the lessons to be drawn from this? First, the diversification and circularity critiques should be abandoned because they are, simply, wrong. Second, the trend of cutbacks and existential challenges fueled by these critiques should be rethought. Even if there are problems with securities litigation as it currently exists, it is important to understand correctly what those problems are—which, as scholarship currently stands, we do not.

The full article is available for download here.


[1] The following is representative of the diversification critique: “For every shareholder who bought at a fraudulently inflated price, another shareholder has sold: The buyer’s individual loss is offset by the seller’s gain, investors can expect to win as often as lose from fraudulently distorted prices. With no expected loss from fraud on the market, shareholders do not need to take precautions against the fraud; they can protect themselves against fraud much more cheaply through diversification. Losses from the few fraudulent bad apples will be offset by the gains from the honest companies.” Adam C. Pritchard, Evaluating S. 1551: The Liability For Aiding and Abetting Securities Violations Act of 2009: Hearing Before the Committee on the Judiciary, Subcommittee on Crime and Drugs of the United States Senate, September 17, 2009 at 3-4.
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[2] The circularity critique takes various forms; a fairly strong form was stated by the so-called Paulson Committee. “[Securities class action] recovery is largely paid by diversified shareholders to diversified shareholders and thus represents a pocket-shifting wealth transfer that compensates no one in any meaningful sense and that incurs substantial wasteful transaction costs in the process.” Interim Report of the Committee on Capital Markets Regulation, Section III, November 30, 2006, at 79 (available at
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[3] James Cameron Spindler, We Have a Consensus on Fraud on the Market—And It’s Wrong, forthcoming Harvard Business Law Review 2017, (available at
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[4] One conservative estimate of fund management fees alone puts them at over $600 billion. See Charles M.C. Lee, Eric S. So, Alphanomics: The Informational Underpinnings of Market Efficiency, 9 Foundations and Trends in Accounting 59, at 80—81 (2015).
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[5] The derived formula is that the per share remedy equals the per share fraudulent price inflation (here, $1) divided by 1 minus the proportion of plaintiff shares (here, 20%).
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August 29, 2016
SEC Charges Firm, Promoters With Offering Fraud
by Tom Gorman

The SEC brought another offering fraud action centered on false projections by an issuer regarding its expected performance. Unlike the action filed early last week, this one did not settle and is headed for litigation. SEC v. Enviro Board Corporation, Civil Action No. 2:16-cv-0427 (C.D. Cal. Filed August 26, 2016).

Named as defendants in the action are the company, supposedly a firm that would profit from recycling agricultural waste products; Glenn Camp, its co-founder and co-chairman, and co-CEO; William Peiffer, its co-founder, co-chairman and co-CEO; and Joshua Mosshart, who solicited investors.

The firm traces its roots to 1992. It planned to develop a technology that would permit the manufacturing of low-cost, environmentally-friendly building panels out of straw and other agricultural waste fiber. Over twenty year period the firm was only able to construct prototypes. Development was suspended in 2011. The offerings were not.

From 2011 through 2014 the defendants offered and sold securities to nearly 40 investors in several states, raising about $6 million. Investors purchased about $3 million in stock, $2 million in bonds that were supposedly secured by tax credits, $1 million in unsecured bonds and $50,000 in promissory notes.

Key to the solicitations was a PPM furnished to investors. Each iteration of that memorandum contained financial projections for the firm, although precise numbers in each differed. For example, the PPM used in 2011 forecast about $42.8 million in revenue and $30.8 million in net income. The mid-2012 – 2013 version claimed that revenue would be $58.8 million and that there would be $32.3 million in net income. Both sets of projections were for the first year of operations.

The revenue was projected to come from three sources: the sale of certain tax credits once the firm successfully commercialized its technology, the sale of products and the sale of mills and associated royalty payments. The PPMs also represented that the firm had previously designed and installed a viable product line, that its panels were available in two sizes and already in use and that the company had secured about $161 million in "vendor financing."

Those representations had no basis in fact. The company never generated any meaningful operating revenue. The individual defendants did, however, profit, taking as much as $2.6 million of the offering proceeds as compensation. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 15(b). The case is in litigation. See Lit. Rel. No. 23628 (August 26, 2016).

August 29, 2016
BRT's Updated Governance Principles: What's Good for the Goose...
by John Jenkins

The Business Roundtable recently updated its "Corporate Governance Principles" for the first time since 2012. The updates focus on encouraging more shareholder engagement, boardroom diversity, and cybersecurity. But the most interesting part of the update may be its call for increased shareholder responsibility & accountability.

The BRT contends that an increase in shareholder access to the boardroom requires an increase in transparency regarding the "nature of [a shareholder’s] identity and ownership, even in cases where the federal securities laws may not specifically require disclosure." But its call for shareholder responsibility goes well beyond that:

More fundamentally, we believe that the responsibility of shareholders extends beyond disclosure. We sense that there is a rising belief that shareholders cannot seek additional empowerment without assuming some accountability for the goal of long-term value creation for all shareholders. Moreover, we believe that shareholders should not use their investments in U.S. public companies for purposes that are not in keeping with the purposes of for-profit public enterprises, including but not limited to the advancement of personal or social agendas unrelated and/or immaterial to the company’s business strategy.

Well, when you put it that way – sure, personal and social agendas that aren’t material to the company’s business have no place in the shareholder dialogue. We can’t argue about that, right?

Should Shareholders Be Engaging Over Social Issues?

Okay, maybe we can argue about that. There are a lot of investors who would take issue with the BRT’s position on advancing "personal or social agendas." Some heavy hitters contend that the environmental, social and governance (ESG) issues that others would lump into this category are closely linked with long-term value creation. For example, here’s an excerpt of what BlackRock’s Investment Stewardship team says on the subject:

ESG considerations are integral to our investment stewardship activities. Our clients are long-term investors and it is over the longer term that ESG risks and opportunities tend to be material and have the potential to impact financial returns. The best companies ensure that their investors, as well as other constituents of the company, have enough information to understand the drivers of, and risks to, sustainable financial performance.

When it’s put like this, disagreeing with the importance of ESG issues sounds akin to disrespecting mom or apple pie.

The problem with this debate is that vague concepts like "sustainable financial performance," "long-term value creation," and the need to avoid agendas "that are not in keeping with the purposes of for-profit public enterprises" don’t add a whole lot to the conversation about where to draw the line between legitimate investment concerns and frivolous personal agendas.

Poll: Should Shareholders Be Engaging Over Social Issues?

Please take a moment to participate in this anonymous poll:

John Jenkins

August 28, 2016
Do CEOs Affect Employee Political Choices?
by Ilona Babenko, Song Zhang, Viktar Fedaseyeu
Editor's Note:

Ilona Babenko is Associate Professor at W.P. Carey School of Business at Arizona State University. This post is based on a recent paper by Professor Babenko, Viktar Fedaseyeu, Assistant Professor in the Department of Finance at Bocconi University, and Song Zhang, University of Lugano and Swiss Finance Institute.

Do CEOs affect political choices of their employees? Using a large sample of U.S. firms, we find evidence that they do. First, we document that employees donate significantly more money to CEO-supported political candidates than to otherwise similar candidates not supported by the CEO. In 2012, for example, Barack Obama raised three times more money from employees of firms whose CEOs donated to him than from employees of firms whose CEOs donated to Mitt Romney (see Figure). We find similar effects for all federal elections (House, Senate, and President). Second, we find that employees located in congressional districts where CEOs support political candidates are more likely to vote in elections, suggesting that CEOs can affect not only their employees’ campaign contributions but also voter turnout.


Interactions between firms and politicians have received substantial attention in the literature. Firms can invest in political capital by establishing direct connections with legislators, for example through employment of current or former politicians (Faccio (2006), Faccio, Masulis and McConnell (2006)), by spending money on lobbying (Borisov, Goldman, and Gupta (2015)), and by financing candidates’ political campaigns through corporate political action committees, known as PACs (e.g., Cooper, Gulen, and Ovtchinnikov (2010), Akey (2015)). These activities may create value for firms’ shareholders because of subsidies, preferential allocation of government contracts and external financing, less strict regulation, and lighter taxation. Yet another, and largely unexplored, mechanism through which firms can establish political connections is campaign contributions made by their employees. This mechanism can be important since political contributions made by individuals in the United States far exceed those made by corporate PACs (e.g., Ansolabehere, de Figueiredo, and Snyder (2003)).

Our first result is that CEOs and employees tend to donate to the same political candidates. This relation per se is not necessarily causal, but neither is it to be expected. On one hand, the livelihoods of both the CEO and the firm’s employees are at least partially tied to the success of their firm, which makes them susceptible to common economic forces and may result in a contemporaneous relation between their political donations. On the other hand, participation in the political process is a high civic duty of an individual and is not determined by economic factors alone. Moreover, employees typically have different socioeconomic characteristics from those of CEOs and may favor different political outcomes. Thus, we further analyze the relation between CEO and employee contributions and investigate the mechanisms that may give rise to such a relation.

The relation between CEO and employee political contributions may exist either because they share a common set of political and economic goals or because CEOs explicitly advocate for their preferred candidates. We find evidence consistent with the second explanation. In particular, we show that CEO influence cannot be explained by common geographic factors or candidate strength. We also show that the relation we document holds around CEO turnover (including plausibly exogenous turnovers caused by natural retirement or death), which indicates that changes in employee contributions result from changes in how their CEOs donate and not the other way around. Also consistent with the idea that CEOs have direct influence over their employees’ political choices, we show that the link between CEO and employee campaign contributions is strongest in firms that explicitly advocate for political candidates. While we cannot observe all communication by CEOs on election matters, the U.S. federal law requires corporations that spend more than $2,000 per election on express advocacy of the election or defeat of a political candidate to report such communication costs to the Federal Election Commission. We find that the estimated effect of CEOs on employee contributions goes up by more than five times in firms that report communication costs. Thus, our results cannot be fully explained by common economic shocks or reverse causality (i.e., by CEOs observing political preferences of their employees and contributing to the candidates favored by them).

We also analyze cases when CEO impact is likely to be most effective and find that politically connected CEOs and CEOs of firms from heavily regulated industries are more successful in influencing how their employees donate. Further, employees are more likely to contribute money to the candidates supported by the CEO if those candidates are members of congressional committees with direct jurisdiction over the firm.

Campaign contributions are not the only way in which employees participate in the political process. Since most employees are voters, they can also directly affect electoral outcomes by going to the polls and voting for a particular candidate. While anecdotal evidence suggests that CEOs attempt to influence how their employees vote, we are not aware of any study analyzing the success of such attempts. Prior research does show, however, that voter turnout can be substantially increased through direct contact and communication with the voters (e.g., Gerber and Green (2000)). To study whether CEOs are effective in mobilizing their employees to vote, we use individual employee survey data from the NBER’s Shared Capitalism Research Project, which contains self-reported information on voting behavior (Kruse, Freeman, and Blasi (2010)). We find that employees located in areas in which CEOs make campaign contributions are approximately 11.5% more likely to vote than employees in other areas.

Overall, our evidence indicates that CEOs are a political force, with potentially important welfare implications for firms they manage and for the nature of democracy. These welfare implications depend both on whether CEOs promote their own political agenda or act in the interests of the firm, and on whether the interests of the firm coincide with the interests of its employees. If CEOs only promote their own political agenda, then their impact on employee contributions is likely to be welfare decreasing. While we cannot rule out that CEOs pursue personal political goals, our evidence does indicate that at least some of their political impact is driven by the interests of the firms they run: CEOs appear to exert greater influence on employee contributions in regulated industries and to candidates with jurisdiction over the firm, both of which are likely to be correlated with firm-specific benefits from political participation but not necessarily with CEOs’ political ambition.

The full paper is available for download here.

August 27, 2016
Recovery and Resolution: Uneven Bars for CCPs and Banks
by Adam Gilbert, Armen Meyer, Dan Ryan, Mike Alix, PricewaterhouseCoopers
Editor's Note:

Dan Ryan is Leader of the Financial Services Advisory Practice at PricewaterhouseCoopers LLP. This post is based on a PwC publication by Mr. Ryan, Mike Alix, Adam Gilbert, and Armen Meyer.

The CFTC last month issued extensive new recovery and resolution planning guidance (CFTC Guidance) for central counterparty clearinghouses (CCPs).[1] While banks and insurance companies have recently received some relief with respect to their resolution plans,[2] the CFTC Guidance significantly raises the bar on the depth and breadth of detail and analysis expected for CCPs.

The CFTC was the first CCP supervisor to finalize a rule (in 2013) establishing recovery and resolution planning requirements.[3] The CFTC Guidance significantly expands on the 2013 rule and demonstrates that the CFTC is once again leading the advancement of CCPs’ recovery and resolution planning. Although this guidance only applies to the CFTC-regulated CCPs, it is likely to be followed (in at least some respects) by other CCP regulators given CCPs’ increasing importance to the global financial infrastructure.

In fact, international standard setters released new documents this week concerning the financial and operational resilience of CCPs.[4] The Financial Stability Board (FSB) issued a series of questions for the industry on CCP resolution planning, which will be incorporated in FSB guidance to be released in 2017. Further, the Committee on Payments and Market Infrastructure and the International Organization of Securities Commissions (CPMI/IOSCO) published reports identifying several areas for improvement in the recovery practices of ten CCPs, as well as further guidance on risk management standards that they had issued in 2014.[5] Even US policymakers have expressed interest in CCPs recently with Senator Mark Warner, Senator Elizabeth Warren, and Representative Elijah Cummings requesting information from two systemically important CCPs on their recovery and resolution plans.

As most major financial institutions are clearing members of at least one systemically important CCP and are dependent on them for clearing and settling of transactions, increased costs faced by CCPs are likely to have impact throughout the industry. However, under the CFTC Guidance, clearing members will gain the opportunity to provide input into the CCPs’ plans.

This post analyzes the key ways in which the CFTC has raised expectations for CCPs’ recovery and resolution plans, and provides our view of next steps.

Expanded recovery and resolution requirements

The CFTC Guidance not only significantly raises the bar on the depth and breadth of CCPs’ resolution and recovery plans, it also goes materially beyond comparable bank guidance.[6] The following five areas of the CFTC Guidance will be among the most challenging for these CCPs to implement.

Plans must analyze at least eight risk scenarios, not limited to idiosyncratic stress situations

The CFTC Guidance requires detailed analysis and recovery planning for a minimum of eight business and operational risk scenarios, in addition to risk scenarios resulting from a clearing member default. This requirement goes well beyond the 2013 rule, which only required CCPs to maintain recovery plans which would account for (1) credit losses and liquidity shortfalls and (2) general business, operational, or other risks that threaten the CCP’s viability. Furthermore, CCPs may need to analyze even more scenarios than these eight since the CFTC Guidance underscores a requirement that the CCP must additionally determine the full range of distinct risks that could require it to activate a recovery plan (each, a “recovery scenario”).[7]

Eight required risk scenarios
  1. A settlement bank failure
  2. A custodian bank failure
  3. Scenarios resulting from investment risk
  4. Poor business results
  5. The financial effects of cybersecurity events
  6. Internal fraud, external fraud, and/or other actions of criminals or public enemies
  7. Legal liability not specific to the CCP’s business as a CCP (e.g., tort liability, liability related to intellectual property)
  8. Losses resulting from interconnections and interdependencies among the CCP and its parent, affiliates, and/or internal or external service providers (e.g., the financial effects of the inability of an internal service provider to supply key systems or services to the CCP)

The CFTC Guidance goes further than guidance for banks which requires them to consider “a wide range of internal and external stresses” rather than prescribing risk scenarios. It also calls for CCPs to consider systemic stress events in their scenarios, which banks similarly do not have to do (although banks must incorporate a severely adverse macro-economic environment). Meeting the CFTC Guidance in this respect will be difficult for CCPs, especially without any assumption of government or programmatic support of the financial system (not specific firms).

Multiple considerations prescribed for each risk scenario, including sequential action plans

Each risk scenario must have a separate recovery analysis which incorporates a minimum of 13 specified considerations. These considerations include detail on (1) the specific sequential actions that the CCP would take for each risk scenario, (2) the governance framework that the CCP would follow to execute the actions, and (3) the financial and operational impact of each action on the CCP, its clearing members, internal and external service providers, and relevant affiliated companies. Although typical bank recovery plans include a potentially lengthy menu of recovery options, the banks are not required to pre-determine precisely which recovery actions would be taken (and in what order) for each possible risk scenario. See the Appendix below for the list of all 13 considerations.

With respect to resolution, the CCP must first describe the point at which it would transition from recovery to resolution. This expectation also differs from that for banks, which currently have separate recovery and resolution planning requirements (although there is evidence of a trend toward convergence of recovery and resolution planning, and associated risk governance). Similar to the recovery analysis, 12 considerations are required for each wind-down option including (1) any options to sell, transfer, or otherwise permanently cease operations and (2) detail on how each of those options would be executed.

Severe risk scenarios could mean more resources, and higher costs for clearing members

CCPs will need to conduct a detailed analysis of the financial and operational resources required to execute each recovery and wind-down option. Given the severity of the scenarios that must be contemplated, including systemic events, the CCP’s analysis may show that it will need additional financial resources in order to execute a recovery or an orderly wind-down. If additional resources are needed, CCPs would likely pass those costs on to their clearing members, either directly or indirectly.

Feasibility testing will result in stronger plans, but also more work

Regular feasibility testing of recovery and wind-down plans is introduced for the first time in the CFTC Guidance. The plans must describe the type of testing performed, including the frequency, methodology, and utilization of the testing results. Feasibility testing has proven to be a very useful tool, often resulting in the identification of gaps or desired enhancements. However, feasibility testing also requires dedication of significant resources and the involvement of clearing members, which could further impact costs for all parties.

Industry coordination and more transparency

Although the CFTC Guidance does not mandate a public section of the recovery and resolution plans, as is required for banks, the CFTC Guidance effectively mandates even greater transparency by requiring CCPs to involve their clearing members in the development, review, and updating of its plans, including feasibility testing, where applicable. The CCPs are asked to detail their clearing members’ involvement in recovery and resolution plan development and governance, and also to address how recovery and wind-down actions are included in the clearinghouse’s rule book. Due to the many clearing members CCPs have,[8] coordinating with them to meet this requirement will provide a great deal of transparency into CCP operations and resilience for the industry.

Next steps

The CFTC Guidance provides welcomed specificity around concepts set forth in the CFTC’s 2013 rule, which was brief and nonprescriptive. Given the severity of required scenarios, including systemic events, recovery and resolution planning holds the potential to unearth the need for CCPs to hold more capital or liquidity, or possibly to have access to additional contingent financial resources.

While the guidance is silent on the effective date, we believe that fully implementing this guidance will be a multi-year iterative process and will involve a very significant dedication of CCP resources. As such, we recommend that CCPs begin to scope out this effort, develop the work plan, and begin work on those areas that will require the most effort such as scenario creation and the detailed analysis.

Appendix A baker’s dozen of considerations for each recovery scenario

The CFTC Guidance delineates 13 elements that should be identified and analyzed for each recovery scenario:

  1. The particular recovery tools that the CCP would expect to use in for that scenario
  2. The specific order in which the CCP would expect to use such tools; the event that would trigger the use of each tool in the sequence; and any discretion that the CCP has in the use and/or sequencing of the tools, the parameters for the exercise of such discretion, the factors that guide such discretion and the governance processes for the exercise of such discretion
  3. Whether each tool is mandatory or voluntary
  4. The specific steps that would be required to implement each tool
  5. The roles, obligations, and responsibilities of the parties that are involved in the use of each tool
  6. The time frame within which each tool could be used
  7. The key risks associated with the use of each tool
  8. The steps that the CCP would expect to take before an event occurs to mitigate such identified risks
  9. Any constraints on the use or effectiveness of each tool
  10. An evaluation of the likelihood that, given the factors identified in 8–9 above, the recovery tool would be effective within the relevant timeframe
  11. The expected impact on the CCP, its clearing members and their customers, its parent, affiliates, and owners, and the financial system more broadly if a particular tool is used; the manner in which the CCP would mitigate any adverse impacts; and the mechanisms by which the CCP would enable its clearing members to understand, measure, manage, and control the exposure created by the tool
  12. Any incentives that would be created by the availability or the use of the tool
  13. The relevant rules or rule amendments that support (or are needed to support) the use of each tool

[1] The CFTC uses the term “Derivative Clearing Organization” (DCO) to refer to the CCPs it regulates. The DCOs subject to the CFTC Guidance are the two designated as systemically important by the Financial Stability Oversight Council (FSOC) (i.e., the Chicago Mercantile Exchange (CME) and ICE Clear Credit (ICE)) and those that opt-in in order to achieve “Qualified CCP” status (which provides favorable capital treatment to the QCCPs’ clearing members). CME and ICE are among the five CCPs (along with three other financial market utilities, together “Systemically Important Financial Market Utilities” or “SIFMUs”) that the FSOC designated as systemically important in 2012. The other SIFMUs are not directly subject to the CFTC Guidance, as they are regulated by the SEC or the Federal Reserve. See PwC’s Regulatory brief: More Scrutiny for Financial Market Utilities (May 2013) for more information.
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[2] Last April, the Federal Reserve and FDIC (Agencies) released feedback that was highly critical of the eight July-filing domestic banks (generally, those US banks with over $250 billion in nonbank assets) and found five of their resolution plans to be “not credible.” At the same time, the Agencies provided some relief by delaying these banks’ next filing date to July 2017. See our post, Agencies’ Resolution Plan Feedback (April 2016). Then in June, the Agencies similarly delayed the four July-filing foreign banks’ next filing date to July 2017, and at the same time issued guidance allowing 84 December-filing banks with limited US operations to file “reduced content” plans for the next three years, beginning on December 31, 2016. See PwC’s First take: Five key points from the Agencies’ FBO resolution plan announcements (June 2016). Finally, this month, the Agencies delayed the filing date for the remaining 38 December-filing institutions (36 banks and two insurance companies) to December 2017 in order to allow them adequate time to incorporate feedback to plans filed in December 2015, which we expect the Agencies to provide by year-end. Overall, we believe these deferrals free the Agencies to focus their attention on the July-filing banks’ plans over the next year and may be an indirect acknowledgement that the annual plan submission cycle is not effective for either the banks or the Agencies.
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[3] Under the 2013 rule, CCPs were required to establish their recovery and resolution plans by December 31, 2013. For more information, see PwC’s Regulatory brief, Systemically important derivatives clearing organizations: The CFTC proposes recovery and wind-down plans (September 2013).
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[4] The international standard setters have provided further detail on some of their expectations for CCP recovery and resolution. Nonetheless, the CFTC’s latest guidance sets a higher bar for CCPs in most respects.
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[5] The FSB and CPMI/IOSCO publications build off of their prior 2014 issuances which are discussed in our post, Financial Market Utilities: Is the System Safer? (February 2015).
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[6] For an analysis of bank resolution planning and recovery guidance, see our posts: Agencies’ Resolution Plan Feedback (April 2016) and OCC’s Recovery Planning Proposal (December 2015); as well as PwC’s Ten key points from the FDIC’s resolution plan guidance (December 2014) and Ten key points from regulators’ feedback to Wave 1 resolution plan filers (August 2014). See also PwC’s Regulatory brief, Recovery planning: Until the last gasp (October 2014).
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[7] However, the CFTC Guidance noted that CCPs do not need to analyze the large range of market risk scenarios that are used for capital and liquidity stress testing purposes. See PwC’s First take, Five key points from the 2016 Comprehensive Capital Analysis and Review (June 2016).
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[8] CME and ICE each have at least 30 clearing members.
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8/29/2016 posts

Bridging the Week: Bridging the Week: August 22 to 26 and August 29, 2016 (Summarily Barred; False Performance Data; Inadequate Disclosure; The Grass Is Greener)
CLS Blue Sky Blog: How New CEOs Use Disclosure to Cut Uncertainty and Boost Their Careers
CLS Blue Sky Blog: PwC explains New Margin Rule for Broker-Dealers in To-Be-Announced Transactions
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Blockholders: a Survey of Theory and Evidence
The Harvard Law School Forum on Corporate Governance and Financial Regulation: We Have a Consensus on Fraud on the Market - And It's Wrong
SEC Actions Blog: SEC Charges Firm, Promoters With Offering Fraud Blog: BRT's Updated Governance Principles: What's Good for the Goose...
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Do CEOs Affect Employee Political Choices?
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Recovery and Resolution: Uneven Bars for CCPs and Banks

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.