United States: Structured Thoughts: Volume 4, Issue 3 - February 6, 2013

Reverse Inquiry Transactions in the Spotlight

“Reverse inquiry transactions” take a variety of forms. In the classic example of a reverse inquiry, a particular investor or its representative reaches out to a structured note manufacturer to request a note of a particular type, underlying asset, and other pricing terms.

In addition, a variety of transaction types, and types of relationships among the parties, fall within this rubric. A prior course of dealing may exist between the investor, on the one hand, and the product manufacturer on the other hand. The parties may engage in ongoing discussions as to a particular transaction type. In addition, an investor may reach out to a variety of manufacturers about the same investment idea, and select the one that reverts with the most favorable pricing terms.

A reverse inquiry transaction can often be effected on a private placement basis, due to the limited number of investors, and (in general) their relative sophistication. And in fact, some institutional investors prefer Rule 144A transactions, in order to maintain the confidentiality of their investment idea as to a particular underlying asset, especially if that underlying asset consists of an individual equity security. However, many (or most) reverse transactions that occur today are effected on a registered basis, since that is often the most convenient “wrapper” for the parties to use for the product. And the registered basis for the offering is one of the key factors (but not the only factor!) that makes these offerings subject to regulation by the SEC and FINRA.

In recent months, a variety of issuers and broker-dealers have received questions from these regulators about these transactions. The aim of these inquiries has been obscure to some extent, and many market participants have been curious about the nature of the review – the investors who make reverse inquiries are often the investors who are most expert in the relevant products, and they are often in a position to negotiate the best economic terms with product manufacturers. As a result, these transactions might at first glance appear to be the ones that would be of reduced interest to securities regulators.

Of course, a variety of “garden variety” securities law and related concerns may be relevant to many reverse inquiry transactions:

  • Is the broker-dealer applying its proper approval and other procedures before effecting a reverse inquiry transaction? For example, is it considering whether a security issued in a reverse inquiry transaction should be treated as a “new product”, subject to its standard new product approval procedures?

  • Has the broker-dealer properly discharged its duty to make a suitability determination for that investor? (Under FINRA’s guidance, an “institutional account” may be deemed to be able to look out for itself. (FINRA Rule 2111(b).)

  • Does the broker-dealer have a contrary research recommendation relating to the stock or other asset that is the subject of the reverse inquiry transaction? Is the investment thesis of the reverse inquiry transaction inconsistent with the firm’s overall recommendations? If either is the case, has the broker-dealer disclosed this to the investor?

  • Is the investor making its investment decision based on the improper use of material non-public information about the underlying asset? If so, does any representative of the product manufacturer have any responsibility for that improper use?

  • How do the pricing and economic terms afforded in the reverse inquiry transaction compare to the pricing and economic terms in broader offerings? Are there any superior economic terms that call into question the appropriateness of the terms of similar offerings made to retail investors? How do the profits of the broker-dealer compare in each case, and are they disclosed in each case in an appropriate manner?

  • Has appropriate conveyance of information about the issuer and the offering been made available to the investor in the reverse inquiry transaction prior the investor’s investment decision?

In addition to these issues, it is possible that in some reverse inquiry transactions, a “stub” piece of a reverse inquiry transaction could be sold to investors other than the investor that initially made the reverse inquiry. This could occur, for example, if a structured note was designed around a “lead order” made on a reverse inquiry basis, and the product manufacturer sought to sell the offering to additional investors. In such a case, a variety of additional concerns may arise. For example, does the reverse inquiry transaction consist of a product that is too complex for certain other investors who might purchase it? In addition, the investment goal of the lead investor (for example, to hedge a different position) may be inconsistent with the investment needs of the additional investors added to the offering.

The ongoing investigation of reverse inquiry transactions is yet another factor in today’s environment that should encourage market participants to carefully consider how they offer and price these transactions. During 2013, we may see from the SEC and FINRA the results of their review, and whether they have identified practices that they deem to be inappropriate.

How Will the Fed’s Proposed Foreign Bank Rules Affect Foreign Bank Debt Financing Activities in the U.S.?

Last December, the Federal Reserve Board proposed regulations to implement the enhanced prudential regulation and early remediation requirements of Sections 165 and 166 of the Dodd-Frank Act. These proposals, if adopted, would apply to systemically-important foreign banks with U.S. banking operations, and to foreign nonbank financial institutions that are designated by U.S. authorities as systemically significant. The proposed rules, which are very similar to rules proposed in December 2011 for large U.S. banks, cover a broad range of regulatory subjects, including capital, liquidity, stress testing, risk management, single counterparty credit limits, conditional debt-to-equity ratios, and early remediation. In addition, the proposed rules would require a covered foreign banking organization with $10 billion or more of U.S. assets (excluding its U.S. branch and agency assets) to place all such assets and related activities under an intermediate U.S. holding company that would be separately subject to U.S. regulatory capital and other requirements, substantially as if it were a U.S. bank holding company.

While the specific requirements of the proposed rules may be changed during the process of adopting them in final form—which may occur sometime in 2013—the broad thrust of these proposals is not likely to change materially when they are finally adopted, for at least two reasons. First, these foreign banking organization rules, with the exception of the intermediate holding company requirement, are required under the Dodd-Frank Act, so the Federal Reserve Board is obligated by statute to put into place a regulatory scheme of this nature for large foreign banks with U.S. banking operations. Second, the Federal Reserve Board has signaled its concerns over the nature, size and tenor of foreign banking organizations’ U.S. operations, especially their capital markets and corporate finance operations, and the ramifications of such activities for U.S. financial stability. In short, the Federal Reserve Board has effectively committed itself to the regulatory course of action reflected in its proposed rules.

The rule proposals have generated extensive discussion about their impact on foreign banking organizations doing business in the U.S., and how those foreign banking organizations may respond to these rules in conducting or modifying their U.S. activities. Although the focus of these discussions has generally revolved around the substantive U.S. business activities and operations of foreign banking organizations, foreign bank issuers that obtain funding for their operations in the U.S. through debt issuances should pause and reflect on the possible effects of these rules on their U.S. financing activities.

Fortunately, for many foreign banking organizations, the news on this front should be relatively good. First, foreign banks that do not have any U.S. banking operations other than representative offices, and that issue debt in the U.S. markets, will not be affected in any respect by the new rules when they are adopted. Second, foreign banking organizations that access the U.S. debt markets directly from their home offices (e.g., through registered or Rule 144A offerings) also will not feel the impact of the Federal Reserve Board’s foreign bank rules.

Two other types of foreign banking organization debt issuances, however, may be affected: (i) debt issuances where a U.S. branch or agency issues or guarantees a debt security issued in the U.S. markets in reliance on the Securities Act section 3(a)(2) exemption for securities issued or guaranteed by a bank, and (ii) debt issuances by the U.S. holding companies of foreign banking organizations.

In the case of section 3(a)(2) offerings, the Federal Reserve Board’s rules may have an incrementally greater impact, but even that impact should not be significant in most cases. U.S. branches and agencies are not subject to the rules’ separate U.S. regulatory capital requirements, and the impact of the risk-management, stress-testing, single counterparty credit limits and early remediation requirements on U.S. branch and agency financing activities will either be indirect or incidental. The proposed liquidity requirements that would apply to U.S. branches and agencies of foreign banking organizations with $50 billion or more of combined U.S. assets (namely, 14 days of liquidity in the form of cash and high-quality assets), might have an impact on the use of debt issuance proceeds by affected foreign banking organizations. Also, the conditional debt-to-equity limits for foreign banking organizations that are identified as posing a “grave threat” to U.S. financial stability, and the asset maintenance requirements (calculated as a percentage of assets to covered liabilities) for designated foreign banking organizations, and foreign banking organizations that are not in compliance with the rules’ stress-testing requirements (or are in Level 3 remediation), would be a potentially significant complication for troubled or noncompliant foreign banking organizations with U.S. branch/agency debt outstanding. That complication, however, would not be present in the ordinary course of the U.S. branch’s or agency’s funding activities, although it would have to be factored into the risk management and stress-testing activities required under the rules, and would complicate asset-liability management activities if the foreign banking organization were to be designated or remediated, or fall out of stress testing compliance.

The impact of the rules on U.S. financing activities conducted through domestic intermediate holding companies presents more interesting questions, assuming foreign banking organizations elect to pursue this route for their funding activities. Foreign banking organizations that seek debt funding through their intermediate holding companies would need to consider the impact of the Federal Reserve Board’s separate regulatory capital and liquidity requirements on the direct and indirect costs of such funding. The cost-benefit analysis of this funding strategy, however, may be influenced by the fact that the Federal Reserve Board at some point is likely to require U.S. bank holding companies—and possibly the top U.S. intermediate holding companies of foreign banking organizations—to hold minimum amounts of long-term debt that would be available to absorb losses in the event of a resolution. Moreover, the issuance of intermediate holding company debt would have to become part of the intermediate holding company’s broader risk management, stress testing and capital planning activities that would be required under the Federal Reserve Board’s rules.

In sum, the impact of the Federal Reserve Board’s rules on the U.S. operations of foreign banking organizations will be of greater or lesser significance depending on the size and tenor of a foreign banking organization’s U.S. activities. The rules’ impact on their U.S. debt financings, however, currently is not expected to be material in most cases.

IOSCO Commences Consultation on Benchmarks

A task force of the International Organization of Securities Commissions (“IOSCO”) has announced a consultation on financial benchmarks. The consultation demonstrates the heightened regulatory interest in the uses and reliability of market measures. In addition, the consultation and its results will also likely be considered by many market participants in connection with the construction of a variety of both proprietary and non-proprietary indices. IOSCO’s materials relating to the consultation may be found at the following link: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD399.pdf.

To some extent, the consultation focuses on interest rates and exchange-traded products as examples of benchmarks that are subject to its review. However, the scope of the review extends to indices and other common market measures.

In the consultation, IOSCO requested responses to concerns regarding the potential inaccuracy and manipulation of different investment benchmarks. The consultation identifies a broad range of questions and policy issues.1

Among the issues addressed by the consultation are:

  • the methodology of benchmarks, and whether they are appropriate as to the asset or assets that they are measuring;

  • the transparency of benchmarks;

  • the potential for manipulation of benchmarks, or errors in their calculation;

  • the extent of a sponsor’s discretion in calculating the benchmark, or making adjustments based on unforeseen circumstances;

  • the process by which benchmark changes are made and publicized;

  • oversight of a benchmark, and whether an independent third party is used to address questions and conflicts; and

  • the degree of regulatory oversight (including possible self-regulation) that may be appropriate for different benchmarks.

According to the consultation, IOSCO’s task force considers benchmarks as needing to have the following characteristics in order to be credible:

  • Representative: a Benchmark should clearly convey the economic realities of the underlying interest it seeks to measure to its users;

  • Reliable: the data relied upon to construct the Benchmark should be sufficient to represent that interest and the data should be bona fide;

  • Transparent: there should be sufficient transparency over the Methodology, calculation and inputs to allow users to understand how the Benchmark is derived and its potential limitations; and

  • Subject to clear governance and accountability mechanisms.

Most market participants would probably generally agree as to the validity of these criteria. However, in light of the wide variety of investment benchmarks and their various assets and markets that they measure, a one-size fits all approach would probably not be workable.

The consultation raises the topic of “independent review” of a financial benchmark. This topic is often controversial in the context of proprietary and bespoke indices. For some index manufacturers, the index may have a new and untested market, or may be directed at a relatively limited number of investors. Under these circumstances, the benchmark's developer may be reluctant to invest in the effort to educate a third party reviewer as to the rules and nature of the index, or to commit to the ongoing expense of retaining these types of services. Accordingly, for many types of proprietary indices, the absence of independent review may remain an ongoing obstacle to conforming to any review practice that emerges among some types of indices. Instead of independent review, sponsors of these indices are likely to seek to adopt alternative systems of controls to ensure integrity, and to avoid the misuse of discretion.

The consultation also does not appear to differentiate between benchmarks that are designed to serve as a measurement of a market sector, such as the S&P 500 Index or a typical commodity index, on the one hand, as opposed to proprietary indices that follow a particular investment strategy that is designed to outperform the market, or to avoid correlation with other assets. These latter types of market-measures are often likely to involve different planning considerations than the former. In fact, because proprietary indices are not typically thought of as “benchmark indices” that are put to broad use, they may not be the principal focus of IOSCO’s inquiry.

The task force indicated that it expects to issue final principles to reflect the findings of its review. However, it will not (emphasis in original) make recommendations relating to any particular benchmark.

IOSCO has requested responses to the consultation on or prior to February 11, 2013.

Extended Settlements and Regulation T

When scheduling settlements of registered securities to be paid in cash, issuers and broker-dealers should be wary of requests from investors to extend the settlement period beyond the fifth business day after the pricing date (“T+5”). Section 220.8(b)(1) of Regulation T (12 C.F.R. § 220) requires that a creditor (a broker-dealer) obtain full cash payment for nonexempted securities from the customer within five business days of the pricing date for the securities. Section 220.8(b)(2) of Regulation T provides an exemption for payment delays of up to 35 calendar days, if caused by the mechanics of the transaction and not related to the customer’s willingness or ability to pay. That exemption is construed as encompassing, for example, settlement extensions caused by market mechanics or mechanics relating to the security itself, such as certain types of pass-through asset-backed securities, which have resulted in a practice of delayed delivery. Settlements exceeding T+5 and not within an exemption provided by Regulation T may constitute prohibited extensions of credit.

Remedies for violations of Regulation T are administered by the Securities and Exchange Commission and the Financial Industry Regulatory Authority, Inc., and such violations could be cited in a FINRA deficiency letter.

Footnotes

1 The new consultation follows on from the UK’s Financial Services Authority issuing its own consultation in December 2012 as to financial benchmarks. (Available at: http://www.fsa.gov.uk/static/pubs/cp/cp12-36.pdf. )

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Bradley Berman
Anna Pinedo
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions