Obama lays down the law

Speed and change have so far been the hallmark of the Obama administration, at least in the business and financial services world.

We saw it first in the bankruptcy court. Within 45 days, a deal was struck and closed to sell Chrysler's operating assets under Section 363 of Chapter 11 of the US bankruptcy code, to a newly-created shell company, called New Chrysler, all of the stock of which was issued to auto unions, Fiat and the US Government in return for promises to provide New Chrysler with skilled labour, technology and government loans. Never mind that several of the secured lenders objected to the sale. Never mind that the assets of Chrysler, which served as collateral for secured loans of $6.9bn (£4.2bn), were valued at their liquidation price of $2bn (£1.2bn) for the purpose of repaying the secured lenders, but that the same assets, when transferred to New Chrysler, were re-valued at $25bn (£15bn) for the purpose of compensating unsecured creditors.

The sale, which short-circuited Chapter 11 confirmation procedures, which would have got as many interested parties as possible to agree to a plan of reorganisation, was rushed through, emergency ward-style, to save Chrysler from dying in court and to prevent a liquidation which would have put hundreds of thousands out of work. The minority secured lenders that objected to the sale complained that they were dragged along by the majority of secured lenders, who, having received bailout money from the US Government, were allegedly reluctant to block the sale. Although many were disturbed by these events, and in particular by the high level of government involvement in the process, the US Bankruptcy Court approved the sale.

It ruled that the increased value that the unsecured creditors received out of the assets of New Chrysler, relative to the secured lenders, was not in compensation for their pre-bankruptcy claims, but rather the result of separately negotiated agreements with New Chrysler pursuant to which the workers union, the government and Fiat contributed additional consideration to New Chrysler. As for the dissenting secured lenders being dragged along by the majority of secured lenders, the Court ruled that at the time of the loan, the secured lenders had contractually agreed to defer to the rule of the majority with respect to the sale of Chrysler's assets. As for the possible breach of the fiduciary duty of the majority secured lenders toward the minority by agreeing to the sale under the influence of government bail out money, the court found that this had not been sufficiently proven. The Court of Appeals confirmed the decision and the US Supreme Court refused to intervene.

And then there is the President's overhaul of the US Financial Services Industry. Most significantly the plan, if passed by Congress, would subject managers of hedge funds, private equity funds and venture capital funds to the regulatory scrutiny and reporting requirements of the Investment Advisers Act, including rules governing advertising, record-keeping, custody of assets, and the adoption of compliance procedures and codes of ethics. The plan would also require such funds to provide information to the Securities & Exchange Commission on a confidential basis regarding their size, borrowings, off balance sheet exposure and interdependence with other financial institutions. Such information would be passed on to the Federal Reserve to assess whether a particular fund posed a threat to the country's financial stability and whether to make such fund subject to Federal Reserve regulation. The plan is expected to eliminate the exemption for managers with fewer than 15 clients which most private fund managers rely on to avoid registration under the Investment Advisers Act. Although the existing exemptions from registration of the funds themselves under the Investment Company Act would continue to apply for funds beneficially owned by not more than 100 US residents or whose investors are all qualified purchasers, the records of such exempt funds will be open to the regulators under the record keeping requirements of the Investment Advisers Act. Non-US advisers that do not have a place of business in the US, have less than fifteen US clients and less than $25m (£15m) of assets under management attributable to clients in the US would be excluded from this regulation.

Because the investing public no longer differentiates between the traditional role of the broker dealer, that merely executed trades for commission, and the role of the investment adviser, that provided investment advice for a fee, and because the lines between the two services have become blurred by competition, the plan wishes to harmonise the rules of the Investment Advisers Act that apply to investment advisers with the rules of the Securities and Exchange Act that apply to broker dealers. This may result in elevating the standard of care of the broker dealer from the current suitability level, which merely requires the broker dealer to make sure that the investment is suitable for the client's pocket, to the higher fiduciary level of the investment adviser which requires him to act in the best interest of the client. Most significantly, it might mean that broker dealers will now be restricted, as investment advisers are, from selling stock they own to their clients or purchasing stock directly from their clients in principal trades. It is also unclear at the moment whether investment advisers will be regulated, as broker dealers are, by the Financial Industry Regulatory Authority.

Another proposed change is the prohibition of mandatory arbitration of claims against broker dealers. Arbitration, which has long been thought of as the more expedient way to resolve claims, may be replaced by court proceedings which might result in higher costs and more delays for the client.

Finally and most importantly, various financial institutions like Bear Stearns and Lehman Brothers that escaped the Bank Holding Company Act and the scrutiny of the Federal Reserve by structuring themselves in various way that did not fit into the definition of 'banks' under the Bank Holding Act, will now be brought under the Bank Holding Act regulation and will have to provide information on a current basis to enable a newly created Financial Services Oversight Counsel to determine whether they constitute a systemic risk to the financial system as a whole.

Raphael Grunfeld is a partner at Carter Ledyard & Milburn in New York.