As a result of the complexity of securities lending transactions and processes involving many different parties, the practice has led to a broad range of types of litigation. This section describes three types of cases relevant to institutional lenders and their agents: unsuitable investments, inappropriate fees and dividend arbitrage (also referred to as “yield enhancement”). We also describe some analyses that experts might conduct.
In unsuitability cases, plaintiffs often allege that the agents made inappropriate investments from the cash collateral generated in an SLP. These cases fall into two general types:
Claims of violation of the Investment Guidelines have tended to be less common. An example of such a case occurs when plaintiffs allege that the purchase of a particular security violated the provision of the guidelines requiring that a domestic U.S. company must issue any securities purchased under the SBL program.
Plaintiffs typically argue that a foreign entity issued the U.S. security. Defendants commonly argue that the security had a U.S. issuer and that reputable sources like Bloomberg treated the securities as having U.S. issuers. Another example occurs when plaintiffs allege that securities with stated maturities of several years violate the guidelines even when the effective maturity—measured by the reset date for the interest rate—is far shorter.
Following the financial crisis of 2008, when collateral investment portfolios suffered losses, the more frequent allegation has claimed that investments were unsuitable for an SLP (even if permitted by the Guidelines) or that the agent should have sold the securities as the financial crisis worsened. Common plaintiff allegations of failure to preserve principal include the following:
For their part, defendants commonly respond with the following:
Experts might conduct one or more of the following analyses, depending on the facts and circumstances:
In another type of lawsuit, plaintiffs allege that lending agents either charged too high a fee and/or had an incentive to take excessive risks in the collateral investment portfolio because they shared in any income (receiving a percentage of the lending fee) but not in any principal losses.
Defendants commonly make several arguments in response:
Plaintiffs also sometimes allege improper fees in connection with allegations of unsuitability.
Experts might conduct one or more of the following analyses:
Many of the securities lending issues described in this article are even more relevant in a class certification context. When multiple plaintiffs band together to sue a defendant, they must seek permission from the court to do so as a class. For example, pension plans may band together to sue a defendant because they believe they have similar claims. To be certified as a class, plaintiffs must meet all of the requirements of Rule 23(a) and must satisfy one of three subsections of Rule 23(b).24 In federal class actions primarily seeking damages, the plaintiffs must demonstrate that the class satisfies Rule 23(b)(3) predominance criterion, which requires that common questions of law and fact predominate over any individual questions.
One difference between securities lending class actions and other securities class action cases relates to the element of reliance. The Advisory Committee Notes to Rule 23 (b) (3) state: “a fraud case may be unsuited for treatment as a class action if there was material variation in the representations made or in the kinds or degrees of reliance by the persons to whom they were addressed.”25 In a typical securities class action, the court can presume reliance on alleged misrepresentation if a security at issue trades in an efficient market. An efficient market incorporates all public information, including alleged misrepresentations, into security prices in a timely fashion. Such a presumption, however, does not apply in a securities lending class action and plaintiffs must affirmatively demonstrate that all class members received either identical or substantively similar representations on which the class members similarly relied and thereby suffered injury.
In addition, in its Comcast decision, the Supreme Court held that in order to establish predominance under Rule 23(b)(3), plaintiffs must offer a damages method tied to their theory of liability. How much this has changed class certification opinions is open to dispute: some legal observers claim it has had little effect on class certification, but some district courts have applied Comcast to deny class certification.
Plaintiffs and defendants typically dispute whether the reliance and damages requirements raise important questions in cases involving the suitability of investments in securities lending. The plaintiffs’ position is relatively simple: they believe they do not. According to plaintiffs, the unsuitability of an investment for an SLP (due to the nature of securities lending as a relatively conservative investment) is a common question applicable to all putative class members. Defendants argue the opposite and desire to make suitability into an individualized issue. Defendants argue that an appropriate damages theory— one that matches the theory of liability and contains only members who have sustained injury, among other things—cannot be quantified at the class certification stage. In terms of suitability, defendants often argue that suitability for one investor does not necessarily imply suitability for another. Consider these factors:
In terms of damages, a defendant might argue that plaintiffs must specify their damages theory and that it must match their liability theory. For example, if a plaintiff alleges that the agent improperly purchased broad classes of securities, defendants might argue that the plaintiff must specify what alternative portfolio of investments the agent should have purchased and then require plaintiff to explain how, for each lender, that alternative portfolio would have made sense in terms of the required returns that investor desired.
With dividend arbitrage (yield enhancement) transactions, taxpayers temporarily lend securities to parties in lower tax and/or withholding tax jurisdictions across the record date for dividend payments. These parties then return the securities after dividends are paid. The lender, borrower and intermediary bank share the tax savings. Dividend arbitrage transactions can take a variety of forms, often involving stock loans and/or equity swaps. Entities use these across international borders.
Numerous variations on the basic structure of a dividend arbitrage transaction exist, some extremely complex. A proper analysis of any particular transaction structure usually requires an in-depth understanding of the transaction.
The Internal Revenue Service, financial regulators and their counterparts in foreign countries frown on purely tax motivated transactions. Their challenges argue that such transactions entail little to no risk and that the parties would not have entered into these transactions in the absence of tax benefits. In other words, they argue that the transactions had no economic substance.
Taxpayers often argue that they complied with all statutes, that they acted for the benefit of their stakeholder-beneficiaries, that the transactions were profitable even without the tax benefits and that the transactions entailed significant risks. To show that the transactions were profitable in such securities lending cases, defendants often argue that the parties profitably used the loaned securities in other parts of their equities business because the parties could:
Defendants often argue that, besides the usual risks that accompany securities lending described in Section 30.2(b) (counterparty risk, liquidity risk or risk of recall, operational risk), they were exposed to numerous other risks inherent in equities finance operations, including:
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