On July 21, 2010, President Obama signed into law a package of financial regulatory reforms unparalleled in scope and depth since the New Deal. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the legislation) is a sweeping reaction to perceived regulatory failings revealed by the most severe financial crisis since the Great Depression. The legislation is intended to restructure significantly the regulatory framework for the U.S. financial system with broad and deep implications for the financial services industry where the crisis started. However, its impact will be felt well beyond the financial sector. Aspects of the legislation have the potential to affect all public companies by extending federal regulation of corporate governance. In addition, some of the provisions will affect the U.S. operations of foreign companies as well as global transactions involving U.S.-based businesses, assets, and financial instruments. Despite its broad reach and more than 2,300 pages of text, few of the legislation's provisions will take effect immediately. In large measure, Congress has delegated both the substantive details of the reforms and their implementation to federal regulators whose authority grew dramatically with the stroke of the President's pen.
Systemic Risk
The legislation touches upon nearly every facet of the financial sector, and, for the first time in U.S. history, creates a framework designed solely to regulate systemic risk. That framework largely resides in a powerful council of financial regulators, a new authority allowing the Federal Deposit Insurance Corporation (FDIC) to seize control of a financial company whose imminent collapse is found to threaten the financial system, and enhancements to existing crisis management powers of the Federal Reserve Board and the FDIC.
Financial Stability Oversight Council - Through the Financial Stability Act of 2010, a Financial Stability Oversight Council (Council) is established to serve as the nation's systemic risk regulator, and arguably the most powerful regulatory body in the U.S. It will monitor sources of systemic risk/promulgate rules to be implemented by various financial regulators. The Treasury Secretary will chair the Council, which will have nine additional voting members. Decisions will be reached by majority vote, except in certain circumstances a supermajority of seven votes including that of the Treasury Secretary will be required. The Council will not be a supervisory body. Those responsibilities are left to the regulatory agencies. Companies identified by the Council as systemically important are subject to regulation/supervision/ examination by the Federal Reserve (Fed).
A range of financial firms may be swept into a new systemic risk regulatory/supervisory framework. "Large, interconnected" bank holding companies with consolidated assets of $50 billion or more and nonbank financial companies, which are entities predominantly engaged in financial services and have at least 85% of their consolidated revenues or assets stemming from "activities that are financial in nature," will be subject to the Council's registration/reporting requirements and direct supervision by the Fed. The legislation includes the Payment, Clearing, and Settlement Supervision Act of 2010, which authorizes the Council to designate by a supermajority vote entities that engage in systemically important payment/ clearing/settlement activities for supervision by the Fed, the Securities and Exchange Commission (SEC), or the Commodity Futures Trading Commission (CFTC). Designated financial utilities will be subject to a set of systemic risk management standards such as enhanced collateral, margin and capital requirements.
Orderly Liquidation Authority - Based largely on the FDIC's resolution process, a new mechanism is established for the liquidation of systemically important financial companies, including those regulated by the Council and the Fed as well as any financial company whose imminent failure may have adverse ramifications for the financial system. The U.S. Bankruptcy Code will continue to apply to most financial companies, except those posing a systemic risk. In those cases, the new Liquidation Authority will preempt the bankruptcy process, permit the FDIC to seize control of the entity and proceed to liquidate it. The Authority potentially applies only to a "financial company." State regulators will continue to handle insolvent insurance companies, and insured banks/thrifts will continue to be handled under the existing FDIC framework.
Although the Treasury Secretary ultimately will determine whether the "failure of the financial company would threaten U.S. financial stability," the FDIC and the Fed must initiate the process by recommending that such a determination be made, which must be approved by two-thirds of the members of the boards of the FDIC and the Fed. If the financial company is a broker-dealer, then the SEC must make this recommendation. The Treasury Secretary must consult with the President before rendering a final determination of systemic risk. Upon issuing a recommendation that the Liquidation Authority be exercised with regard to a particular company, the Treasury Secretary is required to ask the company's board of directors whether it "acquiesces" to FDIC receivership. If the board of directors does not acquiesce, then the Treasury Secretary must petition the U.S. District Court for an order appointing the FDIC as receiver.
FDIC's Powers and Responsibilities as Receiver - The Liquidation Authority is as its name implies a receivership followed by an orderly liquidation. Rehabilitation/reorganization is not permitted unlike Chapter 11 bankruptcies, where a debtor may remain in possession of the company. The FDIC will assume full control so that the company's creditors/shareholders - and not U.S. taxpayers - bear the company's losses. Other creditors or shareholders may not receive any payment until all other claims have been paid fully, and the FDIC must ensure that the claim priority provisions are followed. Also, the FDIC is to dismiss the members of the failing company's management responsible for the company's financial condition .
Treasury is to establish an Orderly Liquidation Fund to be managed by the FDIC. Although the FDIC may borrow from the U.S. Treasury, the FDIC is required to replenish any amounts borrowed through ex-post assessments on claimants and, if necessary, risk-based assessments on financial companies with consolidated assets of $50 billion or more. Congress thus has fashioned the Liquidation Authority to ensure it will not be paid for by taxpayers but by members of the financial industry and those who directly benefited from a prior resolution.
Enhanced Powers of the Federal Reserve and FDIC - A final pillar of the new framework is the enhancement of various crisis-management powers of the Fed and the FDIC by amending the Fed's lending authority and the FDIC's authority to provide guarantees. Going forward section 13(3) of the Federal Reserve Act allows the Fed to use its lending authority only to provide liquidity and not as a back door to equity injections into individual firms. The FDIC's current systemic risk authority may be used only when an institution is placed in receivership.
Banking Industry
Significant aspects of the legislation relate to changes in the regulation of banks, thrifts, holding companies, and related institutions, which are largely embodied in two separate statutes: the Enhancing Financial Institution Safety and Soundness Act of 2010 and the Bank and Savings Association Holding Company and Depository Institution Regulatory Improvements Act of 2010. They not only substantially restrict the activities of certain institutions, but also address the consolidation of U.S. financial regulators.
The legislation includes a number of detailed rules for banks and other insured depositories related to minimum capital and leverage requirements, mergers and acquisitions, branching restrictions, lending limits, and transactions involving management and directors. One of the more important activity restrictions is the so-called "Volcker Rule," which is actually two separate rules: (1) a prohibition on proprietary trading for the financial institution's own account, and (2) a ban on certain hedge fund and private equity activities, which are to apply to all "banking entities" and the U.S. operations of foreign banks. Nonbank financial companies technically are not subject to the Volcker Rule, but the Fed is to impose additional capital requirements/quantitative limits on them to mitigate the perceived risks inherent in proprietary trading, hedge fund, and private equity activities. Any banking entity is prohibited from buying and selling any security, derivative, or other financial instrument for its "trading account,"(with certain exclusions) as opposed to its customer accounts. The Volcker Rule prohibits banking entities from acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring any hedge fund or private equity fund, subject to certain exceptions. Despite the expansive scope of the ban, a key exception will allow U.S. banking entities to organize/offer private equity/hedge funds if a number of requirements are met. As a practical matter, forced divestments under the Rule could take place from approximately three to possibly 12 years after the enactment of this legislation.
Banks have been singled out for additional restrictions relating to derivatives. The legislation requires that insured depositories largely "push out" their swaps operations to an affiliate within the holding company structure. In addition, derivatives, heretofore excluded, are included as a category of transactions under 23A and 23B of the Federal Reserve Act, and will be treated as covered transactions with collateral requirements.
Derivatives
The derivatives section is arguably as important to Congress's reforms as the new systemic risk framework and changes to the banking industry. The legislation attempts to resolve the perceived systemic risk and transparency deficiencies of the current over-the-counter (OTC) swaps market by requiring the centralized clearing of all swaps suitable for the clearing process. The legislation charges the CFTC and the SEC with joint oversight of the OTC swaps market. The SEC will regulate security-based swaps, and the CFTC will regulate all other kinds of swaps. The CFTC and the SEC are required to consult with each other and relevant bank regulators when exercising this rulemaking authority. Clearing for all swaps that the CFTC or SEC determines should be cleared will be done through a registered clearinghouse. The CFTC and the SEC must review each swap, or any group, category, type, or class of swaps. The swap must be cleared on a regulated exchange or a swap execution facility (SEF). If neither an exchange nor an SEF is willing to list the swap, counterparties to the contract nevertheless are required to comply with any relevant CFTC or SEC recordkeeping/reporting requirements and applicable capital/margin requirements. Highly customized swaps not suitable for clearing still may be consummated but must be reported to a trade repository, the CFTC, or the SEC.
The legislation exempts from the mandatory clearing requirements a party using swaps to hedge or mitigate any "end user" commercial risk (other than a financial entity) who notifies the CFTC or the SEC of how it generally meets its financial obligations associated with entering non-cleared swaps.
Regulation of Swap Dealers and Major Swap Participants - Congress has determined that the risk exposure of important entities in the swaps market, swap dealers and major swap participants (MSPs) must be regulated. Those that are depository institutions are subject to capital and margin requirements imposed by their primary regulator, and swap dealers/MSPs that are not depository institutions will be subject to capital/margin requirements imposed by the CFTC or the SEC. Swap dealers/MSPs are subject to conduct regulations, i.e., disclosure and reporting standards set by the CFTC or SEC.
An insured depository institution will not be considered to be a swap dealer in connection with CFTC-regulated swaps if it enters into a swap with a customer in connection with originating a loan with that customer. Swap dealers/MSPs are subject to new/additional capital rules as well as initial and variation margin requirements to be established by bank regulators, the CFTC, or the SEC. The agencies will review all the activities of the swap dealers and MSPs when setting capital requirements. For uncleared CFTC-regulated swaps, a swap dealer/MSP must first notify its counterparty that it has the right to require that the initial margin posted with that swap dealer/MSP be maintained in a segregated account with an independent third-party custodian. All swap dealers/MSPs are required to maintain certain records as well as follow certain additional requirements with regard to non-swap dealer and non-MSP counterparties. Perhaps most importantly, swap dealers/MSPs - when entering into swaps with a governmental entity, employee benefit plan, or endowment - are required to have a reasonable belief that the counterparty is represented by an independent representative that meets certain standards. Given the potential exposure of swap dealers/MSPs to liability for a violation, this new obligation could make it quite difficult for pension funds to participate in the swaps market altogether.
Hedge Funds & Private Equity
The "private adviser" exemption is eliminated for advisers to fewer than 15 clients and substantially modifies the "intrastate adviser" exemption from registration under the Investment Advisers Act of 1940 (Advisers Act). Advisers to private funds, except for venture capital funds and family offices, with assets of at least $150 million will be required to register as investment advisers with the SEC one year after the enactment of this legislation. Five new narrow exemptions from registration are created. The exemptions are designed to exempt smaller hedge fund/private equity advisers from SEC registration, allowing the SEC to concentrate on private fund advisers perceived to have a greater impact on markets.
The threshold of assets under management is increased, from $25 million to $100 million for certain advisers triggering mandatory SEC registration under the Advisers Act, which significantly could reduce the number of smaller investment advisers currently registered with the SEC. The SEC is to conduct periodic inspections of the records of private funds maintained by a registered adviser and is authorized to conduct other examinations it deems necessary. The SEC is to investigate the state of short-selling and submit a study to Congress, which will address the feasibility of short-selling reporting and a pilot program for public companies as to trades in real time as "short," "market maker short," "buy," etc. The SEC will require all advisers to maintain records and file certain periodic reports.
The current Regulation D standard promulgated under the Securities Act of 1933 (Securities Act) for accredited investor is modified to exclude the value of a person's primary residence from the net worth calculation. Every four years after enactment, the SEC is directed to increase the personal net worth standard from $1 million.
Securities Regulation
Securitizations - The federal bank regulators and the SEC jointly are to prescribe rules requiring securitizers of asset based securities (ABS) to retain an economic interest in the credit risk (generally 5 percent) of any asset transferred/sold/conveyed to a third party through the issuance of an ABS with more disclosure in the securitization process. That economic interest may not be hedged or transferred to a third party. Collateralized debt and mortgage obligations are covered. The 5 percent risk-retention requirement has some exceptions. Regulators are to establish various asset classes with different credit risk retention rates. The SEC is directed to adopt regulations requiring ABS issuers to disclose for each tranche of security information regarding the specific assets backing each security.
Credit Rating Industry - The credit rating industry will be subject to heightened oversight and expanded liability. The SEC will establish an Office of Credit Ratings (OCR) to promote accuracy of credit ratings and prevent conflicts of interest.
Credit Rating Agencies (CRAs) will not be allowed to rely on the safe harbor for forward-looking statements under the Securities Act, so it will be easier for private litigants to sue them. Rule 436(g) of the Securities Act, which exempted certain credit ratings from being considered part of certain registration statements, is nullified. Given their small number and the new very substantial liability, CRAs may approach ratings differently than in the past. The SEC may fine CRAs and their associated persons for certain securities law violations, which, if it affects the integrity of a rating, may eventually lead to the suspension or revocation of a CRA's SEC registration.
Under the legislation there are new restrictions and requirements on a CRA's corporate governance, internal controls, transparency, conflicts of interest, and liability exposure. At least half of a CRA's board of directors must be independent directors, who along with its senior credit officer will be responsible for the procedures and methodologies applied to the credit ratings. The SEC must promulgate new rules requiring an internal separation of the credit rating activity from sales and marketing activity within individual CRAs, excepting for smaller CRAs under certain circumstances. CRAs must report to the SEC when a former CRA employee becomes employed by an underwriter or obligor of a security or money market instrument subject to a rating by that CRA. It must undertake a one-year look-back review to evaluate if any conflicts of interest relating to the employee influenced the rating. The material changes to rating procedures are to be applied consistently and publicly disclosed.
The SEC is to carry out a study that analyzes the credit rating process for structured finance products. Within two years, the SEC must establish a system to prevent a structured finance product issuer, sponsor, or underwriter from selecting the CRA determining and monitoring the initial credit ratings of structured finance products. The current proposal is for the SEC to create a self-regulatory organization (SRO) that will assign CRAs to provide initial ratings of structured finance products.
"Municipal advisers" must register under section 15B of the Exchange Act, and liability is imposed on them for fraudulent, deceptive, or manipulative acts or practices. An Office of Municipal Securities (OMS) is established within the SEC to administer the SEC's various municipal securities rules. OMS must coordinate with the MSRB in rulemaking and enforcement.
Insurance Industry
For the first time Congress has created a federal agency charged with monitoring and, to a very limited extent, regulating the insurance industry - the Federal Insurance Office (FIO) within Treasury. Specifically, the FIO is focused on national coordination of the insurance sector, mitigation of systemic risk, and facilitation of international regulatory cooperation. It is a relatively narrow, but nonetheless significant, toe-hold by the U.S. government in insurance regulation. State-based insurance regulation for the most part is undisturbed. The FIO or Treasury are not granted general supervisory authority over the insurance business, but they are to streamline state regulation with uniform national and international insurance regulations and standards.
Surplus lines insurance and reinsurance regulations are streamlined because only the state where a policyholder resides or is headquartered may collect or allocate premium tax obligations due to surplus lines insurance. Placement of surplus lines insurance exclusively is subject to the states' legal requirements. If a ceding insurer is domiciled in a National Association of Insurance Commissioners (NAIC)-accredited state or has solvency requirements substantially similar to those required for NAIC accreditation, a non-domiciliary state may not deny credit for reinsurance. The domiciliary state of a reinsurer possesses the exclusive authority to regulate the reinsurer's solvency. Surplus lines insurers and reinsurers are now subject to the regulatory authority of only one state.
Consumer & Investor Protection
The Consumer Financial Protection Act of 2010 (CFPA) establishes the Bureau of Consumer Financial Protection (BCFP) within the Fed to regulate consumer financial products and services. The BCFP, which will consolidate and strengthen consumer protection responsibilities currently managed by the Fed and other U.S. regulators and will have extensive authority to regulate substantive standards for any person that offers or sells a financial product or service to any consumer. Despite being formally an entity within the Fed, the BCFP will enjoy significant operational and policymaking independence. The BCFP will have a presidentially appointed Senate-confirmed director and its own dedicated, non-appropriated funding supply from the Fed's earnings. The BCFP's central mission will be to implement and enforce relevant federal laws to ensure that markets for consumer financial products and services are "fair, transparent, and competitive." The BCFP is to protect consumers from discrimination and "unfair, deceptive, or abusive acts and practices." The BCFP will have supervisory/rulemaking/enforcement authority over "covered persons"(any person who offers or provides a consumer financial product) for all consumer finance activities except insurance, as well as CFTC- and SEC-regulated activities.
There are two important points here. First, nonbank entities will be regulated in the same manner and by the same regulator as their bank counterparts engaging in the same activities. Secondly, the BCFP is the first agency dedicated solely to consumer protection that will supervise and examine these entities. The BCFP will have limited examination authority over banks, thrifts, and credit unions with $10 billion or less in assets. The federal banking agencies will be responsible for examining and enforcing these institutions' compliance with federal consumer financial laws. A number of entities will be exempt from the BCFP's authority.
The Mortgage Reform and Anti-Predatory Lending Act of 2010 sets minimum underwriting standards for mortgages by requiring lenders to verify that consumers have a reasonable ability to repay when the mortgage is consummated. Certain "qualified mortgages" are presumed to meet this standard. Appraisal reforms prohibit lenders from making a higher-cost mortgage without first obtaining a written appraisal. Enforceable federal appraisal independence standards are established that prohibit parties involved in a real estate transaction from influencing the independent judgment of an appraiser through collusion, coercion or bribery. Federal oversight of the state appraisal regulatory system is enhanced. Additional new mortgage-related consumer protections include limits on "yield spread premiums." Prohibitions are established on single-premium credit insurance, mandatory arbitration clauses, and prepayment penalties for adjustable-rate mortgages and mortgages that do not meet the definition of a qualified mortgage. The scope of consumer protections for high-cost loans under the Home Ownership and Equity Protection Act (HOEPA), which requires additional disclosures to consumers, is enhanced.
A new permanent Investor Advisory Committee (IAC), made up of a broad cross-section of individuals from the public and government, is established to consult with and advise the SEC on certain investor protection initiatives. The SEC must disclose promptly its assessment of any IAC findings and recommendations and the actions it intends to take to address them.
The reporting of securities laws violations is expected to increase due to enhancing existing rewards and protections for whistleblowers. A whistleblower providing "original" information to the SEC leading to a successful enforcement action resulting in monetary sanctions exceeding $1 million will be eligible for a reward of between 10 and 30 percent of the funds collected. A whistleblower can sue a retaliating employer directly in federal court. Existing whistle-blower protections under the Sarbanes-Oxley Act apply to parent companies and affiliates whose financial information is included in the parent's consolidated financial statements.
Governance & Executive Compensation
Significantly, financial and market transparencies will be increased. However, majority voting for directors, limits on executive compensation, and mandatory board risk committees for nonfinancial companies were not included in the final legislation.
Proxy Access Authority - The SEC has express discretionary authority to adopt procedures for the inclusion of shareholder board nominees in a company's proxy solicitation materials. Shareholders are to be provided "proxy access," significantly lowering the cost of nominating a director candidate to run against a nominee proposed by the board. The SEC has broad discretion to consider exemptions.
Say-on-Pay - The Securities Exchange Act of 1934 (Exchange Act) is amended to require companies to include a provision in certain proxy statements for a nonbinding shareholder vote on executive compensation, including "golden parachutes," and it requires certain disclosures as well as a nonbinding separate shareholder vote for compensatory arrangements of "named executive officers" arising from an M&A transaction involving a shareholder vote. While not binding on the company, it will likely apply pressure on boards to consider shareholder views. The SEC can create exemptions, including for small companies disproportionately affected. Every institutional investment manager subject to section 13(f) of the Exchange Act must report at least annually how it cast its votes on these nonbinding items.
Broker Discretionary Voting - The SEC must direct national securities exchanges to prohibit member brokers from voting customer shares without first receiving voting instructions from the beneficial owner on most director elections, executive compensation, and any other "significant matter" determined by the SEC. The principal effect of this proposal is to prevent broker discretionary voting on "say-on-pay" proposals.
Compensation Committee and Adviser Independence - The SEC must direct national securities exchanges to require each member of a listed company's compensation committee to satisfy a heightened standard of independence, similar to that required for audit committee members. Audit committees are authorized to retain, compensate and oversee compensation consultants, legal counsel and advisers who must be independent.
Disclosure of Board Leadership - The SEC must issue rules requiring companies to disclose in annual proxy statements why they have separated or combined the positions of chairman of the board and CEO. (Already fulfilled by SEC rule changes effective on February 28, 2010.)
Additional Executive Compensation Disclosures - The SEC must issue rules requiring companies to describe clearly in annual proxy statements, using its stock price performance and dividend policy, the relationship between paid executive compensation and the company's financial performance. The SEC must issue rules requiring disclosure of the median of the annual total compensation of all the company's employees except the CEO, the annual total compensation of the CEO and the ratio between both categories.
Clawback of Incentive Compensation - The SEC must instruct national securities exchanges to require each listed company to develop, implement, and disclose a "clawback" policy for the three-year period preceding the restatement date.
Hedging by Employees and Directors - The SEC must issue rules requiring companies to disclose in their annual proxy statements whether any employee or director is permitted to purchase financial instruments intended to hedge or offset any decrease in the market value of any equity securities granted by the company as part of compensation or held by that person.
Compensation Structures of Financial Institutions - Within nine months, the federal regulators jointly must prescribe regulations or guidelines to require certain financial institutions with assets of $1 billion or more to disclose to their federal regulators the structures of all incentive-based compensation arrangements offered, so the regulators can determine if the structures provide executives, employees, directors, or principal shareholders with excessive compensation or benefits that could lead to material financial losses and provide guidelines to prohibit incentive-based arrangements that encourage inappropriate risks or that could lead to material losses.
The above summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act is extracted from a more comprehensive document to be found on Weil Gotshal's website athttp://www.weil.com/files/ upload/NY%20Mailing%2010%20FRR%20100721%20Weil_Dodd_Frank_Overview_2010_07_21.pdf. For questions about this article or the document, please contact Heath Tarbert at [email protected].
Published August 2, 2010.