editors: revised tarp strategy treasury secretary outlines … · 2020. 4. 14. · the eesa. the...

Editors: Michael J. Missal [email protected] +1.202.778.9302 Matt T. Morley [email protected] +1.202.778.9850 Brian A. Ochs [email protected] +1.202.778.9466 Mark D. Perlow [email protected] +1.415.249.1070 _________________________ In this issue:

• Revised TARP Strategy • TARP/CPP Update • The Obama Transition • Lessons from Lehman Bankruptcy:

Centralized Cash Management Causes Problems for Creditors

• FDIC Temporary Liquidity Guarantee Program

• IRS Notice: Treatment of Losses in Bank Mergers

• State AG Initiatives • German Financial Market Act • Regulatory Implications of

Goldman Sachs and Morgan Stanley Becoming Bank Holding Companies

• Resolving Lehman Trade Fails • "Veil Piercing" for MERS

Shareholders Rejected • Insurance Coverage for Claims

Arising from the Credit Crisis • NASAA Initiatives on Principal

Protected Notes • No U.S. Court Jurisdiction for

"Foreign-Cubed" Class Action • State and Local Measures to

Prevent Foreclosures • Federal Loan Guarantees • Discounts for Settlement Costs

Upheld Under RESPA • Patents for Business Methods and

Software • K&L Gates Events

November 17, 2008 Volume 1 - Issue 3

Revised TARP Strategy

Treasury Secretary Outlines Revised TARP Strategy Anthony R.G. Nolan and Laurence E. Platt

On Wednesday, November 12, 2008, U.S. Treasury Secretary Henry M. Paulson, Jr. delivered a significant speech outlining current issues regarding the implementation of the financial rescue package authorized by the Emergency Economic Stabilization Act of 2008 (“EESA”), and a revised strategy for the use of funds through the Troubled Asset Relief Program (“TARP”) to address those issues. Please go to http://www.treas.gov/press/releases/hp1265.htm for a link to Secretary Paulson’s speech. One of the key aspects of Secretary Paulson's speech was that the remaining funds authorized by EESA will not be used to purchase illiquid mortgage-related assets, but rather to pursue alternative strategies to refloat credit markets and to create new mechanisms to facilitate price discovery for troubled assets. The Secretary’s remarks seem to reflect a belief that it will be a losing battle to buy troubled mortgage assets in the face of deteriorating economic circumstances that are likely to cause home loan defaults to increase at a dramatic pace. This new approach appears to focus on addressing circumstances that may cause consumers to default—such as the loss of jobs—rather than on the effects of such defaults. Secretary Paulson outlined three alternative strategies for the use of the remaining funds authorized under the EESA: • Building additional capital in financial institutions, as has already been done

with more than $200 billion of the amounts authorized under EESA.

• Supporting consumer access to credit outside the banking system.

• Further mitigating mortgage foreclosures.

Governmental efforts to support consumer access to credit outside the banking system, the second strategy mentioned above, may have profound implications for the securitization markets. In his remarks, Secretary Paulson spoke forcefully of the need to resuscitate the securitization markets because of their importance as a source of liquidity, not only to financial institutions, but also to consumers who necessarily rely on credit. His speech suggests that the Treasury is prepared to take significant steps to prime the pump for securitization activity, including a liquidity facility for AAA-rated securitizations. This is an important statement of policy in light of the views of many who have concluded that the securitization markets are permanently dead, or that securitization is an inherently antisocial activity. Paradoxically, the announcement of this strategy may actually end, for a time, the modest thawing of the securitization markets that we have recently seen for certain asset classes, as new issuances are delayed until the Treasury further elaborates its plans to revive securitization markets. Issuers may be reluctant to go forward with securitizations that might obtain better pricing in the near future if they may be backed by a Treasury liquidity facility.

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Global Financial Markets

The third strategy described by Secretary Paulson—additional efforts to mitigate mortgage foreclosures—may have important consequences for the ongoing struggle among mortgage servicers, borrowers, whole loan holders and investors in mortgage-backed securities as to who will ultimately bear the risk of loss inherent in loan modifications that reduce borrower payments. While the issue is difficult regardless of the type of loan or investor, it is particularly complex in the case of loans pooled in mortgage-backed securities. While servicers of securitized mortgages have been modifying mortgage loans in great numbers, there are significant obstacles to expanding the scope of modifications. Among these obstacles are investors’ reluctance to waive contractual rights in a manner that arguably shifts a social cost to them where modification costs more than foreclosure (even where the outstanding loan balance arguably represents principal that should never have been extended in the first place). Another issue, evident in the tepid reaction of consumer advocates to the recently announced mortgage modification protocol, revolves around disagreements over the extent to which modification relief should be made available to borrowers with similar loans but who are in different economic circumstances, and the extent to which relief should be made permanent. The success of any program to expand mortgage modifications will depend not only upon Treasury’s ability to craft solutions that are perceived to be fair, but also its ability to resolve some of the deeper obstacles to broad loan modifications. Ordinarily, most borrowers could be expected to resolve the need for mortgage modifications by refinancing their homes or selling them—neither of which may be feasible given changes in the economic circumstances of borrowers following loan closing, declines in property values, and the drying up of sources of credit for borrowers with anything other than pristine credit histories. The solutions to these problems go well beyond the authority and capability of Treasury. Strategies for promoting mortgage loan modifications may include the use of TARP funds, but there simply is not enough money for this tactic alone to have a material impact on a nationwide basis. The significance of Treasury’s shift in direction should not be overstated, as it is likely to be quickly

overtaken by other events. However, it sets a new direction for the financial recovery as the transition to a new administration begins. Elements of the previously announced asset purchase program may come back in some form. More broadly, we remain in the beginning stages of what may turn out to be a massive shift of leverage from private balance sheets to the public debt. ______________________________

TARP/CPP Update

TARP Capital Purchase Program Update Daniel F.C. Crowley and Karishma Shah Page

The U.S. Department of Treasury (“Treasury”) continues to implement the Emergency Economic Stabilization Act of 2008 (“EESA,” H.R. 1424, P.L. 110-343). Among other things, EESA authorized the Secretary of the Treasury to establish a Troubled Asset Relief Program (“TARP”) to purchase troubled assets from financial institutions. Under this authority, Treasury continues to develop the Capital Purchase Program (“CPP”) to make equity investments in banking institutions. However, Treasury has recently indicated that it no longer intends to purchase troubled assets as described below. On October 31, Treasury released additional CPP documents for publicly traded financial institution applicants, including a Securities Purchase Agreement, Form of Letter Agreement, Certificate of Designations, Form of Warrant, Term Sheet, and SEC/FASB Letter on Warrant Accounting, available at http://www.treas.gov/press/releases/hp1247.htm. The documents contain terms and conditions and make representations and warranties, to which a CPP applicant must agree. As noted in the previous issue, applications must be submitted by 5 p.m. (EST), November 14, 2008. In the same notice, Treasury stated it will be posting a CPP application form and term sheet for private and mutual banks in the future. In his testimony (http://www.treas.gov/press/releases/hp1234.htm), before the Senate Committee on Banking on October 23, Interim Assistant Secretary for Financial Stability Neel Kashkari noted that Treasury is also developing a mortgage-backed

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securities program, whole loan purchase program, and insurance program for troubled assets. On November 10, following a speech in New York City (http://www.treas.gov/press/releases/hp1262.htm), Mr. Kashkari indicated that U.S. Treasury Secretary Henry M. Paulson, Jr., will determine whether and when to roll out these additional programs. On November 10, the government announced changes to the AIG bailout, available at http://www.treas.gov/press/releases/hp1261.htm, totaling $152.5 billion. Using its EESA authority, Treasury will purchase $40 billion in senior preferred stock from AIG. The Federal Reserve will provide AIG with a $60 billion bridge loan, purchase $22.5 billion of its mortgage-backed securities and supply $30 billion to backstop the insurer’s credit default swap agreements. Mr. Kashkari indicated that the AIG deal was a “one-off” arrangement rather than a broadening of the CPP beyond banking institutions. Treasury has also started to build its CPP implementation group. The Department has named James H. Lambright, former head of the Export-Import Bank, to serve as the interim Chief Investment Officer (http://www.treas.gov/press/releases/hp1232.htm). Treasury has also posted a solicitation for financial agents to provide asset management services for CPP. Application guidelines are available at http://www.treas.gov/press/releases/hp1260.htm; the deadline for submission was 5 p.m. (EST), November 13, 2008. Of the $700 billion in funds authorized by EESA, Treasury has thus far committed $250 billion to banks. The President must certify the use of an additional $100 billion and, for use of the remaining $350 billion, submit a notice to Congress, which has the ability to disapprove. On November 4, 2008, the Treasury submitted its “First Tranche Report,” http://www.treas.gov/initiatives/eesa/tranche-reports.shtml, to Congress on the implementation of the EESA. The report noted that “it is premature to assess the impact of the CPP.” Preliminarily, Treasury is “encouraged by recent signs of improvement in the markets and in the confidence in our financial institutions,” but Treasury also reported that restoring liquidity to the long-term credit markets remains a challenge.

On November 12, Secretary Paulson provided an update on the implementation of EESA and indicated that the Department has changed its strategy, available at http://www.treas.gov/press/releases/hp1265.htm. Secretary Paulson stated that the Department has abandoned efforts to purchase bad assets under TARP, because the indirect purchase would delay bank recapitalization. Instead, CPP equity purchases would continue to be the central feature of Treasury’s bailout efforts. Secretary Paulson noted that the Department also will pursue two additional strategies: strengthening the asset-backed securitization market in order to support consumer finance and expanding foreclosure mitigation. (please see above article: Treasury Secretary Outlines Revised TARP Strategy.) Strategic shifts in the efforts to ameliorate the credit crisis will presumably continue with the incoming administration. Moreover, with the continued instability of the financial markets, we believe that we are in the beginning stages of what will ultimately prove to be a massive shift of leverage from private balance sheets to the public debt as new programs are implemented. The K&L Gates Public Policy & Law group consists of senior, bipartisan policy professionals who are closely monitoring these developments in order to provide insights to and effective advocacy on behalf of firm clients. http://www.klgates.com/newsstand/Detail.aspx?publication=5052 ______________________________

The Obama Transition

The Obama Transition and the 110th Congress Daniel F.C. Crowley and Karishma Shah Page

The U.S. Department of Treasury (“Treasury”) is conferring with the Obama transition team, led by former Clinton Chief of Staff John Podesta, on policy decisions in order to ensure continuity between administrations. The transition team has also turned its attention to selecting the next Treasury Secretary. The new Secretary is likely to

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have been involved in the development of programs under the Emergency Economic Stabilization Act of 2008 (EESA, H.R. 1424, P.L. 110-343). Possible choices include New York Federal Reserve President Timothy Geithner, Federal Deposit Insurance Commission Chairwoman Sheila Bair, former Federal Reserve Chairman Paul Volcker, and former Treasury Secretaries Larry Summers and Robert Rubin. President Bush (http://www.whitehouse.gov/news/releases/2008/10/20081022.html) hosted the G-20 summit (http://www.g20.org/G20) on November 15 in Washington, D.C. to discuss a globally coordinated response to the financial crisis. European Union leaders have urged the President to join them in devising international regulatory measures to govern the banking industry. In his remarks on November 12, U.S. Treasury Secretary Henry M. Paulson, Jr. underscored the importance of reaching a consensus on a broad-based reform agenda during the meeting. Although President-elect Obama was not expected to formally participate, some delegates were planning to engage with him while in Washington, D.C. Congress is scheduled to reconvene for one week, beginning November 17. House Speaker Nancy Pelosi (D-CA) and Senate Majority Leader Harry Reid (D-NV) would like to pass a stimulus package, but the Majority Leader has said there may not be enough support. President-elect Obama has stated that if a bill does not pass in the lame-duck session, he will make it his first order of business upon being sworn in. The stimulus bill may be a vehicle for legislative directives relative to the Troubled Asset Relief Program (“TARP”) , especially in the area of preventing mortgage foreclosures. The FDIC has proposed using $50 billion of TARP funds for a loan modification and guarantee program. Senate Banking Committee Chairman Christopher Dodd (D-CT), http://dodd.senate.gov/index.php?q=node/4616, and House Financial Services Committee Chairman Barney Frank (D-MA), http://www.house.gov/apps/list/press/financialsvcs_dem/press102008.shtml, are supportive of the proposal.

As expected, congressional oversight of EESA implementation has continued apace. On October 24, Senators Charles Schumer (D-NY), Jack Reed (D-RI), and Robert Menendez (D-NJ) wrote a letter, http://menendez.senate.gov/newsroom/record.cfm?id=304512, recommending Treasury adopt guidelines to ensure that institutions use bailout funds to restart lending activities rather than acquisitions or dividends. On October 29, House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid sent a letter, http://speaker.house.gov/newsroom/pressreleases?id=0876, urging Treasury to strengthen the interim final rules on executive compensation for CPP institutions. In addition, the following congressional hearings have recently taken place or are planned to take place: Private Sector Cooperation with Mortgage Modifications Wed., Nov. 12, 10:00 a.m., 2128 Rayburn Bldg. House Financial Services Committee http://www.house.gov/apps/list/hearing/financialsvcs_dem/hr111208.shtml Regulation of Hedge Funds Thurs., Nov. 13, 10:00 a.m., 2154 Rayburn Bldg. House Oversight and Government Reform Committee http://oversight.house.gov/ Oversight of Emergency Economic Stabilization Act Thurs., Nov. 13, 10:00 a.m., 538 Dirksen Bldg. Senate Banking Committee http://banking.senate.gov/public/index.cfm?Fuseaction=Hearings.Detail&HearingID=1d38de7d-67db-4614-965b-edf5749f1fa3 Is Treasury Using Bailout Funds for Foreclosure Prevention, as Congress Intended? Fri., Nov. 14, 10:00 a.m., 2154 Rayburn Bldg. House Oversight and Government Reform Committee’s Subcommittee on Domestic Policy http://oversight.house.gov/story.asp?ID=2276 Troubled Asset Purchase Program Oversight Tues., Nov. 18, 10:00 a.m., 2128 Rayburn Bldg. House Financial Services Committee http://www.house.gov/apps/list/hearing/financialsvcs_dem/hr11102008.shtml

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Collapse of Fannie Mae and Freddie Mac Tues, Dec. 9, 10:00 a.m., 2154 Rayburn Bldg. House Oversight and Government Reform Committee http://oversight.house.gov/schedule.asp Congress is preparing to consider comprehensive financial services reform legislation early next year. Senator Schumer, a member of both the Senate Finance and Banking Committees, has outlined six principles that he believes should guide the deliberations: 1. A key focus should be on controlling systemic

risk and ensuring stability. 2. The regulatory structure should be unified under

a single regulatory authority, or at a minimum, simplified.

3. Complex financial instruments should be subject to regulation under clear regulatory authority.

4. Global financial markets require globally coordinated solutions.

5. Increased transparency should be a central goal. 6. The laissez-faire view of regulation must come

to an end. For more details on the impact of the recent election on current and future policy initiatives relating to the financial services industry, please see the recent K&L Gates Public Policy and Law Alert, “Financial Services Reform: What Comes Next?” (http://www.klgates.com/newsstand/Detail.aspx?publication=5052). The K&L Gates Public Policy & Law group consists of senior, bipartisan policy professionals who are closely monitoring these developments in order to provide insights to and effective advocacy on behalf of firm clients. ______________________________

Lessons from Lehman Bankruptcy: Centralized Cash Management Causes Problems for Creditors

Lessons of the Lehman Brothers Bankruptcy: Global Cash Management v. Legal Provincialism Richard S. Miller, Robert T. Honeywell and Jeffrey N. Rich

The Lehman Brothers bankruptcy sometimes seems to have exhausted the list of “biggest ever” superlatives: Biggest ever bankruptcy filing in the United States ($639 billion in assets). “By far the largest securities broker-dealer liquidation ever attempted,” according to the trustee overseeing the liquidation of Lehman’s U.S. broker-dealer. His British counterpart, overseeing the insolvency of Lehman’s London operations, told the press, “Enron and BCCI were large and complex but not on this scale.” The Lehman collapse has been tied to the fall of the investment banking model, to continuing uncertainty in financial markets, and to the current turmoil in the global economy itself. A less-discussed theme of the Lehman bankruptcy is the strain it is revealing between the efficiencies of global corporate cash management and the legal regimes governing creditor claims. When the cash literally stops flowing, creditors and investors naturally ask, “Where’s my money?” The Lehman insolvency has revealed, like many of the largest corporate bankruptcies in recent years, that this can be an extremely difficult question to answer. Part of the problem is that most corporate cash management systems involve one corporate entity moving cash on behalf of its affiliates, but reflecting their interests primarily through intercompany claims. This has obvious operational efficiencies, but when “the music stops” upon a bankruptcy filing, the cash is held by the entity with legal title to it (i.e., in its accounts). Creditors of the entity holding the cash have an immediate enforcement advantage – the money is there – while creditors of its affiliates have to chase it down, possibly across jurisdictional boundaries. The Lehman bankruptcy is the latest example.

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Like most large companies, Lehman operated a centralized cash management system that had one entity – in this case the holding company – operate as the “central banker” for the numerous Lehman entities. According to court filings, the holding company generally swept excess cash into its own U.S. and foreign operating accounts and used it to fund expenses of subsidiaries. The degree to which subsidiaries were integrated into the system varied. For example, unregulated subsidiaries had their excess cash swept on a daily basis to the holding company’s operating accounts, while regulated subsidiaries (generally broker-dealers) transferred cash to the holding company less frequently, to pay down intercompany loans for prior advances. Some subsidiaries managed their own cash and disbursements independently (e.g., Lehman Brothers Commercial Bank). Others had some of their collections deposited into the accounts of other subsidiaries. For example, the regulated U.S. broker-dealer (Lehman Brothers Inc. (“LBI”)) received collections from some derivatives, futures and foreign exchange transactions of Lehman Brothers Commercial Corporation, Lehman Brothers Special Financing Inc., and Lehman Brothers International (Europe) (“LBIE”). As to disbursements for expenses, the holding company acted as “paymaster” for most of Lehman’s European operations, while the regulated U.S. broker-dealer (LBI) acted as “paymaster” for most U.S. operations. A centralized cash management system such as Lehman’s may make utter sense pre-bankruptcy, but can produce legal nightmares afterward. For one, the sheer number of transactions can make untangling intercompany claims based on those transactions a herculean task. Lehman reported that the portion of its business related to the sale of derivatives alone involved approximately 1,500,000 transactions with approximately 8,000 counterparties. It is now faced, in the post-bankruptcy setting, with sorting these out with a radically reduced staff, going from more than 13,000 employees to about 140. Lehman’s London office recently lost over half of its legal staff. Its current U.S. management, led by an outside restructuring firm, is reportedly focused on preserving its information systems and retaining employees, and estimates being able to respond to creditor inquiries in 45-60 days. Impatient creditors in the U.S. case

have filed motions for their own investigations and for the appointment of an examiner and for an independent trustee to replace Lehman’s remaining officers and directors. Its UK insolvency administrators reported difficulty determining the UK companies’ assets, partly due to difficulties getting information from other asset custodians around the world, and that “it will take many years to finally resolve the inter-company and third-party claims.” A review of Lehman’s cash management system also shows that numerous legal and regulatory regimes are now at play that may affect intercompany claims and, as a result, creditors’ ultimate recoveries. The holding company that acted as the “central bank” is now subject to the U.S. Chapter 11 case, along with 16 subsidiaries; LBI is subject to a separate liquidation proceeding supervised by the Securities Investor Protection Corporation; LBIE and three other British entities are in a UK administration proceeding; other foreign subsidiaries are subject to insolvency proceedings in their own jurisdictions (for example, in Hong Kong, Australia, Singapore, Japan, The Netherlands, France and Germany); and various Lehman entities and funds are still “non-debtors,” not having yet filed a formal insolvency proceeding and thus continuing to be subject to whatever laws govern the entities and their various contracts. From an insolvency perspective, this means that a creditor or investor evaluating its recovery prospects must:

a. first determine which entity or entities it did business with, both directly and through guaranties, cross-collateralization, setoff and netting rights; then

b. determine which assets (including collateral) are available for recovery and which courts and regulators may have jurisdiction over those assets (including a possible stay or injunction prohibiting enforcement or foreclosure); then

c. file claims in the relevant insolvency proceedings prior to the applicable deadlines (subject to considering the risks of submitting to jurisdiction), exercise any voting and participation rights available to creditors (for example, attending creditors’ meetings and voting on a plan of

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reorganization), and possibly take other enforcement action (for example, a motion to modify any stay against foreclosure or other litigation); then

d. monitor the relevant insolvency proceedings, to determine the timing and amount of creditor recoveries.

The multiplicity of bankruptcy regimes now governing Lehman means that each Lehman entity is now considered a separate “bankruptcy estate” – i.e., a separate group of assets and creditors – and each is now vying with the other bankruptcy estates for a piece of the Lehman group’s remaining assets. Intercompany claims are often the main vehicle through which these separate bankruptcy estates try to recover assets for themselves. Anyone who has lived through other large corporate bankruptcies (e.g., Adelphia, Global Crossing, Refco) knows that intercompany litigation can be the most complex, intractable and even unresolvable feature of the insolvency proceeding. Some cases feature creditors attempting to “substantively consolidate” all of the companies by collapsing all of the different bankruptcy estates into one, eliminating intercompany claims in the process, but other creditors naturally, and fiercely, resist. Some creditors will of course benefit from corporate separateness by preserving their respective debtor-companies’ assets for themselves. Creditors and investors of the “asset-weak” companies try to reach through corporate boundaries by any and all means. If they are unsuccessful, their recoveries can be much lower than their counterpart creditors at other entities in the corporate tree, in what is ostensibly the “same company.” A typical pattern is that lenders and investors at one level (for example, stockholders and bondholders of the holding company) assert that they financed the operations of the subsidiaries and should recover accordingly; conversely, creditors of the subsidiaries assert that holding company creditors were aware of their “structural subordination” and have to live with the consequences. Hence, the (often furious) litigation that attends many complex corporate bankruptcies and is now gathering steam in the Lehman cases. In addition to the multiple insolvency proceedings around the world, there are now securities class actions and criminal investigations, all of which will presumably

take years to resolve. One of the well-publicized complaints is from creditors of Lehman’s UK entities, who claim that several billion dollars was swept into Lehman’s U.S. accounts on the eve of its Chapter 11 filing. These creditors are now faced with trying to claw back cash that once flowed easily within “Lehman Brothers” and is suddenly beyond their reach due to legal boundaries that became very real, and difficult to pierce, upon Lehman’s bankruptcy filing. This is one of the difficult lessons that is learned repeatedly in corporate bankruptcies but is especially potent for companies with global operations. At a court hearing, one of Lehman’s lawyers explained its cash management system as “cash moves around with great velocity.” This can be profitable for creditors in good times yet very dangerous in others. Creditors should be aware of the benefits and risks of centralized cash management – specifically, of exactly which entities they have claims against, and where those entities’ cash and other assets are – so that they can understand and be prepared for the consequences in the event, “the music stops ______________________________

FDIC Temporary Liquidity Guarantee Program

Temporary Liquidity Guarantee Program Stanley V. Ragalevsky and Sean P. Mahoney

Federal Deposit Insurance Corporation (“FDIC”)-insured depository institutions, bank holding companies, financial holding companies and certain thrift holding companies have until December 5, 2008 to decide whether to participate in the FDIC’s Temporary Liquidity Guarantee Program (“TLGP”). FDIC established the TLGP as of October 14, 2008 after determining that rapid and substantial outflows of uninsured deposits from banks threatened the stability of our financial system. The purpose of the TLGP is to preserve public confidence and encourage liquidity in the banking system. Participation by FDIC-insured institutions is voluntary. The TLGP has two components: an FDIC guaranty of certain senior unsecured debt ("Debt Guarantee

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Program") and unlimited FDIC deposit insurance coverage for non-interest bearing transaction accounts through 2009 ("Transaction Account Guarantee Program"). Under the Debt Guarantee Program, covered debt in an amount up to 125 percent of the senior unsecured debt of a participating institution outstanding on September 30, 2008 that matures no later than June 30, 2009 will be guaranteed by FDIC, for an annual fee of seventy-five basis points of the covered amount. Covered senior unsecured debt includes commercial paper and unsecured borrowings from Federal Reserve Banks but excludes derivatives, deposits in foreign currency, and convertible debt. If investors in an institution's unsecured debt do not insist upon the FDIC guaranty, the cost of the Debt Guarantee Program may not be a worthwhile expense. The Transaction Account Guarantee Program supplements existing FDIC insurance with temporary, unlimited deposit insurance coverage on non-interest bearing transaction accounts such as demand deposit accounts, payroll and other processing accounts, certain custodial accounts for loan servicing or similar activities and non-interest bearing savings accounts into which funds from transaction accounts are swept. Institutions that participate in the Transaction Account Guarantee Program will be assessed an annual premium in an amount equal to 0.10 percent of covered transaction account balances in excess of standard FDIC coverages. Although it is theoretically voluntary, participation in the Transaction Account Guarantee Program may effectively be mandatory for most banks that depend upon commercial demand deposit accounts for funding. The market may simply demand this coverage. This may not be the case for institutions with specialized balance sheets or business models. Institutions have until 11:59 p.m. (EST) on December 5, 2008 to opt out of participation in the Debt Guarantee Program or Transaction Account Guarantee Program. For institutions that do not opt out, the TLGP is scheduled to expire on December 31, 2009, although senior unsecured debt guaranteed under the TLGP will remain guaranteed until the later of maturity or June 30, 2012. Each institution will be required to disclose whether or not it is participating in the Transaction Account Guarantee

Program. If an institution participates in the Debt Guarantee Program, it will have to disclose to investors in a commercially reasonable manner whether or not the debt instrument being offered is guaranteed under the TLGP. ______________________________

IRS Notice: Treatment of Losses in Bank Mergers

IRS: Little Noticed Notice Unlocks Losses in Bank Mergers Roger S. Wise

Notice 2008-83, quietly issued by the Internal Revenue Service (“IRS”) on September 30, 2008, removes significant limitations that would otherwise apply to a category of tax losses upon a change of control involving a bank. The notice’s brevity – its operative section contains a single sentence – should not obscure the profound impact that it may have on merger and acquisition activity involving banks. Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), was originally enacted to prevent “trafficking” in loss corporations. Congress was concerned about transactions where one corporation would acquire a target corporation – perhaps even one that had disposed of its historic business – solely to utilize the target’s loss carryforwards. Under current law, when a corporation undergoes an “ownership change,” Section 382 limits the amount of income that may be offset with historic losses. This limit is generally equal to the value of the loss corporation at the time of the ownership change multiplied by the long-term tax-exempt rate, a rate which is published monthly by the IRS. In essence, this limitation gives the acquiring corporation the benefit of the target’s losses only to the extent of the benefit it would have received if it had instead made an investment in tax-exempt bonds. An ownership change generally occurs when there is a more than 50 percentage point change in the ownership of the loss corporation by 5 percent shareholders during the three-year period ending on the testing date. An ownership change can arise if shares of a target corporation are acquired from

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existing shareholders, or if a new equity investment is made in the target. The rules described above deal with losses that have already been recognized. Section 382(h) of the Code extends these limitations to certain built-in losses – i.e., losses existing at the time of an ownership change that are not recognized until later. If a corporation has a net unrealized built-in loss (“NUBIL”) at the time of an ownership change and meets certain other conditions, any deductions relating to the recognition of those NUBILs during the following 5 years will be subject to the limitations described above. Certain deductions during the 5-year period that are attributable to periods before the ownership change may also be treated similarly. Under the new IRS notice, the rules on NUBILs do not apply “to any deduction properly allowed after an ownership change . . . to a bank with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts).” This simple statement appears designed to encourage mergers with, and investments in, troubled banks, by permitted loss deductions arising from bad debts held by the banks. By removing a significant limitation that would otherwise apply to these losses, the notice in effect creates a tax asset that would otherwise not be available. A bank is defined in Section 581 of the Code as a bank or trust company incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia) or of any state, which among other things is subject by law to supervision and examination by State, Territorial, or Federal authority having supervision over banking institutions, and also includes a domestic building and loan association. The long-term impact of the notice is difficult to predict, but it had an almost immediate impact on the takeover of Wachovia, in that the bid by Wells Fargo – which came shortly after the release of the notice, when an offer by Citibank was nearly finalized – appears to have been encouraged by the change in tax law.

The notice was effective upon issuance and may be relied upon unless and until additional guidance is issued. ______________________________

State AG Initiatives

State Attorneys General – A Force to be Reckoned With Paul F. Hancock

State attorneys general aspire to be the primary protectors of consumers. The housing collapse provided new opportunities for them to flex their muscles and seek a role in the development of solutions. Federal preemption remains a controversial issue, but the threat of preemption has only caused state attorneys general to be more aggressive in the areas where they have legal authority. Recently elected attorneys general have pledged to focus attention on the housing and financial markets, and we can reasonably expect attorneys general, as a group, to push the limits of their authority in addressing the issues. Some examples of their actions in recent months are described below. Auction-Rate Securities Allegations of deception have provided a basis for attorney general involvement in auction-rate securities markets. New York Attorney General Cuomo reached agreement with twelve financial institutions on claims that they “sold auction-rate securities as safe, cash-equivalent products, when in fact they faced increasing liquidity risk.” The institutions agreed to buy back the securities from certain customers, generally individuals and foundations, and otherwise provide restitution to “individual investors who were fraudulently sold auction-rate securities.” Cuomo says that the settlements “returned over $50 billion back to investors’ hands.” Similar settlements were reached by attorneys general in Massachusetts and Michigan. Mortgage Fraud Attorneys general have identified mortgage fraud, particularly inflated appraisals, as a major contributor to the housing crisis. The Florida Attorney General sued ten companies and fifteen individuals that defrauded lenders by recruiting

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“straw buyers'” with good credit and conspiring with realtors to artificially inflate purchase prices. Other states have filed similar claims. Foreclosures The State Foreclosure Prevention Working Group released its third report on mortgage foreclosures at the end of September, contending that 80 percent of delinquent borrowers are not receiving meaningful foreclosure relief. Although the Group’s collaboration with servicers is described as cooperative, a stronger stick is laying in wait. After a number of states announced a settlement with Bank of America regarding the Countrywide portfolio that centers on loan modification, on October 7, the Group sent a letter to sixteen subprime servicers stating: “We urge you in the strongest possible terms to adopt a comprehensive, streamlined, and effective loan modification program as soon as possible.” The implicit threat of prosecution is clear. State attorneys general investigated and prosecuted deceptive conduct by foreclosure rescue companies. This issue is a neat fit for traditional attorney general enforcement and is a priority in many states. Loan Origination The settlement with Bank of America regarding the Countrywide portfolio continues a trend of aggressive state attorney general action regarding home mortgage lending practices. The attorneys general already have extracted major business changes in the lending industry through lawsuits and compelled settlements. The monetary value of the attorney general settlements with Household ($484 million) and Ameriquest ($295 million), as well as the extensive loan modification relief obtained from Countrywide, certainly overshadow any action by federal agencies. The only real question is which firm will be the next target – perhaps one of the sixteen servicers that received the October 7 letter, or the originators of the loans that they are servicing. 2008 Attorney General Elections Eleven seats were up for election and the announced plans of the winners indicate a continued, and perhaps increased, focus on mortgage and financial markets.

Chris Koster, newly elected in Missouri, and Richard Cordray, newly elected in Ohio, focused their campaigns on credit and foreclosure issues. Other well-known attorneys general who already enjoy a strong reputation in seeking mortgage reform and foreclosure relief – such as Roy Cooper in North Carolina and Rob McKenna in Washington – were reelected. Mark Shurtleff was reelected in Utah, as was Darrell McGraw in West Virginia; they have prioritized mortgage fraud and other credit-related issues. First-term attorneys general were elected in Indiana (Greg Zoeller), Montana (Steve Bullock) and Oregon (John Kroger), and incumbents were reelected in Pennsylvania (Tom Corbett) and Vermont (William Sorrell). All emphasized the importance of consumer protection in seeking office. Conclusion The states want a place at the remedial table. Some offer an olive branch of cooperative efforts to work through the present crisis. Others are more aggressive from the start. But if conditions do not improve quickly, it can be expected that many states will join forces to compel reform, based on claims that consumers and investors were deceived or otherwise were victims of unfair practices of loan originators, servicers or secondary market participants. ______________________________

German Financial Market Act

German Measures to Address the Financial Crisis Wilhelm Hartung and Oliver M. Kern

The German government has enacted significant new measures to stabilize German financial markets. These efforts seek to restore trust in the financial system and to revive the business interaction among financial institutions and other market participants. Central to these measures is the creation of a €100 billion fund to support troubled financial institutions, called the Financial Market Stabilisation Fund ("SoFFin") (www.soffin.de). SoFFin has been authorized to operate through



December 31, 2009, after which date, under current legislation, it will be dissolved. SoFFin is directed toward financial market participants headquartered in Germany. Among the types of institutions eligible for assistance are banks and credit institutions, investment management companies, operators of securities and futures exchanges, as well as some specific affiliates of such companies, including parent companies of public law state banks (Landesbanken) (e.g., BayernLB Holding AG, Landesbank Berlin AG) (all together referred to hereinafter as "Financial Sector Enterprises"). SoFFin is authorized to provide the following types of financial assistance to Financial Sector Enterprises: • €20 billion to make payments under guarantees

issued for the benefit of Financial Sector Enterprises. SoFFin may issue up to €400 billion in such guarantees.

• €80 billion to (a) acquire participations in Financial Sector Enterprises or (b) assume risk positions held by such companies.

Guarantees. Guarantees have been designated as the preferred method for SoFFin to use in seeking to stabilize the markets. The hope is that recipients can use such assistance to overcome short-term liquidity problems and seek to recapitalize themselves on the market. SoFFin may provide standard first-demand guarantees in connection with obligations of 3 years or less that are created between October 18, 2008 and December 31, 2009. Guarantees may also be issued to single purpose entities which have assumed risk positions of Financial Sector Enterprises. Recipients of these guarantees will be required to pay fair market rates for the guarantee, and be required to meet certain minimum capital requirements. If adequate capital resources are not available, the Financial Sector Enterprises may apply for recapitalization assistance from SoFFin. Acquisitions of Risk Positions. SoFFin may also determine to assist Financial Sector Enterprises by acquiring certain risk positions, including, but not limited to, receivables, securities, derivative financial instruments and rights and obligations under loan commitments. Ordinarily, no Financial

Sector Enterprises may receive more than €5 billion of this type of assistance, and recipients may be required to repurchase such risk positions as SoFFin determines to be appropriate. Recapitalizations. Where the national interest requires it, and where no reasonable alternatives exist, SoFFin may acquire equity interests of up to €10 billion in any Financial Sector Enterprises seeking such assistance. New regulations have been put into place to SoFFin’s participation in a recapitalization by easing requirements under German corporate, capital markets, and commercial law. Recipients of assistance under any of these measures must meet certain preconditions, which vary according to the form of assistance provided. Recipients may be required to cease certain types of business transactions, to restrict compensation of individual employees to €500,000 or less, and to suspend dividend payments to anyone other than SoFFin. In addition to legal changes to facilitate the recapitalization of market participants by SoFFin, amendments have been made to the Banking Act (Kreditwesengesetz, KWG), to the Insurance Supervision Act, and to the German federal insolvency law (modifying the definition of over indebtedness (Überschuldung)). While the European Commission (“EC”) has generally approved, under EC treaty state aid rules, the German assistance measures, EC authorities have in one instance already questioned whether guarantees provided to one company met EC requirements because they may not have been granted at fair market value. According to publicly available sources, further investigations are pending. There has been one further development of note for companies subject to IFRS accounting standards. In October 2008, the International Accounting Standards Board issued amendments to IAS 39 and IFRS 7 which were endorsed by the EC by regulation (Commission Regulation No. 1004/2008 of October 15, 2008). These amendments, which are effective retroactively to July 1, 2008, allow certain reclassifications of non-derivative financial assets



out of the "Fair Value through Profit or Loss" category and also allow the reclassification of financial assets from the "Available for Sale" category to the "Loans and Receivables" category in particular circumstances. A number of companies have taken advantage of these provisions. In one widely reported example, Deutsche Bank’s third quarter report (http://annualreport.deutsche-bank.com/2008/q3/notes/basisofpreparationunaudited.html) notes that, due to reclassifications allowed by these amendments, the company increased income before income tax by €825 million. ______________________________

Regulatory Implications of Goldman Sachs and Morgan Stanley Becoming Bank Holding Companies

Regulatory Implications of Goldman Sachs and Morgan Stanley Becoming Financial Holding Companies Rebecca H. Laird and Edward G. Eisert

On September 22, 2008, in simultaneous actions, the Federal Reserve Board (“FRB”) announced that it had approved the joint application of The Goldman Sachs Group, Inc. and Goldman Sachs Bank USA Holdings LLC (collectively, “Goldman Sachs”), and the joint application of Morgan Stanley, Morgan Stanley Capital Management LLC and Morgan Stanley Domestic Holdings, Inc. (collectively, “Morgan Stanley”), to become bank holding companies. Each company already owned an institution insured by the Federal Deposit Insurance Corporation (“FDIC”) (a Utah industrial loan company), which was converted into a commercial bank with full deposit taking and lending powers. Though initially bank holding companies, Goldman Sachs and Morgan Stanley have each stated their intention to become a “financial holding company,” i.e., a company that is permitted under the Bank Holding Company Act of 1956 to engage in activities that are “financial in nature,” including securities underwriting, merchant banking, and insurance underwriting and sales (“FHC”). Set forth below are answers to a number of frequently asked questions about the regulatory implications of an investment banking firm, such as

Goldman Sachs or Morgan Stanley, becoming an FHC: 1. What are the minimum capital and liquidity

requirements for a company to become an FHC? The FHC’s bank must be “well-capitalized” on a consolidated basis, which means that the bank must maintain a “total risk-based capital ratio” of 10.0 percent or greater and the bank must maintain a “Tier 1 risk-based capital ratio” of 6.0 percent or greater. The “total risk-based capital ratio” is the ratio of total capital to assets, which are calculated on a risk-weighted basis. The “Tier 1 risk-based capital ratio” is the ratio of Tier 1 capital – basically common and perpetual preferred stock and surplus minus goodwill and intangibles – to total assets, which are calculated on a risk-weighted basis. In addition, the bank’s leverage ratio, which is the ratio of capital to total assets (which are not calculated on a risk-weighted basis), cannot be less than 3.0 percent. The FRB has stated that at least 100 to 200 basis points above the 3.0 percent leverage ratio is required of all but the very strongest banking organizations. There are no express liquidity requirements in the regulations.

2. How would an investment banking firm have to restructure its business if it were to become an FHC? An FHC is permitted to engage in activities that are “financial in nature,” including securities activities, insurance activities, and other financial services activities, such as merchant banking and private equity investing, and may do so in addition to owning banks under a single corporate umbrella. To the extent an activity of an investment banking firm is not “financial in nature” and is not in compliance with applicable regulations, the firm would have two years in which to divest the activity, which the FRB may extend for three one-year periods.

3. What discretionary powers does the FRB have over an FHC? The FRB is vested with broad supervisory powers and enforcement tools with which to oversee FHCs. The FRB has the power to conduct examinations, not just at the bank level, but at the holding company and affiliate level. The FRB conducts examinations on a regular basis at each supervised institution and maintains offices at, and continuously



monitors the activities of, the largest holding companies. In addition to its general rulemaking authority, the FRB also imposes reporting requirements, restricts activities, imposes operational and managerial standards, and may bring enforcement actions to maintain the “safety and soundness” of the companies it regulates. The FRB also has the authority to require undercapitalized FHCs to take “prompt corrective action” to raise additional capital or find a merger partner. The jurisdiction of the FRB does not supplant the jurisdiction of other federal banking regulators (such as the FDIC) over the banks owned by the FHC, or state banking regulators over such banks organized under state law. Perhaps most importantly from the investment banking perspective, the SEC remains the primary federal regulator of any registered broker-dealer and investment adviser controlled by the FHC, and the Commodity Futures Trading Commission remains the primary federal regulator of any registered commodity trading advisor, commodity pool operator and futures commission merchant controlled by the FHC. However, the FRB retains ultimate supervisory authority. This multifaceted regulatory regime has far-reaching and significant consequences for new FHCs, including the regulatory compliance programs that are required and the manner in which regulatory examinations and deficiencies are addressed. For example, historically, the FRB and other bank regulators have been viewed as “prudential” regulators that apply a more “principles based,” collaborative approach to supervision, which is often handled behind closed doors on a confidential basis, as opposed to federal and state securities regulators that are generally viewed as more public-action, enforcement-based regulators.

What are the rules on capital for separate subsidiaries of FHCs and how does the FRB regulate transfers of funds from subsidiaries? In general, the FRB wants the FHC to be a source of strength to the bank; it does not want the bank to be used to support the FHC. Consequently, the FRB will generally not allow funds to flow from the bank to the FHC to support its debt, pay dividends or fund general

operations, unless there is clearly no detriment to the bank in doing so. ______________________________

Resolving Lehman Trade Fails

Resolving Lehman Trade Fails Gordon F. Peery

Prior to September 15, 2008, portfolio managers placed thousands of trades with brokers at Lehman Brothers Inc. (“LBI”) in New York City. These trades, many of which were subsequently transferred for settlement to LBI affiliates throughout the world, eventually failed to settle last month (and are referenced in settlement parlance as “trade fails”) as a result of the worldwide collapse of Lehman Brothers and the landmark civil proceedings that followed on at least three continents. The circuitous routes taken by these trades prior to settlement failure and the legal and business implications along the way demonstrate the complexity of the global system of modern finance and the need for qualified legal counsel. As of this time, two sets of authoritative statements have been issued with regard to certain trade fails involving LBI. • SIPC Protocol and LBI Trustee Statement.

The Securities Investor Protection Corporation (“SIPC”), on September 26, 2008, published a protocol for closing certain open trades (“SIPC Protocol”). The LBI bankruptcy trustee (the “LBI Trustee”) issued a related clarifying statement (“LBI Trustee Statement”).

• SIFMA RMBS Protocol. The Securities Industry and Financial Markets Association (“SIFMA”), on October 9, 2008, published Protocol 08-02 for resolving certain outstanding agency mortgage-backed security trades with LBI (the “SIFMA RMBS Protocol”).

In light of the foregoing developments, the short and long term tasks for handling related Lehman trade fails are as follows: 1. Understand the relevant players, law and

timing. With the assistance of qualified legal counsel in the appropriate jurisdiction, the first step is to identify



a. the relevant trades and the Lehman entity that is properly deemed to be the counterparty,

b. the particular court/trustee/administrator that will have authority to resolve issues relating to the trades, and

c. the time periods under the relevant protocols for securing rights and performing obligations.

Missing deadlines for filing claims in proceedings may result in the loss of important rights, including the right to recover losses. 2. Determine whether any contractual

obligations are subject to a stay. Counsel’s early efforts should focus on establishing a legal, contractual obligation that is enforceable in light of applicable insolvency proceedings. Prime brokerage agreements often set forth remedies for trade fails and, so long as the transactions are not stayed by a Chapter 11 proceeding, stayed in a SIPC proceeding, or UK or other administration, contractual rights may be pursued with the advice of counsel and in accordance with applicable settlement protocols.

3. Interface with the relevant trustee or administrator. Perhaps the most important step throughout the process is properly interfacing with the appropriate trustee or administrator in a timely manner. In many cases the trustee, legal counsel representing the trustee—or both—will communicate important milestones, deadlines and, in some cases, settlement protocols.

More generally, with respect to trades involving non-LBI counterparties, affected parties would be well advised to reexamine their current forms of trade documentation. Agreements should include terms that are consistent with current market practice, the law and the global arrangements relating to trade execution and settlement. While the extraordinary efforts to resolve LBI trade fails seem likely to yield favorable solutions, many of these issues may arise in other situations today and in the future. ______________________________

“Veil Piercing” for MERS Shareholders Rejected

Delaware Court Rejects “Veil Piercing” Claims Against MERS Shareholders: Dismisses Shareholders From Lawsuit Irene C. Freidel and Gregory N. Blase

A federal court in Delaware recently held that shareholders of Mortgage Electronic Registration Systems, Inc. (“MERS”) – some of the country’s largest mortgage lenders – could not be held liable for the alleged activities of MERS. Trevino et al. v. Merscorp., Inc., et al., No. 1:07-cv-00568-JJF (D. Del.). MERS was created in 1996 by the real estate finance industry to eliminate the need to prepare and record assignments when trading residential and commercial mortgage loans. MERS’s chief business purpose is to simplify and streamline the manner in which mortgage ownership and servicing rights are originated, sold and tracked. Recently, in light of its visibility in connection with mortgage defaults and foreclosures, MERS and its shareholders have come under attack by plaintiffs’ class action lawyers. The court’s decision resulted in the dismissal from the putative class action of MERS shareholders Citigroup, Inc., Countrywide Financial Corp., Fannie Mae, Freddie Mac, GMAC-RFC Holding Company, LLC, HSBC Finance Corporation, JPMorgan Chase & Co., Washington Mutual Bank, and Wells Fargo & Company (the “shareholder defendants”). In their complaint, plaintiffs alleged that MERS overcharged them and a class of similarly situated individuals for costs arising out of proceedings to enforce mortgage instruments, including foreclosures. Plaintiffs asserted that MERS’s alleged actions constituted breach of contract, unjust enrichment, and breach of the duty of good faith and fair dealing. Plaintiffs sought to hold the shareholder defendants liable for the alleged actions of MERS through the theory of “piercing the corporate veil.” Specifically, plaintiffs contended that because of its alleged “diminutive size and meager asset base,” MERS is undercapitalized and would be unable to pay on any judgment that plaintiffs and the putative class may eventually obtain. Plaintiffs contended



that these facts stated the basis for their request to pierce MERS’s corporate veil and to hold the shareholder defendants liable for MERS’s alleged wrongdoing. The shareholder defendants moved to dismiss the complaint arguing, among other things, that there was no allegation that MERS was set up for the purpose of committing fraud or some other injustice to borrowers, that MERS was established for a legitimate business purpose, and that its shareholders – all competitors in the marketplace – could not be considered a “single functioning entity” for veil-piercing purposes. The court agreed, finding in part, that plaintiffs had failed to allege an overall element of injustice. The court noted that the plaintiffs’ only substantive factual allegation in support of their claim against the shareholders was that MERS was undercapitalized. But the court held that a shortage of capital is not a per se reason to pierce the veil. This is particularly the case where there is no allegation that the alleged undercapitalization was undertaken to defraud a corporation’s creditors. The court noted plaintiffs’ acknowledgment that MERS was established for a legitimate business reason, i.e., to “create a secondary mortgage market, internally administer the buying and selling of mortgages, and to simplify the administration of home mortgages.” Finally, the court found that plaintiffs had failed to allege any unfairness sufficient to ignore MERS’s corporate form. Specifically, while plaintiffs alleged that MERS was created to facilitate its shareholders’ business interests and to limit their liability, neither of these factors shows unfairness, unless the attempt to limit liability was undertaken in order to avoid responsibility for a specific tort or class of torts.The Trevino decision is significant because it spared MERS’s shareholders from potential exposure to consumer class actions on the now rejected theory of indirect liability. MERS is integral to the successful functioning of the secondary mortgage market. Plaintiffs’ discredited legal theory, if not rejected by the court, could have exposed MERS shareholders to liability for the actions of third party investors and servicers, causing further stress to the already embattled mortgage market. ______________________________

Insurance Coverage for Claims Arising from the Credit Crisis

Insurance Coverage for Claims Arising from the Credit Crisis: Policyholders Should Take Steps to Preserve Their Rights to Coverage for Lawsuits and Investigations Gregory S. Wright

I. Introduction In 2007, the subprime mortgage crisis triggered a wave of litigation and regulatory action involving not only the lenders that sold subprime mortgages, but also the issuers, underwriters, and other financial institutions that participated in the securitization of the mortgages and the sale of securities backed by the subprime loans. The credit crisis of the last few months has exacerbated (and likely will continue to exacerbate) this wave of litigation and regulatory action, not only by increasing the number of claims, but also by expanding the universe of targets to include companies and individuals that were not directly involved in the sale or securitization of subprime loans. Given this expanding crisis, many corporations (as well as their officers and directors) will be forced to incur substantial sums to defend such claims, to settle such claims, and/or to pay judgments. In many cases, insured companies and their officers and directors should be entitled to coverage for such costs under their Directors’ and Officers’ (“D&O”) liability policies. While this article focuses on D&O coverage, policyholders also should consider the potential for coverage under other policies, such as Errors and Omissions liability policies and Fiduciary liability policies. It should be noted that the terms of D&O policies vary widely. In addition, one should assume that insurers will assert all available defenses to such claims based on the specific policy language and facts at issue. Given the potential for coverage, policyholders facing claims and investigations should carefully review their D&O policies and should take appropriate steps in order to maximize their potential insurance recoveries.



II. Credit Crisis Litigation and Investigations The subprime mortgage crisis, and the ensuing credit crisis, has produced a wide array of claims, lawsuits, and government investigations. Companies and individuals in a rapidly expanding list of industries have been impacted. Many of the claims at issue target individuals who are commonly insured under D&O policies (e.g., individual directors and officers), as well as the target entity itself, and allege conduct that often potentially triggers coverage under D&O policies, such as alleged misstatements in public filings, negligent misrepresentations, and/or breaches of fiduciary duties. Merely to illustrate, this wave of litigation and investigations includes the following types of current claims, all of which potentially may trigger coverage under D&O policies: • Lawsuits by shareholders against lenders and

certain directors and officers alleging (in part) that defendants made false and misleading statements to the public about subprime lending activities.

• Lawsuits by shareholders against investment banks and certain directors and officers alleging misstatements about the value of and risks associated with subprime-backed assets.

• Lawsuits by investors against financial institutions and certain directors and officers alleging that the defendants that sold them mortgage-backed securities misrepresented the risks associated with such securities.

• Class action lawsuits against failed banks, related holding companies, and related officers and directors, alleging that the defendants misled investors about the financial status of the bank, violated securities laws, committed fraud, made negligent misrepresentations, etc.

• Class action lawsuit on behalf of preferred shareholders of Fannie Mae and Lehman Brothers alleging false statements by named officers and directors in connection with the offerings.

• Class action lawsuits against companies not directly involved in the subprime area (such as Constellation Energy), as well as their directors and officers, alleging failure to make appropriate disclosures about exposures arising

from credit problems of trading partners (e.g., Lehman Brothers).

• Class action lawsuits and regulatory investigations against companies concerning auction rate securities. The lawsuits allege in general that the companies failed to make appropriate disclosures about the risks associated with auction rate securities. Some (but not all) of the lawsuits name individual directors and officers. While most of the lawsuits have been filed on behalf of the purchasers of the auction rate securities, at least one lawsuit was filed on behalf of shareholders of the entity (Merrill Lynch) that sold the auction rate securities to other investors. See also M. King, SEC and FINRA Focusing on Individuals in Auction Rate Securities Investigation, available at http://www.klgates.com/newsstand/Detail.aspx?publication=4966.

• SEC investigations into possible market manipulation in connection with short selling in the securities of financial institutions. See B. Ochs, Manipulation Tied to Short Selling a Top Enforcement Priority, available at http://www.klgates.com/newsstand/Detail.aspx?publication=4966.

• FBI and DOJ criminal investigations regarding accounting, disclosure, and corporate governance matters. See M. Ricciuti, DOJ Opens Criminal Investigations under New Guidelines for Prosecuting Corporate Entities, available at http://www.klgates.com/newsstand/Detail.aspx?publication=4966.

III. Potential Coverage under D&O Policies In general, D&O policies afford coverage for “Claims” against an “Insured” alleging “Wrongful Acts” that result in a covered “Loss.” The availability of coverage turns on the definitions of such terms (which vary widely), other policy terms and conditions, and the nature of the specific allegations in the claim at issue. Claim. D&O policies generally afford coverage for “claims.” All (or virtually all) D&O policies include “lawsuits” within the definition of “claim,” but coverage for regulatory or criminal



investigations varies widely. For example, certain D&O policies define “claim” to include SEC investigations commenced by the service of a subpoena on an insured person or criminal proceedings commenced by the return of an indictment, information, or similar document. Other D&O policies cover a broader array of informal investigations, while other policies limit coverage to investigations commenced by a “formal order” of investigation. In any event, given the broad array of policy language available in the market, insureds should not wait for lawsuits to be filed before analyzing the potential for coverage. Entity Coverage. In addition to covering claims against insured directors and officers, many D&O policies afford coverage for claims against the insured entity itself (for example, many D&O policies cover so-called “Securities Claims” filed against the insured entity, including class action securities lawsuits). The inclusion of “entity coverage” in D&O policies often helps insurers and policyholders avoid disputes on how to allocate defense costs and/or settlement payments among covered individuals and the entity itself. Loss. The definition of “loss” in D&O policies varies widely. For example, some policies expressly cover fines, penalties, multiplied damages, and punitive damages, when permitted by law. Some D&O policies do not. In addition, insurers and policyholders frequently litigate (and courts recently have reached conflicting opinions on) the availability of coverage for so-called “disgorgement,” “restitution,” and/or for losses paid pursuant to Section 11 of the Securities Act of 1933. See, e.g., Bank of America Corp. v. SR International Business Ins. Co., 2007 WL 4480057 (N.C. Super. 2007) (holding that settlement of Section 11 claim may be covered under D&O policy). Conduct Exclusions. Insurers also may seek to rely on various exclusions in the relevant policy to deny coverage for subprime-related claims. For example, insurers may seek to rely on so-called conduct exclusions, which bar coverage for certain claims relating to criminal or fraudulent activity or for claims alleging that the insured received a profit to which he or she was not legally entitled. Again, it should be noted that the terms of these exclusions vary widely. Some exclusions arguably bar coverage when the excluded conduct is merely

alleged. However, in most policies, the exclusions do not apply unless the insurer meets its burden of proving that the excluded conduct “in fact” occurred or unless the excluded conduct is established via a “final adjudication.” When the policy at issue includes the “in fact” test or “final adjudication” test, insureds are often entitled to coverage for defense costs and/or settlements that are made without any finding or admission with respect to the excluded conduct. In addition, many D&O policies contain severability provisions that prevent the insurer from imputing the knowledge or conduct of one insured to other insureds, which in effect preserves coverage for the “innocent insureds” and/or the company itself. Defense Issues. In many D&O policies, the insurer is not obligated to defend a claim, but rather is required to reimburse the policyholder’s defense costs. Nevertheless, certain D&O policies state that the policyholder should not incur defense costs or settle a claim without the consent of the insurer. In addition, certain D&O policies require the policyholder to obtain the insurer’s consent with respect to the selection of defense counsel (such consent not to be unreasonably withheld). To avoid potential insurer defenses, policyholders may wish to consider taking steps to address any conditions in the policy related to defense and/or cooperation with the insurer. Rescission Issues. In response to claims alleging misleading statements in a public filing, insurers often attempt to rescind the policy at issue entirely to the extent the public filing at issue was attached to or incorporated by reference into the insured’s “application” for coverage. State law on this defense varies widely, but most courts impose a high burden of proof on insurers to demonstrate (among other things) that the alleged misrepresentation was material and that the insurer in fact relied on the alleged misrepresentation when it decided to issue the policy. In addition, many current D&O policies make coverage non-rescindable for certain types of claims or certain insureds. Further, many D&O policies contain strict severability clauses that limit the insurer’s right to rescind to only those individuals that had specific knowledge of the misstated facts.



Renewal Issues. As noted above, the terms of D&O policies vary widely. Further, insureds and insurers frequently negotiate certain terms of coverage during the renewal process. With proper planning, insureds potentially may obtain coverage-enhancing changes to standard policy forms that may be outcome-determinative when a claim is filed. Insureds frequently retain outside coverage counsel to review their D&O policies and participate in this renewal process. IV. Conclusion D&O policies offer a potentially valuable resource for policyholders facing claims arising from the subprime crisis and related credit crisis. Policyholders should take steps now to preserve their rights to coverage. ______________________________

NASAA Initiatives on Principal Protected Notes

State Securities Regulators - On the Warpath Against Principal Protected Notes? David N. Jonson

Recent pronouncements from the North American Securities Administrators Association ("NASAA") indicate that its members (state and Canadian provincial securities regulators) are fielding so many investor inquiries and complaints regarding Principal Protected Notes ("PPNs") that NASAA is considering the formation of a multistate investigative task force to investigate how PPNs were offered and sold. Such a task force would likely be similar to the one that NASAA created earlier this year to investigate auction rate securities. A PPN is a type of structured investment product designed to provide a return of principal investment at maturity (typically 3-8 years), plus the potential to earn additional returns that are tied to the performance of an equity or commodity index. Accordingly, PPNs tend to attract investors who are risk-averse and long-term oriented, and who seek a guaranteed return of their principal investment. In order to preserve principal and offer a degree of upside potential, PPNs are comprised of two components. A portion of the principal is used to

purchase a zero coupon bond with a face value equal to the full principal amount at maturity, assuring that the original amount invested will be returned, so long as the bond's issuer does not default during the life of the PPN. The remainder of the principal amount is invested in options on an underlying index with the same expiration date as the PPNs maturity date. The two primary risks of investing in PPNs are the credit risk of the issuer and the lack of liquidity, since PPNs are designed to be held until maturity. The total size of the PPN market is estimated to be approximately $35 billion. In the wake of the insolvency of some PPN issuers, state regulators have been contacted with allegations that the risks of these investments were misrepresented or that PPNs were sold to investors for whom they were unsuitable. Given the volatility of today's financial markets and the speed with which bad news travels, investors in PPNs of solvent issuers have also expressed concerns about the safety of their investments. Several key dynamics will influence whether NASAA's Board of Directors and Enforcement Section decide to create a PPN task force. First, state securities regulators view themselves as the "local cops on the beat," and thus, the first line of defense in protecting investors. If the number of investor complaints is significant enough, NASAA and its members will act quickly, as they did most recently in connection with NASAA’s auction rate securities task force, which took the leading regulatory role away from the SEC and FINRA. Second, if one of the more active state securities regulators, such as the New York Attorney General or Massachusetts Secretary of State, takes early action, NASAA will be sure to organize a more widespread group of states to join the fray. Third, although there is now a pro-regulation environment in Washington, NASAA and its members have historically been mindful of and concerned about any efforts to pre-empt the states from asserting their regulatory authority. By acting quickly and decisively on the heels of their successful auction rate task force, NASAA members would be taking advantage of another opportunity to reemphasize the importance of the states' role in the securities regulatory arena. We are continuing to monitor the situation through our NASAA contacts, and will report any material developments in the future.



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No U.S. Court Jurisdiction for “Foreign-Cubed” Class Action

Second Circuit Dismisses Its First “Foreign-Cubed” Securities Action for Lack of Jurisdiction Michael J. King

Proclaiming that “we are an American court, not the world’s court,” the U.S Court of Appeals for the Second Circuit recently rejected an effort to extend U.S. jurisdiction over foreign securities transactions. The decision in Morrison v. National Australia Bank Ltd., – F.3d –, 2008 WL 4660742 (2d Cir. Oct. 23, 2008), arose in a so-called “foreign-cubed” securities class action case: an action brought by foreign investors, in foreign securities, purchased on a foreign securities exchange. Morrison, the first such case considered by the Second Circuit, offers a measure of reassurance to foreign issuers and investors who might otherwise avoid even tangential connections with U.S. capital markets due to fear of the U.S. legal system. Australian investors sought to bring a class action suit in the U.S. District Court for the Southern District of New York against National Australia Bank (“NAB”) and others, alleging securities fraud under U.S. law in connection with purchases of NAB securities on an Australian securities exchange. According to the plaintiffs, NAB’s subsidiary, HomeSide Lending, Inc. (“HomeSide”), a U.S. mortgage service provider, used improper accounting methods that overstated the value of its mortgage servicing rights (“MSR”). These improper accounting methods led NAB to write down $2 billion in the value of HomeSide’s MSR in 2001, resulting in significant declines in the price of NAB’s securities. Plaintiffs alleged that the defendants made false and misleading statements concerning HomeSide’s operations and its contributions to NAB’s financial health in filings with the SEC, foreign securities exchanges, in statements to the press, and in corporate documents. Since it was confronted with allegations of securities fraud involving foreign securities transactions, the district court looked to the “effects” and the “conduct” tests developed by the Second Circuit for

deciding whether to exercise jurisdiction over such suits. Morrison v. National Australia Bank Ltd., -- F. Supp. 2d--, 2006 WL 3844465 (S.D.N.Y. 2006). Under the effects test, a district court may exercise jurisdiction over foreign plaintiffs where the alleged illegal activity causes a “substantial effect” on U.S. investors or markets. Under the conduct test, a district court may exercise jurisdiction if a defendant’s conduct in the United States was more than “merely preparatory” to the fraud, and particular acts or culpable failures to act within the United States “directly caused” losses to foreign investors abroad. The district court quickly concluded that the effects test did not support exercise of subject matter jurisdiction since the alleged fraud had very little, if any, effect in the U.S. markets. Moving to the conduct test analysis, the district court concluded that HomeSide’s alleged misconduct in the United States was immaterial to a securities fraud claim given the much more significant extra territorial conduct of NAB. Thus, the district court found that the foreign actions, not the domestic actions, “directly caused” the alleged harm in this case and dismissed the complaint. On appeal, the appellants relied solely on the “conduct” component of the conduct and effects tests in support of their jurisdictional argument. Reviewing prior precedent, the Second Circuit reaffirmed that pursuant to “the ‘conduct’ component, subject matter jurisdiction exists if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad . . .. Our determination of whether American activities ‘directly’ caused losses to foreigners depends on what and how much was done in the United States and on what and how much was done abroad.” Morrison, 2008 WL 4660742, at *4. The Second Circuit then reviewed the comparative significance of the conduct in the United States with those actions that occurred abroad and concluded that actions of NAB in Australia were significantly more central to the alleged fraud and more directly responsible for the harm to investors than the alleged manipulative accounting by HomeSide in the United States. In reaching its decision, the Second Circuit stressed that the responsibilities of NAB’s Australian



headquarters included overseeing its own and its subsidiaries’ operations, and reporting to shareholders and to the financial community. The court also emphasized that NAB, not HomeSide, was the issuer of the securities and therefore was responsible for the public statements and filings and for relations with its investors. The Second Circuit also noted the absence of any allegation of harm to U.S. investors or markets and the lengthy chain of causation between HomeSide’s contribution to the misstatements and harm to investors. Based upon the totality of this analysis, the court concluded that it lacked subject matter jurisdiction and affirmed the dismissal. Id. at *7 & 8. In addition to addressing for the first time the issues presented in a foreign-cubed class action case, the Second Circuit’s decision is significant because the court refused to replace the conduct test analysis with proposed alternative formulations for determining subject matter jurisdiction. Appellees and certain of the amici urged the court to adopt a bright-line rule that, in foreign-cubed cases, domestic conduct should never be enough and subject matter jurisdiction cannot be established where the conduct in question has no effect in the United States or on U.S. investors. The court flatly rejected this proposal. The court also rejected the SEC’s proposed alternative standard proffered in its amicus brief that the “antifraud provisions of the securities laws [should] apply to transnational frauds that result exclusively or principally in overseas losses if the conduct in the United States is material to the fraud’s success and forms a substantial component of the fraudulent scheme.” The court’s implicit rejection of the SEC’s materiality test – the decision does not even address it – is particularly important because the materiality standard would likely permit more cases alleging transnational frauds to stay in U.S. courts. For example, the SEC amicus brief urged that, under the materiality test, jurisdiction existed in Morrison. The decision provides needed stability in an area of the law that is important to non-U.S. companies considering investing in the United States who are concerned about the risks and burdens of U.S. class action lawsuits, existing foreign investors in the United States with similar concerns, and the financial markets and intermediaries that service such investors and potential investors. At a time

when the U.S. plaintiff’s bar is taking deliberate steps to cultivate foreign claimants for U.S. class action suits, these protections are welcome. Although the conduct and effects tests are very fact specific, the Second Circuit’s decision to adhere to these tests when considering subject matter jurisdiction in transnational fraud cases provides a reliable framework for disposing of cases at a preliminary stage. This is particularly important to firms concerned about exposure to class actions, where attendant disruptions and defense costs alone can prove very burdensome, even where defendants have fully complied with the law. ______________________________

State and Local Measures to Prevent Foreclosures

Make My Day: States Dare Servicers to Foreclose Nanci L. Weissgold

Approximately 7.3 million American homeowners are expected to default on their mortgages between 2008 and 2010, and 4.3 million of those are expected to lose their homes. Taking the response to the ongoing foreclosure crisis into their own hands, in recent months a number of states and local governments have enacted measures to protect their home-owning constituents. These measures impose notice and other practice requirements on mortgage loan servicers, create new rights for homeowners, and encourage the parties to communicate and to attempt to work out alternatives to foreclosure. Through such measures, states are doing what they can to stop foreclosures in their tracks or make it so burdensome to foreclose that generous loan modifications look better and better. Although their impact cannot yet be measured, what is clear is that the numerous measures that state and local governments have enacted are impacting the way that mortgage lenders and loan servicers conduct their business. These measures require lenders and servicers not only to keep up to date on legislative changes, but also (in many cases) to adjust their business practices to comply with new statutory requirements. At a minimum, many of these measures effectively extend the time frame for bringing a foreclosure action; they may also add procedural requirements to the process. The article



“Make My Day: States Dare Servicers to Foreclose,” available at http://www.klgates.com/newsstand/Detail.aspx?publication=5040, uses examples of each type of new measure to explore that impact. ______________________________

Federal Loan Guarantees

EESA: No Guarantees of Federal Loan Guarantees Laurence E. Platt

Press reports claim that the Federal Deposit Insurance Corporation and the U.S. Department of Treasury (“Treasury”) are close to announcing a plan pursuant to which the federal government will guarantee the timely repayment of principal and interest on modified eligible residential mortgage loans held by private parties pursuant to the Emergency Economic Stabilization Act of 2008 (“EESA”). Such a plan might conflict with legal and accounting rules for mortgage-backed securities, raises questions about its relationship to other recent federal initiatives, requires Treasury to develop an actuarially sound, self-funded mortgage insurance program, and calls for loan holders to make principal write-downs they might not be willing to make. Because of these issues, we are not convinced that the proposal will morph into a real program. As events unfold, we want to take the opportunity to highlight certain issues for which you should watch if a home loan guarantee program actually is promulgated by Treasury. These issues are addressed in the article, “EESA: No Guarantees of Federal Loan Guarantees,” available at http://www.klgates.com/newsstand/Detail.aspx?publication=5039. They include the following: 1. What residential mortgage loans will be eligible

for loan guarantees? 2. What is the difference between an FHA-insured,

refinancing mortgage loan under the HOPE for Homeowners Program (“HOPE Program”), which Congress created earlier this year as part of the Housing and Economic Recovery Act of 2008, and a Treasury-guaranteed modified loan?

3. Will loan holders permanently write down the existing indebtedness by the amount necessary to qualify for a loan guarantee?

4. Given the write-downs that it will take to qualify an existing loan for a HOPE Program refinancing or a federal loan guarantee, why not just sell the loans to Treasury under the recently enacted Troubled Asset Relief Program (“TARP”)?

5. Does a federal loan guarantee provide a comparative advantage to loan holders over the HOPE Program or TARP?

6. How will Treasury ensure that the insurance premiums are sufficient to meet the statutory standard of actuarial soundness?

______________________________

Discounts for Settlement Costs Upheld Under RESPA

Eleventh Circuit Rejects Challenge to Optional Discounts under RESPA Phillip L. Schulman, R. Bruce Allensworth, Andrew C. Glass and David D. Christensen

Through a spate of lawsuits, the plaintiffs’ class action bar has sought to articulate a novel theory of liability under the Real Estate Settlement Procedures Act (“RESPA”), 12 U.S.C. § 2601, et seq. Specifically, the plaintiffs’ bar has brought RESPA Section 8 claims against home builders and their affiliates who offer optional discounts on settlement costs if home buyers choose to use the affiliates’ services. In conflict with RESPA’s goal of lowering settlement costs, plaintiffs’ lawsuits challenge the ability of home builders, as well as of affiliated mortgage lenders, title insurance companies, and other settlement service providers, to offer meaningful discounts to consumers. Becoming the first federal appellate court to consider the issue, the U.S. Court of Appeals for the Eleventh Circuit recently rejected plaintiffs’ theory. See Spicer v. The Ryland Group, Inc., Appeal No. 07-15426, 2008 WL 4276909 (11th Cir. Sept. 16, 2008) (per curiam), aff’g 523 F. Supp. 2d 1356 (N.D. Ga. 2007). Plaintiff Tanya Spicer sued The Ryland Group, Inc. (“Ryland”) and its affiliate Ryland Mortgage Company (“Ryland Mortgage”), alleging that defendants violated RESPA Section 8 through offering an optional settlement costs discount if



Spicer chose to use Ryland Mortgage to finance the purchase of her home from Ryland. 523 F. Supp. 2d at 1358-59. Spicer attempted to articulate a theory of “economic coercion” in support of her claim. In particular, Spicer argued that because the amount of the discount allegedly was too great to pass up, she had “no viable economic option but to use the affiliated lender.” Id. at 1361. RESPA Section 8 prohibits kickbacks in exchange for the referral of, and unearned fees received in connection with, real estate settlement services. The statute, however, provides a qualified exemption from Section 8 liability to affiliated business arrangements. Specifically, 12 U.S.C. § 2607(c)(4) provides that the referral of settlement services to an affiliated service provider is permitted if: (a) the existence of the affiliated business arrangement is disclosed to the person referred; (b) the person referred is not required to use any particular settlement service provider; and (c) the only thing of value that is received from the arrangement is the return on the ownership interest. Regulation X, promulgated by the Department of Housing and Urban Development to implement RESPA, permits affiliated service providers to offer “discounts or rebates to consumers for the purchase of multiple settlement services.” 24 C.F.R. § 3500.2. Such discounts do not constitute an impermissible “required use” if the discounts are “optional to the purchaser” and are “true discount[s] below the prices that are otherwise generally available, and must not be made up by higher costs elsewhere in the settlement process.” Following the plain language of RESPA and Regulation X, the Spicer district court held that offering optional discounts on settlement costs if home buyers choose to use affiliates’ services does not violate RESPA or Regulation X. 523 F. Supp. 2d at 1362. The court specifically rejected Spicer’s claim that offering an optional settlement costs discount amounted to “economic coercion.” After briefing and oral argument, the Eleventh Circuit affirmed, adopting the district court opinion as “well-reasoned.” Spicer, 2008 WL 4276909, at *1. The federal district court decisions to date have rejected the “economic coercion” theory of required use, and the Eleventh Circuit’s affirmation of the dismissal of the Spicer matter reinforces the

consensus among federal courts that offering optional discounts on settlement costs if home buyers choose to use affiliates’ services does not violate RESPA. Changes to Regulation X’s definition of “required use” effective in January 2009, however, may alter the landscape for home builders and their affiliates. Phillip L. Schulman, R. Bruce Allensworth, Andrew C. Glass, and David D. Christensen of K&L Gates LLP represented The Ryland Group, Inc. and Ryland Mortgage Company. ______________________________

Patents for Business Methods and Software

In Re Bilski and Patents for Business Methods and Software Stephen C. Glazier

On October 30, 2008, in an en banc decision, the U.S. Court of Appeals for the Federal Circuit handed down the In re Bilski decision. This was a much-awaited decision that addressed the question of what subject matter may be considered for patentability in software, financial services, business methods and telecom services. After citing the Supreme Court precedent in Gottschalk v. Benson, 409 U.S. 63 (1972), Parker v. Flook, 437 U.S. 584 (1978), and Diamond v. Diehr, 450 U.S. 175 (1981), the Federal Circuit, in stating the “definitive test” provided by the Supreme Court for determining whether a “process” may be considered for patentability under Section 101 of the Patent Statute, said that process is “surely patent-eligible if: 1) it is tied to a particular machine or apparatus, or 2) it transforms a particular article into a different state or thing.” This test is referred to as the “machine or transformation” test. (Patent eligibility under Section 101 is only the first hurdle to issuing a valid and enforceable patent. If a patent application claims patent eligible subject matter under Section 101, then the patent must still be novel under Section 102, and non-obvious under Section 103.) The Bilski decision rejects other tests previously adopted by the Federal Circuit for potentially patentable subject matter under Section 101, specifically rejecting the test in State Street Bank &



Trust Company v. Signature Financial Group, 149 F.3d 1368 (Fed. Cir. 1998), and AT&T Corp. v. Excel Communications, Inc., 172 F.3d 1352 (Fed. Cir. 1998), which states that the potentially patentable methods of software or business methods must “produce a useful concrete and tangible result.” After stating the machine or transformation test, the court goes on to state that “certain considerations are applicable to analysis under either branch [of this test]. First, as illustrated in Benson, the use of a specific machine or transformation of an article must impose meaningful limits on the claim scope to impart patent-eligibility. Second, the involvement of the machine or transformation in the claim process must not merely be insignificant extra-solution activity.” The court goes on to say that it may in the future further refine the machine or transformation test. In particular, it may further carve out special rules for patent eligibility where the machine in question is a “computer”; however, the court specifically leaves this further development of case law for possible future action. Specifically, the court says “issues specific to the machine implementation part of the test are not to be decided today. We leave to future cases the elaboration of the precise contours of machine implementation as well as the answers to particular questions such as whether and when recitation of a computer suffices to tie a process claim to a particular machine.” Further, the court says “we agree that future developments in the technology and the sciences may present difficult challenges to the machine or transformation test, such as the widespread use of computers and the advent of the Internet has become the challenge in the past decade.” The court further states “and we certainly do not rule out the possibility that this court may in the future refine or augment the test or how it is applied. At present, however, and certainly for the present case, we see no need for such a departure and reaffirm that the machine or the transformation test is properly applied as the governing test for determining patent eligibility of a process under Section 101.” The term “machine” is commonly used in the practice and includes computers and programmed apparatus. The new Bilski test will be a problem for that small percentage of business method patents and patent applications that cannot be drafted to include any

machine or physical transformation of matters; however, the no-technology, purely “mental step only” invention has never been a large percentage of the U.S. patent portfolio. And, apparently, all software embodied inventions may be drafted to be tied to a machine. For existing patents and patent applications, Bilski might suggest an opportunity to audit current portfolios of interest for possible modification of pending claims in patent applications, and to audit issued patents to modify issued claims in issued patents, where reissues are possible to more precisely comply with the Bilski test. Further, case law should be monitored for possible further refinements in the application of the Bilski test. Specific issues, such as possible modification of the machine requirement where the machine is a computer, should be watched for. As for planning business patent strategies, we can expect, until any further case law development in this area, continued growth in the population of software and computerized business method patent applications and issued patents, and in related enforcement and transactions. However, as is always the case in the development of case law, we must keep alert for the next shoe to drop. ______________________________



K&L Gates Events

Global Crisis, Change, Perspective: A Look at Today's International Real Estate Finance and Investment Markets December 2, 2008 Local time in all locations New York, Boston, Charlotte and Raleigh http://www.klgates.com/events/Detail.aspx?event=1832 12:00 p.m. Lunch begins 12:30 p.m. - 2:00 p.m. Panel discussion and Q&A London http://www.klgates.com/events/Detail.aspx?event=1826 5:00 p.m. Registration 5:30 p.m. - 6:30 p.m. Panel discussion and Q&A 6:30 p.m. Cocktail reception

K&L Gates comprises approximately 1,700 lawyers in 28 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit www.klgates.com.

K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office.

This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.

©2008 K&L Gates LLP. All Rights Reserved.

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