The Collapse of Bear Stearns (PowerPoint, 620 KB)

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R.R. DonnelleySEC Hot Topics Seminar

The Failure of Bear Stearns and

the Resulting Impact on theRegulation and Oversightof the Financial Markets

September 15,2008

Michael A. Saslaw – Weil, Gotshal & MangesRichard L. White – Weil, Gotshal & MangesWarren W. Garden – Block & Garden, LLPRick Lacher – Houlihan Lokey

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Timeline of the Rapid

Collapse of Bear Stearns

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Bear Stearns Timeline

• Fall 2006

• The U.S. housing market begins to exhibit signs of trouble, as record home appreciation stalls, foreclosures rise and lending slows.

• One hedge fund managed by Bear Stearns Asset Management (“BSAM”) begins to experience significant difficulties; instead of taking ameliorative action, BSAM forms a second, similar hedge fund with approximately three times the leverage of the original fund – both funds continue to invest in derivatives linked to the U.S. housing market.

• Summer 2007

• Bear pledges $3B to bail out the two hedge funds managed by BSAM.

• Rumors begin to circulate that Bear may have liquidity problems and may have to file for bankruptcy.

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Bear Stearns Timeline (cont’d)

• Fall 2007

• Numerous investment banks report mortgage related multi-billion dollar write-downs .

• Nervous traders at Bear plead with management to raise capital.

• Bear explores, but ultimately does not consummate potential capital infusion transactions with KKR, J.C. Flowers and J.P. Morgan. A potential transaction with Warren Buffett fails to materialize.

• SEC regulators begin to hold weekly conference calls with Bear executives to ensure Bear has sufficient liquidity resources to fund its trading operations.

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• November and December 2007

• Bear posts a quarterly loss, the first since its inception in 1923.

• Merger discussions with hedge fund Fortress Investment Group ultimately fail.

• Following talks with Bear management, Pimco Investments, a major Bear customer, agrees to delay unwinding numerous multi-billion dollar trades, but provides Bear with an ominous warning – “You need to raise equity.”

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• January 2008

• Reports of an inattentive and disinterested management style result in the ouster of Bear’s CEO, Jimmy Cayne. Cayne is replaced by new CEO Alan Schwartz.

• Rumors regarding Bear’s financial health and potential liquidity continue to circulate, although Bear reports a quarterly profit in February 2008.

• March 7, 2008

• Alan Schwartz flies to Palm Beach to prepare for Bear’s annual media conference and begins to receive reports of new rumors regarding Bear’s troubled financial health and waning liquidity.

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• March 10, 2008 (Monday)

• Rumors that Bear is having liquidity problems circulate in the market. At the time, Bear had approximately $18B in cash reserves.

• A few lenders begin to inform Bear that overnight loans scheduled to expire will not be renewed.

• The trading volume for Bear’s stock explodes – total volume exceeds 50M shares, while volume on a typical day is 7M shares.

• Rumors and speculation rocket through the markets and are broadcast on various financial news networks. One commentator perceptively notes:

• “Someone is always making money on the other side of that bad news or that rumor.”

• Bear releases a statement at the end of the trading day denying liquidity problems.

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• March 11, 2008 (Tuesday)

• The Federal Reserve announces a new securities lending program for major Wall Street firms to assist them with disruptions caused by the credit crisis.

• Large numbers of novation requests (requests for a substitute entity to step in and bear counterparty risk on the other side of a trade) from counterparties to trades with Bear flow into numerous Wall Street banks, including Goldman Sachs, Deutsche Bank and Credit Suisse.

• Because of the sheer number of requests, traders at certain firms are told to await credit department approval before proceeding with additional novations of contracts with Bear. Rumors continue to abound on trading floors throughout the day.

• Following leaks of the news that certain investment banks are “refusing” novation requests involving Bear, numerous hedge funds pull money from Bear. Many of Bear’s daily lenders, which provided the firm’s liquidity needs, tell Bear they will not renew expiring loans.

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• March 12, 2008 (Wednesday)

• Alan Schwartz appears on CNBC and denies the existence of liquidity problems at Bear; however, withdrawals by hedge funds continue to accelerate.

• Several “repo lenders” – those who lend day to day based upon pledged collateral – inform that loans will not be “rolled over” the next morning.

• Bear’s cash reserves are reduced to less than $15B.

• Alan Schwartz instructs Bear’s outside counsel to discuss Bear’s financial situation with the Federal Reserve. Bear’s counsel urges the Federal Reserve to accelerate its plans to introduce additional liquidity into the market and to also exercise its power to lend cash directly to investment banks.

• Had the Federal Reserve allowed direct lending to investment banks on March 12, 2008, Bear could have used its inventory of mortgages, mortgage-backed securities and other securities as collateral for borrowings.

• The cost of a five-year policy to protect against default on $10M of Bear’s debt skyrockets to $655K – two to three times the price of similar insurance on the debt of Bear’s rivals. Two weeks before, the cost of such a policy had stood at $300K.

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• March 13, 2008 (Thursday)

• Major hedge fund clients of Bear withdraw their cash holdings. Bear’s “repo lenders,” among others, refuse to extend or roll over loans to Bear the next day.

• Bear’s cash reserves began the week at approximately $18B; by the end of the day, cash reserves had been reduced to approximately $3B, an insufficient amount of cash to fund Bear’s trading operations the next day.

• Bear’s only options at the opening of business the next day were: (i) a bankruptcy filing or (ii) an emergency cash infusion.

• Alan Schwartz discusses Bear’s bleak financial situation with the Federal Reserve, the SEC, the Treasury Department, and J.P. Morgan (among other potential suitors).

• The solution announced at the opening of the next business day is that J.P. Morgan will provide a liquidity facility to Bear for “up to 28 days.” The cash infusion indirectly comes from the Federal Reserve through J.P. Morgan; however, the risk of the loan is borne by the Federal Reserve.

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• March 14, 2008 (Friday)• Following the announcement of Bear’s new liquidity facility

from J.P. Morgan, the market took several hours to process the news.

• However, by the end of the day, all of Bear’s cash reserves are depleted as hedge funds and other clients accelerated their withdrawals.

• Bear’s stock opened the day with a trading price of $54.24 per share. Just as hedge funds and clients were withdrawing their money from Bear, investors also participated in a rapid sell off of Bear’s stock. Bear’s stock closed at $30.00 per share.

• Treasury Secretary Paulson, after seeing the events of the trading day, informs Alan Schwartz that the Federal Reserve will not provide liquidity for Bear on Monday and that Bear had the weekend to finalize a merger or capital infusion transaction.

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• March 15, 2008 through March 23, 2008

• J.P. Morgan and J.C. Flowers conduct around the clock due diligence to attempt to piece together a deal for Bear.

• J.P. Morgan initially informs the Federal Reserve and Bear that it cannot consummate a transaction because of the enormous risks in Bear’s portfolio.

• Following discussions between the Federal Reserve, Treasury Secretary Paulson and J.P. Morgan CEO Jamie Dimon, J.P. Morgan proceeds with a merger agreement to acquire Bear, valuing Bear at $2 per share.

• As part of the transaction, the Federal Reserve agreed to guarantee up to $29B of certain of Bear’s securities in the event of a default by Bear.

• The next week, following massive protest by Bear shareholders and the discovery of certain errors in the original merger agreement signed by the parties, Bear and J.P. Morgan agree to increase the offer price per share to $10 per share.

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• Stock Price Chart Depicting the Rapid Deterioration of Bear Stearns:

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Significant Factors Contributing to the Failure of Bear Stearns

• A crisis of confidence enveloped Bear Stearns in March 2008 and ultimately resulted in the evaporation of Bear’s liquidity resources and, consequently, its business. While no one has been able to point to a specific event or action as the ultimate cause of Bear’s demise, many experts point to several factors:

• Rumors in the financial markets

• Naked short selling

• Rapid rise in activity involving credit default swaps (“CDS”)

• Delayed opening of the Federal Reserve’s Primary Dealer Credit Facility

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Rumors in the Financial Markets

• “False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling . . . During the week of March 10, 2008, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm.”

SEC Emergency Order, Release No. 58166 / July 15, 2008

• Current Rules Governing Rumors

• Disseminating false rumors about a security can potentially result in liability under both the Securities Act of 1933 and the Securities Exchange Act of 1934, with liability most frequently attaching under Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

• Broker-dealers are also subject to Self-Regulatory Organization (“SRO”) Rules, which prohibit the spreading of false rumors by member entities.

• See NASD Rule 5120(e) and NYSE Rule 435(5).

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Rumors in the Financial Markets (cont’d)

• Previous Regulatory Efforts

• The SEC has the power to bring “fraud” actions under Rule 10b-5 against any person who makes any “untrue statement of a material fact” in connection with the purchase or sale of a security. While this principle has not been officially sanctioned by law or court interpretation to apply to someone merely giving advice or expressing opinions regarding a security, the SEC has argued for such an interpretation.

• In several cases dating back to the 1990s, the SEC charged private individuals with violations of Rule 10b-5 for circulating false rumors via the internet (or for failing to disclose their positions in such securities when making free recommendations on such securities).

• In response to critical analysis and false rumors distributed via the internet, it should also be noted that many public companies have commenced private litigation against the purported sources of such rumors as well as those providing critical analysis. Increasingly, hedge funds and pure short sellers are the targets of such litigation.

• In fact, since 1989, the SEC has brought at least three cases against individuals for spreading materially false negative information regarding an issuer with whom such person had no relationship or duty – with at least one case resulting in a conviction and consent to an injunction in a civil proceeding.

• See SEC v. Moldofsky, SEC Litig. Rel. No. 16493 (Mar. 30, 2000).

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• Previous Regulatory Efforts (cont’d)

• Based upon previous cases brought by the SEC, it appears that the SEC interprets Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder to require all persons – even an individual, unregulated person – to be truthful when publicly giving free “advice”, espousing opinions on securities or otherwise disseminating information regarding securities.

• While the SEC seems to have taken an aggressive position on the issue, many securities law experts believe the SEC’s position is an extremely aggressive reading of the Exchange Act and the rules promulgated thereunder.

• Moreover, notwithstanding the legal correctness of such a position, practical difficulties exist in finding credible evidence linking individuals to demonstrably false rumors (in addition to proving scienter).

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• Recent SEC Efforts to Combat the Spreading of Rumors

• Increased use of subpoenas by the SEC’s Division of Enforcement, with targeted subpoenas to hedge funds, investment banks and broker-dealers.

• On July 13, 2008, the SEC announced it was expanding an existing program of examinations of registered broker-dealers and investment advisers “aimed at the prevention of the intentional spread of false information intended to manipulate securities prices.”

• In conjunction with increased SEC examinations, the Financial Industry Regulatory Authority (“FINRA”) and NYSE Regulation, Inc. have advised members there will be increased investigations and examinations.

• Finally, despite its questionable legal acceptance, enhanced vigilance and action by the SEC’s Division of Enforcement is expected to address the spreading of false or materially misleading rumors via the internet.

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Short Selling and Naked Short Selling

• What is Short Selling?

• Widely considered to be a legitimate trading strategy, a short sale occurs when a trader “borrows” stock and then sells it, in hopes that the price of the stock will fall. If the stock price falls, the trader repurchases the stock in the open market at the lower price, returns the stock that was borrowed, and then keeps the resulting spread as profit.

• In addition, many short sellers do not necessarily desire a market price decrease but instead utilize short positions as part of a hedging or arbitrage strategy relating to existing long positions. One example is an arbitrage strategy utilized in certain Private Investment/Public Equity (“PIPE”) transactions. In such transactions, hedge funds often purchase the PIPE long and at a discount, short the underlying stock, and then capture the “spread” on such positions.

• SEC rules and regulations support legitimate short selling, as the practice helps to transmit price signals to the market in response to negative information or other information regarding the prospects of listed companies. Moreover, as Chairman Christopher Cox recently noted, “short selling helps prevent ‘irrational exuberance’ and bubbles.”

• What is Naked Short Selling?

• Essentially, a naked short sale is the same as a short sale transaction, except that a trader does not take steps to “borrow” the stock before executing the short sale. An investor who “shorts” a stock without first pre-borrowing or owning such stock conducts a naked short sale and such an action is illegal if done intentionally.

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Short Selling and Naked Short Selling (cont’d)

• Current Rules Governing Short Sales• In 2004, the SEC adopted Regulation SHO to address the problem of naked short selling.

• Regulation SHO requires broker-dealers, before accepting a short sale order or effecting such order in their own account, to either :

• (i) borrow the security that is to be shorted; or

• (ii) enter into a contract to borrow the security.

• However, Regulation SHO contains an alternative to the two requirements noted above and a short sale may still be effectuated if the broker-dealer has “reasonable grounds” to believe that the security can be borrowed. It has been argued that the “reasonable grounds” exception creates an opportunity to evade the rule’s purpose and effect naked short sales by purposefully misleading or lying regarding whether a trader has borrowed a stock.

• Additionally, following its amendment in 2004, NASD Rule 3370 requires that a NASD broker-dealer, prior to accepting a short-sale order from a broker-dealer that is not a member of the NASD (“non-member”), must make an affirmative determination that (i) it will receive delivery of the security from such non-member or (ii) that it can borrow the security on behalf of such non-member, in each case, for delivery on the settlement date. The amendments to NASD Rule 3370 effectively eliminated the previous practice of routing short sell orders through broker-dealers domiciled in foreign jurisdictions (including Canadian broker-dealers, who are not subject to U.S. securities laws) whose rules do not require a “borrow” of a security prior to a short sale, effectively making all such short sales “naked.”

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• Recent SEC Action to Address Naked Short Selling

• SEC Emergency Order, Release No. 58166 / July 15, 2008 – the SEC announces an emergency temporary rule preventing short sale transactions in 19 individual securities “unless such person or its agent has borrowed or arranged to borrow the security or otherwise has the security available to borrow in its inventory prior to effecting such short sale and delivers the security on settlement date.”

• The Emergency Order was intended to eliminate any possibility of a naked short sale, because a covered security was required to be delivered on the settlement date. Essentially, for covered securities, the Emergency Order eliminated the “reasonable grounds” exception contained in Regulation SHO.

• The Emergency Order was announced July 15, 2008 and was temporarily extended until August 12, 2008 – the latest possible date allowable by the SEC’s Emergency Order powers.

• Interestingly, the Emergency Order applied only to the institutions who have recently been given access to the Federal Reserve’s Primary Dealer Credit Facility.

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• Other Actions Addressing Naked Short Selling

• Additional subpoena activity by the SEC’s Division of Enforcement , with efforts aimed at uncovering information relating to naked short selling conducted or facilitated by hedge funds, investment banks and broker-dealers.

• SEC Proposal for a new short-selling antifraud rule – Rule 10b-21.

• The proposed rule highlights the liability of those deceiving their broker-dealer or others regarding their intention to pre-borrow stock before effecting a short sale. The rule is designed to prevent short sellers from misrepresenting to a broker that such trader has properly located a stock to borrow.

See http://www.sec.gov/rules/proposed/200/34-57511.pdf

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• Revisiting the “Uptick Rule”

• On July 6, 2007, the SEC eliminated the ‘Uptick Rule”

• The “Uptick Rule” – or Rule 10a-1 under the Exchange Act – contained short selling in rapidly declining markets by requiring that all listed securities be sold short only at a price above such security’s last listed price.

• The “Uptick Rule”, initially adopted in 1938, was designed to prevent the use of short-selling as a tool to drive down the price of a security in a “bear raid.”

• However, the SEC abolished the rule in July 2007 following a two-year pilot program and three academic studies suggesting the rule had been rendered ineffective and non-essential.

• Numerous securities and finance experts have called for a reinstitution of the “Uptick Rule” in light of the following factors: (i) the conditions existing at the time of the rule’s adoption are beginning to reappear, (ii) international regulators are beginning to examine the wisdom of taking similar steps and (iii) the perception that the SEC’s enforcement tools and efforts are increasingly overmatched, antiquated and ineffectual.

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• Possible Future Regulation by the SEC and Others

• Expanding the scope of the recently expired emergency order to address naked short selling, including a potential elimination of the “reasonable grounds” exception to Regulation SHO across the broader market.

• Reinstitution of the “Uptick Rule”

• One member of the U.S. House has already introduced legislation to effect such change.

• Expansion of reporting and disclosure requirements; the SEC is considering a requirement that institutions report substantial short positions (like the longstanding requirement that institutions report substantial long positions).

• Overhaul of the nation’s regulatory and legal framework governing the financial industry; both the SEC and the Treasury Department have proposed sweeping changes.

• Other Congressional / Legislative Action

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Credit Default Swaps (“CDS”)

• What are credit default swaps?

• CDS are akin to insurance contracts that pledge to cover losses on covered securities in the event of a default. CDS typically apply to municipal bonds, corporate debt and mortgage securities. Essentially, the buyer of a CDS purchases a contract over a period of time for a premium and in return receives assurance that any losses will be covered in the event of a default.

• CDS were initially used by those who held corporate bonds as a method of hedging their position in the event of a default. However, today much of the CDS market is dominated by investors (or speculators, as critics would say) who do not necessarily hold the underlying bonds being insured.

• In market parlance, a “naked credit default swap” is the purchase of a CDS by an entity that does not own the underlying asset (corporate or municipal bond).

• The size of the CDS market has grown exponentially in the last decade. There are $62 trillion of CDS transactions outstanding, up from just $1 trillion in 2000. (For comparison, as of mid-2007 the size of the total U.S. stock market was $22 trillion)

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Credit Default Swaps (“CDS”) (cont’d)

• Effects of the Exploding CDS Market

• Prices for CDS have been exceedingly volatile; for example, in 1Q2008, the price for CDS of certain key financial institutions skyrocketed to unprecedented levels.

• Given the volatility in the pricing of CDS and the fact that value is determined by the likelihood of default of underlying issuances, rumors and other potentially negative activity involving an issuer have the potential to make trading in CDS quite lucrative.

• As the stock market has declined in recent months, companies that sold CDS insurance (as the insurer) have taken enormous write-downs.

• For example, in August 2008 AIG disclosed it was taking a $5.6B write-down in its CDS portfolio relating to mortgage-backed securities. Moreover, in the last calendar year AIG has written down the value of its CDS portfolio approximately $26B.

• As of September 2007, bond insurers had written $656B in credit insurance, with approximately $126B of that total relating to mortgage-backed securities. Total resources that have been set aside to pay claims relating to such contracts amount to only $54B.

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• Regulation and Rules Governing the CDS Market?

• On the whole, the CDS market is largely unregulated.

• Intermittent public reporting of the pricing of trades

• No formal clearinghouse for the OTC market and no standard CDS contract

• No standard capital requirements and no standard way of valuing CDS

• CDS contracts can be swapped from investor to investor without oversight (except for contractual limitations set forth in the CDS contract)

• “An original CDS can go through 15 or 20 trades. So when a default occurs, the so-called insured party or hedged party doesn’t know who’s responsible for making up the default and if that end player has the resources to cure the default.”

Harvey Miller, Weil, Gotshal & Manges LLP

• While many observers note that counterparty risk is managed via contract, many observers are calling for increased transparency.

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• Potential Future Regulation of the CDS Market

• Certain state and federal regulators have begun to encourage various large institutions, including Merrill Lynch and AMBAC, to unwind selected CDS transactions and close out their positions.

• For example, on August 1, 2008, AMBAC unwound $1.4B worth of CDS it had written on mortgage-backed securities for 61 cents on the dollar.

• New York’s Insurance Superintendent, Eric Dinallo, has made numerous public comments on (i) the need for increased regulation and transparency in the CDS market and (ii) the need for many regulated companies to unwind certain CDS transactions.

• Regulators, including in New York, have hinted at the implementation of a new regulatory regime whereby the only persons eligible to purchase CDS would be those who have an insurable interest (i.e. persons actually holding the underlying bonds or debt to be insured).

• FDIC Proposal – In July 2008, the FDIC proposed a new rule that would require troubled banks to disclose, upon demand, detailed records and information relating to CDS and other financial contracts held by the institution.

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Access to the Federal Reserve’s Primary Dealer Credit Facility

• What is the Primary Dealer Credit Facility?

• The Primary Dealer Credit Facility is commonly known as the Federal Reserve’s discount “window” – a liquidity facility historically open only to regulated commercial banks.

• The Opening of the “Window” to Investment Banks

• In response to the ongoing credit and liquidity crisis affecting the nation’s financial institutions, the Federal Reserve announced on March 11, 2008 (at the beginning of Bear’s final week of independent operations) that the “window” would be temporarily available to the nation’s investment banks, as well as Fannie Mae and Freddie Mac.

• The opening of the “window” was accelerated to March 17, 2008 (as Bear Stearns collapsed and was acquired by J.P. Morgan) and first extended on July 30, 2008. The temporary access by investment banks is now scheduled to expire on January 30, 2009.

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Access to the Federal Reserve’s Primary Dealer Credit Facility (cont’d)

• The “window” was opened to 19 institutions – the same 19 institutions that were the subject of the SEC’s Emergency Order on July 15, 2008 intended to curtail naked short selling.

• A key point to be made in the opening of the “window” to investment banks is that investment banks are not subject to the same onerous regulations and insurance funds as are commercial banks – the traditional borrowers from the “window.”

• Potential New Regulation Resulting from the Opening of the “Window”

• Financial and industry experts have argued for increased Federal Reserve oversight of investment banks now that such institutions have access to the “window.”

• Both the SEC and the Federal Reserve have testified before Congress and each has argued that it should be given authority to regulate the nation’s investment banks.

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Access to the Federal Reserve’s Primary Dealer Credit Facility (cont’d)

• The Treasury Department has also proposed a sweeping overhaul of the nation’s regulatory regime governing the financial markets. The proposal includes:

• A merger of the SEC and the CFTC to create greater oversight of the securities and derivatives markets.

• Increased information and disclosure requirements applicable to investment banks and others who are given access to the “window.”

• New regulations and oversight of broker-dealers and investment advisers .

• In essence, many observers argue that the Treasury Department has essentially sought to make the Federal Reserve the entity responsible for monitoring risks across the entire financial system.

See http://www.treas.gov/press/releases/reports/Fact_Sheet_03.31.08.pdf

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Conclusion

• The timeline outlining the failure of Bear Stearns and the often-mentioned factors that contributed to such failure tell only part of the story.

• In truth, no one – not even the Bear executives and others who experienced the turmoil first hand – know what specific events or actions caused the demise of Bear Stearns.

• The most enduring legacy may be the opportunity to examine all the factors surrounding the failure of Bear Stearns and the chance to make financial and regulatory changes that will (it is hoped) prevent similar crises in the future.

“In a business based on confidence, when the confidence evaporates, so does the business.”

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The Collapse of Bear Stearns (PowerPoint, 620 KB)