By James Hamilton, J.D., LL.M.
The House of Representatives passed historic legislation today overhauling the US financial regulatory system. The legislation creates a systemic risk regulator, the Federal Stability Oversight Council, whose members include the Fed, the SEC and the CFTC, to monitor the marketplace to identify potential threats to the stability of the financial system (Title I).
The Council will be chaired by the Treasury Secretary. The Council will subject financial companies and financial activities posing a threat to financial stability to much stricter standards and regulation, including higher capital requirements, leverage limits, and limits on concentrations of risk (Section 1106). The Senate draft legislation would establish an Agency for Financial Stability composed of the SEC, Fed and CFTC, with an independent Chair appointed by the President.
The legislation removes outmoded Gramm-Leach-Bliley Act restraints on the consolidated supervision of large financial companies by the Federal Reserve, and provides specific authority to the Fed and other federal financial agencies to regulate for financial stability purposes and quickly address potential problems.
The Federal Reserve will serve as the agent of the Council in regulating systemically risky firms on a consolidated basis and systemically risky activities wherever they occur, ensuring broad accountability for such regulation. The legislation also substantially enhances the authority of the Government Accountability Office (GAO) to examine the Board of Governors of the Federal Reserve and the Federal Reserve Banks to provide greater transparency to Fed facilities and actions.
Among its other duties, the Council must monitor the financial services markets to identify potential threats to the stability of the US financial system and identify financial companies and activities that should be subject to heightened prudential standards in order to promote financial stability and mitigate systemic risk. The Council must also issue formal recommendations to the SEC and other Council members to adopt heightened prudential standards for the firms they regulate in order to mitigate system risk.
Regulators’ inability to see developments outside their narrow “silos” allowed the current crisis to grow unchecked. The legislation’s information gathering and sharing requirements for the Council and all of the financial regulators, including the SEC and CFTC, will ensure constant communication and the ability to look across markets for potential risks. The Council will facilitate information sharing and co-ordination among its members regarding financial services policy development, rulemakings, examinations, reporting requirements and enforcement actions. Also, the Council must provide a forum for discussion and analysis of emerging market developments and financial regulatory issues among its members.
An important duty of the Council is to advise Congress on financial regulation and make recommendations that will enhance the integrity, efficiency, orderliness, competitiveness, and stability of the US financial markets. The Council must meet at least quarterly .
The Council is empowered to require the submission of periodic and other reports from any financial company solely for the purpose of assessing the extent to which a financial activity or market in which the financial company participates, or the company itself, poses a threat to financial stability. In an effort to mitigate this reporting burden, the Council is directed to rely, whenever possible, on information already being collected by the SEC and other financial regulators.
The Council is authorized to issue formal recommendations, publicly or privately, that the SEC and other federal financial regulators adopt heightened prudential standards for firms they regulate in order to mitigate systemic risk. Within 60 days of receiving a Council recommendation, the SEC or other federal financial regulators must notify the Council of any actions taken in response to the recommendation or why the regulator failed to respond.
The Council may subject a financial company to heightened prudential standards upon determining that material financial distress at the company could pose a threat to financial stability; or the nature of the company activities could pose a threat to financial stability. In making this determination, the Council must consider a number of factors, including the amount and nature of the firm’s financial assets and liabilities and its off-balance sheet exposures, as well as its transactions with other financial companies. The company’s importance as a source of credit for households, businesses, and state and local governments must also be considered, as well as its source of liquidity for the financial system. Once a company becomes an identified financial company, heightened prudential standards can be imposed on it in order to mitigate risks to the financial system, including capital, liquidity and risk management requirements.
Securitization
The legislation reforms the process of securitization by, primarily, requiring companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell garbage to investors, because they have to keep some of it for themselves. The legislation would require companies that sell products like mortgage-backed securities to keep some "skin in the game" by retaining at least five percent of the credit risk so that, if the investment doesn’t pan out, the company that made, packaged and sold the investment would lose out right along with the people they sold it to. (Section 1502) In addition, the legislation would require issuers to disclose more information about the assets underlying asset-backed securities (Section 1503).
The SEC is directed to adopt regulations requiring issuers of asset-backed securities to disclose for each tranche or class of security information regarding the assets backing that security. In adopting these regulations, the SEC must set standards for the format of the data provided by issuers of an asset-backed security, which must, to the extent feasible, facilitate comparison of such data across securities in similar types of asset classes.
In order to facilitate investors in performing independent due diligence, the SEC regulations must require issuers of asset-backed securities, at a minimum, to disclose asset-level or loan-level data, including data having unique identifiers relating to loan brokers or originators. The issuer must also disclose the nature and extent of the compensation of the broker or originator of the assets backing the security; and the amount of risk retained by the originator or the securitizer of such assets.
The SEC must also adopt regulations on the use of representations and warranties in the market for asset-backed securities that require each credit rating agency to include in any report accompanying a credit rating a description of the representations, warranties, and enforcement mechanisms available to investors how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities. The regulations must also require any originator to disclose fulfilled repurchase requests across all trusts aggregated by the originator, so that investors may identify asset originators with clear underwriting deficiencies (Section 1504).
Dissolution Authority
The legislation provides, for the first time, a resolution authority to wind down large interconnected failed financial companies in an orderly manner. Currently, there is no system in place to responsibly shut down a failing financial company like AIG or Lehman Brothers. According to Treasury, the lack of a federal regulatory regime and resolution authority for large systemic non-bank financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises (Title I, Subtitle G).
Regulators would be able to dissolve large, highly complex financial companies in an orderly and controlled manner, ensuring that shareholders and unsecured creditors, not taxpayers, would bear the losses. When a financial firm enters the dissolution process, management responsible for the failure would be dismissed, parties that should bear losses, particularly shareholders and unsecured creditors, would do so, and the firm would cease as a going concern. Thus, the legislation establishes an orderly process for the dismantling any large failing financial company in a way that protects taxpayers and minimizes the impact to the financial system.
If a large financial company fails, the legislation holds the financial industry and shareholders responsible for the cost of the company’s orderly wind down, not taxpayers; and protects the stability of the overall financial system. Any costs for dismantling a failed financial company will be repaid first from the assets of the failed firm at the expense of shareholders and creditors. Any shortfall would then be covered by a dissolution fund pre-funded by large financial companies with assets of more than $50 billion and hedge funds with assets of more than $10 billion.
The FDIC will be able to unwind a failing firm so that existing contracts can be dealt with and creditors’ claims can be addressed. Unlike traditional bankruptcy, which does not account for complex interrelationships of such large firms and may endanger financial stability, this more flexible process will help prevent contagion and disruption to the entire system and the overall economy.
Costs to resolve a failing firm will be repaid first from the assets of the failed firm at the expense of shareholders and creditors, and to the extent of any shortfall, from assessments on all large financial firms. In this instance the legislation follows the “polluter pays” model where the financial industry has to pay for its mistakes, not taxpayers.
Fed Audits
In an effort to make the Fed more transparent and accountable, the legislation removes the blanket restrictions on GAO audits of the Fed and allows the audit of every item on the Fed's balance sheet, all credit facilities, and all securities purchase programs. The Act retains a limited audit exemption on unreleased transcripts and minutes. Nothing in the Act shall be construed as interference in or dictation of monetary policy by Congress or the GAO. Also, the Act calls for an180-day time lag on publication of records related to specific market interventions to avoid destabilizing markets or stigmatizing individual firms.
Corporate Governance and Compensation
The legislation requires a non-binding annual shareholder advisory vote on executive compensation. Similarly, there must also be a shareholder advisory vote on golden parachutes. The SEC is allowed to exempt categories of public companies and, in determining the exemptions, the SEC must take into account the potential impact on smaller companies. The legislation also requires at least annual reporting of annual say-on-pay and golden parachutes votes by all institutional investors, unless such votes are otherwise required to be reported publicly by SEC rule The measure also provides that compensation approved by a majority say-on-pay vote is not subject to clawback, except as provided by contract or due to fraud to the extent provided by law (Title II).
The measure would not set any limits on pay, but will ensure that shareholders have an advisory vote on their company's executive pay practices without micromanaging the company. Knowing that they will be subject to some collective shareholder action should give boards pause before approving a questionable compensation plan
In a major governance reform, public companies must have a compensation committee composed of independent directors. Similarly, compensation consultants must satisfy independence criteria established by the SEC. The SEC is allowed to exempt categories of public companies, taking into account the potential impact on smaller companies (Section 2003).
In order to be considered independent, a compensation committee member may not accept any consulting, advisory, or other compensatory fee from the company and cannot be an affiliated person of the company or any of its subsidiaries. The SEC would be authorized to exempt a particular relationship with a compensation committee member from these independence standards.
The legislation gives the compensation committee sole discretion to retain compensation consultants meeting independence standards to be promulgated by the SEC. The compensation committee would be directly responsible for the appointment, compensation, and oversight of the compensation consultant. However, there is no requirement that the compensation committee implement or act consistently with the recommendations of the compensation consultant. In addition, the hiring of a compensation consultant would not affect the committee’s ability or obligation to exercise its own judgment in carrying out its duties.
The compensation committee would also be authorized to retain independent counsel and other advisers meeting SEC independence standards. As with compensation consultants, the compensation committee would be directly responsible for the appointment, compensation, and oversight of such independent counsel and other advisers. But the compensation committee would not be required to implement or act consistently with the advice or recommendations of such independent counsel and other advisers, and the retention would in no way affect the committee’s ability or obligation to exercise its own judgment.
Financial institutions with more than $1 billion in assets must disclose compensation structures that include any incentive based elements. Federal financial regulators, including the Fed, SEC, and FDIC, will jointly determine the disclosure requirements and incentive-based compensation standards. Also, federal regulators must proscribe inappropriate or imprudently risky compensation practices as part of solvency regulation (Section 2004).
The legislation authorizes the SEC to issue proxy access regulations regarding the nomination of directors by shareholders to serve on a company’s board of directors, thereby further democratizing corporate governance. This provision is needed because, without it, the SEC could have faced a lawsuit from corporations and industry groups alleging that the Commission lacked the authority to grant shareholders this right. Congress believes that proxy access is necessary for shareholders to have a meaningful choice in exercising their right to vote for board members, and thus to hold boards accountable. Regulation of proxy access and disclosure is a core function of the SEC and is one of the original responsibilities that Congress assigned to the Commission when it was created in 1934. The legislation would create a new federal right to proxy, but would also ensure that existing laws on the right to proxy are upheld (Section 7222).
Derivatives Regulation
For the first time, credit default swap markets and all other OTC derivative markets will be subject to comprehensive federal regulation under an SEC-CFTC regime in order to guard against activities in those markets posing excessive risk to the financial system and to promote the transparency and efficiency of those markets (Title III). The Senate draft would also authorize the federal regulation of derivatives under a dual SEC-CFTC regime.
The legislation divides jurisdiction over swaps between the SEC and the CFTC. The SEC oversees activity in swaps that are based on securities like equity and credit-default swaps. The CFTC is responsible for all other swaps, including those based on interest rates and currencies.
In setting out the first comprehensive system of regulation of the OTC derivatives market, the House legislation would establish a central clearing requirement for swaps transactions between dealers and large market participants that are accepted by a clearinghouse. Non-cleared swaps must be reported, with major participants and dealers adhering to strengthened capital and margin requirements. OTC derivatives include swaps, which are financial contracts that call for an exchange of cash flows between two counterparties based on an underlying rate, index or credit event or the performance of an asset.
Title III divides jurisdiction over swaps between the SEC and the CFTC. The SEC oversees activity in swaps that are based on securities such as equity and credit-default swaps. The CFTC is responsible for all other swaps.
The legislation would exempt commercial end users from the clearing requirement. These firms, such as airlines, manufacturers, and other small- to medium-sized businesses, often use derivatives markets to hedge their price risk. Regulators would be required to define the types of risk a company may hedge and remain eligible for the limited exception to clearing. The legislation will hold swap dealers like big banks accountable to new standards for capital, margin, and business conduct requirements and will benefit end users’ ability to continue to effectively hedge their price risk by not submitting them to onerous cash collateral requirements.
The legislation will resolve jurisdictional issues between regulators that have compromised past efforts at financial regulation. The House measure will also strengthen confidence in trader position limits on physically deliverable commodities as a way to prevent excessive speculative trading.
Heeding the G-20’s advice to prevent regulatory arbitrage, the legislation calls for international harmonization by requiring foreign boards of trade to share trading data and adopt speculative position limits on contracts that trade U.S. commodities similar to U.S.-regulated exchanges. The SEC and CFTC are also directed to consult and coordinate with foreign regulators to create consistent international standards with respect to the regulation of derivatives. The SEC and CFTC are authorized to engage in information sharing arrangements with foreign regulators consistent with the public interest and the protection of investors and counterparties. In addition, the SEC and CFTC are authorized to prohibit a foreign entity from participating in the US in any swap or security-based swap activities upon determining that the regulation of derivatives in the entity’s foreign jurisdiction undermines the stability of the US financial system.
The legislation specifically forbids federal assistance to support derivatives clearing operations or the liquidation of a derivatives clearing organization set up under the Commodity Exchange Act or a clearing agency described in the Exchange Act unless Congress expressly authorizes such assistance.
The legislation ensures that the expansion of the CFTC’s authority over derivatives will not in any way limit the Federal Energy Regulatory Commission's authority to regulate energy markets. In any area where FERC and the CFTC have overlapping authority, the legislation requires the two agencies to conclude a memorandum of understanding delineating their respective areas so as to avoid conflicting or duplicative regulation. Where FERC has regulatory authority, the CFTC is permitted to step back and let FERC do its job.
The legislation implements important corporate governance reforms in the derivatives markets. In addition to complying with a number of core principles listed in the Act, such as having adequate financial resources and effective risk management, derivatives clearing organizations registered with the SEC must designate a compliance officer to review compliance with the core principles and establish procedures for the remediation of non-compliance. The compliance officer must also prepare an annual report, certifying its accuracy, on the compliance efforts of the derivatives clearing organization. The compliance report will accompany the financial reports that the clearing organization must furnish to the SEC.
Hedge Funds and Private Equity Funds
Hedge funds and other private funds are not currently subject to the same set of standards and regulations as banks and mutual funds, reflecting the traditional view that their investors are more sophisticated and therefore require less protection. This exemption has enabled private funds to operate largely outside the framework of the financial regulatory system even as they have become increasingly interwoven with the financial markets. As a result, there is no data on the number and nature of these firms or ability to calculate the risks they pose to the broader markets and the economy.
The legislation requires investment advisers to hedge funds and other private investment funds to register with the SEC if they have assets under management of at least $150 million and be subject to significant disclosure and other requirements. Current law generally does not require hedge fund and other private fund advisers to register with any federal financial regulator (Title V, Subtitle A).
The legislation accomplishes the registration of hedge fund advisers by eliminating the Investment Adviser Act’s private adviser exemption, which exempts from registration investment advisers that have fewer than 15 clients, do not hold themselves out to the public as investment advisers, and do not act as investment advisers to registered investment companies or business development companies. (Section 5003) The legislation creates a limited exemption for foreign private fund advisers.
The legislation mandates the registration of private advisers to private pools of capital so that regulators can better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole. In addition, new recordkeeping and disclosure requirements for private fund advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until now have largely escaped any meaningful regulation, without posing undue burdens on those industries (Section 5004). Under the legislation, advisers to hedge funds, private equity firms, and other private pools of capital will have to obey some basic ground rules in order to continue to play in the capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.
The legislation authorizes the SEC to require registered investment advisers to maintain records of, and submit reports about, the private funds they advise in two instances. First, as the SEC determines is necessary or appropriate in the public interest and for the protection of investors; and second, as the SEC determines in consultation with the Federal Reserve Board, and to any other entity that the SEC identifies as having systemic risk responsibility, is necessary for the assessment of systemic risk. The records and reports of any private fund are further deemed to be the records and reports of the registered investment adviser.
The SEC is authorized, after considering the public interest and potential to contribute to systemic risk, to set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds they advise. The information that hedge funds and private funds disclose to the SEC is confidential, except that the Commission may not withhold information from Congress. Also, the SEC is authorized to provide the information to the Fed and the new systemic risk regulator, which in turn must keep the information confidential in a manner consistent with the confidentiality regime established by the SEC.
The legislation requires hedge fund advisers covered by the asset threshold exemption to maintain the required records and gives the SEC the discretion to require reports in the public interest or for investor protection. In adopting regulations for investment advisers to mid-sized private funds, the SEC must take into account the size, governance and investment strategy of the funds in order to ascertain if they pose a systemic risk to the financial markets (Section 5007).
The House legislation contains a registration exemption for advisers to venture capital funds. The SEC is directed to identify and define the term venture capital fund and provide an adviser to such a fund an exemption from the registration requirements. But the Commission must require advisers to venture capital funds to maintain records and provide annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors (Section 5006).
The legislation mandates the confidential reporting to the SEC of amount of assets under management, borrowings, off-balance sheet exposures, counterparty credit risk exposures, trading and investment positions, and other important information relevant to determining potential systemic risk and potential threats to overall financial stability. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk.
In addition, the SEC would share the disclosure reports received from funds with the Federal Reserve Board and the new systemic risk regulator, the Financial Services Oversight Council.
This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to overall financial stability and should therefore be under the broad oversight of the new federal systemic risk regulator.
The Act would require the SEC to provide guidance to hedge funds, private equity firms, and other private pools as they adjust to the legislation’s new registration requirements.
The Comptroller General would be required to conduct a study and report to Congress within two years on the costs to the hedge fund industry of the legislation’s registration and reporting requirements. The Act would delay the effective date for one year, although advisers would have the discretion to register earlier with the SEC.
Senate legislation would require the SEC registration of hedge fund and other private fund advisers and disclosure of information to the Commission under a confidentiality regime.
Credit Rating Agencies
The credit rating agencies, nationally recognized statistical ratings organizations or NRSROs, have assumed a central role in the global capital markets. They faced growing criticism over the past years which reached a crescendo in the recent financial crisis. In response, the Act enhances the SEC’s oversight and regulation of NRSROs.(Title V, Subtitle B).
The Commission must establish an office that administers the SEC rules with respect to the practices of credit rating agencies in determining ratings, in the public interest and for the protection of investors, including rules designed to ensure that credit ratings are accurate and are not unduly influenced by conflicts of interest. The new Office must be sufficiently staffed to carry out the mission (Section 6002).
The SEC is directed to revise Regulation FD to remove from FD the exemption for entities whose primary business is the issuance of credit ratings (Section 6007). The legislation enhances the accountability of NRSROs by clarifying the ability of individuals to sue NRSROs. The Exchange Act is amended to provide that, in an action for money damages against a rating agency, it is enough for pleading any required state of mind that the complaint state with particularity facts giving rise to a strong inference that the rating agency knowingly or recklessly violated the securities laws. In addition, statements made by rating agencies will not be deemed forward looking statements for purposes of the Exchange Act’s safe harbor (Section 6003).
In any private action against a rating agency, the same pleading standards with respect to knowledge and recklessness must apply to the rating agency as would apply to any other person in the same or similar private right of action against such person. The Act also amends Rule 436(g) of the Securities Act to remove the “expert” exemption for credit ratings included in a registration statement. Thus, NRSROs will now have greater liability under the securities laws if a rating is included in a registration statement. Rating agencies would be liable for omitting information from a registration statement, putting them on the same level as other experts like accountants, auditors, and lawyers. The provision is intended to make credit rating agencies more accountable for their work by making them liable for misstatements or omissions of fact from a statement (Section 6012).
Transparency is a hallmark of the legislation. Investors will gain access to more information about the internal operations and procedures of NRSROs, methodologies, ratings performance and short-comings in ratings assessment. In addition, the public will now learn more about how NRSROs get paid.
The issuer-pay model has long created inherent conflicts of interest for which NRSROs have been criticized. The legislation contains new requirements designed to mitigate these conflicts of interest. The Act requires each NRSRO to have a board with at least one-third independent directors. The independent directors will oversee policies and procedures aimed at preventing conflicts of interest and improving internal controls, among other things. Moreover, the compensation of the directors cannot be linked to the business performance of the rating agency; and must be arranged to ensure the independence of their judgment
The Act adds a new duty to supervise an NRSRO's employees and authorizes the SEC to sanction supervisors for failing to do so. It also includes revolving-door protections when certain NRSRO employees go to work for an issuer
Additionally, the bill significantly enhances the responsibilities of NRSRO compliance officers to address conflicts of interest. The compliance officer would report directly to the board and would review all of the agency’s policies to manage conflicts of interest and, in consultation with the board, resolve any conflicts of interest that arise. The compliance officer must also asses the risk that compliance or lack of such may compromise the integrity of the rating process. Similarly, the compliance officer must review compliance with internal controls with respect to the procedures and methodologies for determining credit ratings, including quantitative models and qualitative inputs used in the rating process, and assess the risk that such compliance with the internal controls or lack thereof may compromise the integrity and quality of the credit rating process (Section 6002).
The measure also requires the compliance officer to be responsible for administering the policies and procedures required to be established by the legislation and, more broadly, ensure compliance with securities laws and SEC regulations. The compliance officer must annually prepare and sign a report on the compliance of the rating agency with the securities laws and its own internal policies and procedures, including its code of ethics and conflict of interest policies, in accordance with SEC rules. This compliance report must accompany the financial reports of the rating agency that are required to be filed with the Commission and must include a certification that the report is accurate and complete.
The legislation removes all references to credit ratings in federal statutes under the jurisdiction of the Committee on Financial Services. The bill directs the agencies to devise a standard of creditworthiness to serve as a substitute for ratings in rules and regulations (Section 6009).
Fiduciary Standard for Brokers and Investment Advisers
The current regulatory regime treats brokers and advisers differently and subjects them to different standards of care even though the services they provide investors are very similar and investors view their roles as essentially the same. This regime was erected during the New Deal and, while amended many times over the years, is still organically rooted in the last century. The legislation brings regulation into today’s reality and mandates a harmonized federal fiduciary standard for brokers and investment advisers in their dealings with retail customers. In the future, every financial intermediary, such as brokers and investment advisers, that provides personalized investment advice to retail customers will have a fiduciary duty to the investor (Section 7103).
The SEC must adopt rules providing that the standard of conduct for all brokers and investment advisers is to act in the best interest of their customers without regard to their financial or other interest. Any material conflicts of interest must be disclosed to the customer, who must consent.
Under this harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first. The receipt of compensation based on commission or fees will not, in and of itself, be considered a violation of the standard applied to a broker or dealer or investment adviser. The legislation defines retail customers as those receiving personalized investment advice from a broker, dealer, or investment adviser for use primarily for personal, family, or household purposes.
The legislation clarifies that the SEC must not define customer to include investors in a private fund managed by an investment adviser when that private fund has also entered into an advisory contract with the same adviser. This is designed to prevent advisers from being subjected to an irresolvable conflict of interest when they manage a pooled investment with the interest of each individual investor in mind.
Additionally, the SEC must, to the extent practicable, harmonize its enforcement and remedy regulations across brokers, dealers and investment advisers with respect to the provision of investment advice.
Arbitration
The SEC will be enabled to restrict or even prohibit the use of mandatory arbitration clauses in contracts with broker-dealers. For too long, pre-dispute mandatory arbitration clauses inserted into brokerage firm contracts have restricted the ability of defrauded investors to seek redress in the courts for wrongdoing (Section 7201).
SEC Funding and Authority
SEC funding will double over the next five years from $1.115 billion in FY-2010 to $2.25 billion in FY 2015. This will provide the SEC with the ability to hire additional staff with industry expertise. In total, nearly $10 billion over the next 6 years will help the SEC better oversee the multi-trillion dollar securities markets. The Senate legislation would make the SEC a self-funded agency through the transaction and registration fees it collects (Section 7301).
In addition, the SEC will obtain additional funding via assessments on investment advisers. The legislation authorizes the SEC to create a new user fee paid by investment advisers to support the Commission’s work related to the inspection and examination of investment advisers. Broker-dealers presently pay fees to FINRA to cover the costs of their primary regulator, but investment advisers do not pay such fees to the SEC, which serves as their front-line regulator (Section 7302).
In addition, the examination statistics of investment advisers and broker-dealers reveal disparities and further vulnerabilities in the present regulatory framework. Last year, the SEC examined only 9 percent of investment advisers, while FINRA examined more than 50 percent of broker-dealers. This new user fee for the investment adviser community would help to increase the resources available at the SEC to inspect investment advisers and better protect investors.
In assessing the fee, the Commission must consider a number of factors, including the size of the adviser and the number and types of its client. The SEC may retain any excess fees imposed in one year for application in future years. Fee increases are not subject to judicial review.
The legislation also provides and clarifies several important rule-making authorities. The SEC will now regulate and establish formal rules for municipal financial advisors.
There is currently no requirement that mutual funds hold liquid securities. The legislation allows the SEC to impose limits on illiquid investments by mutual funds.
The securities lending program of AIG greatly contributed to its downfall. Thus, the legislation authorizes the SEC to regulate stock loans and borrowing in order to enhance market transparency, reduce collateral risk exposures, and limit conflicts of interest in the securities lending process. The SEC would have broader authority to collect information from and coordinate with foreign regulatory bodies, as well as to pursue legal cases across national borders (Section 7401).
The legislation would also expand the scope of securities that must be reported to the SEC or its designee under the Lost and Stolen Securities Program, to include cancelled, missing or counterfeit securities certificates (Section 7402).
For many years the SEC has relied on Section 20(a) of the Exchange Act, which imposes joint and several liability on control persons unless they can establish an affirmative defense. Recent court decisions, however, have concluded that the provision is available only to private parties. The legislation clarifies that the SEC may once again impose joint and several liability on control persons unless they can establish an affirmative defense (Section 7220).
Several of the Exchange Act’s antifraud provisions apply only to those transactions that involve securities registered on an exchange. Congress believes that, in today’s trading environment, the same standards should apply to transactions whether they involve securities registered on an exchange or not registered on an exchange. Thus, the legislation broadens the SEC’s authority under several sections of the Exchange Act to also apply the antifraud provision to securities transactions not conducted on exchanges. The SEC’s existing antifraud rulemaking powers would be expanded to cover short sales in the over-the-counter markets and of non-equity securities, as well as all options on securities. Government securities are excluded in order to avoid any possible impact of SEC rules on that market. The general antifraud provisions for these transactions would continue to apply (Section 7221).
Since 1975, the SEC has had the authority to examine all the records of broker-dealers and other persons registered under the Exchange Act, as well as all records of advisers registered under the Investment Advisers Act. The SEC’s authority to examine registered investment companies, however, has remained limited to required records. The legislation would change the authority under the Investment Company Act to apply to all records and, by fixing this anomaly, allow the SEC to gain a better understanding of the operations of investment companies (Section 7219).
The legislation also amends the Exchange Act, the Investment Company Act, and the Investment Advisers Act to subject registered individuals and firms at any time, or from time to time, to such reasonable periodic, special, or other information and document requests as the SEC by rule or order deems necessary or appropriate to conduct surveillance or risk assessments of the securities markets (Section 7218).
The legislation authorizes the SEC to require that registered management investment companies provide and maintain a bond against losses caused by any officer or employee of the company or any officer or employee of the company’s investment adviser (Section 7217).
Aiding and Abetting
The current law for determining aiding and abetting violations and the scope of primary liability remains unsettled, resulting in challenges for the SEC in charging people who play substantial roles in fraud cases. Specifically, the Exchange Act provides that the SEC can prosecute people for knowingly aiding and abetting securities fraud. A growing number of courts, however, have held that knowingly means actual knowledge, rather than recklessness, resulting in a standard that is higher for aiding and abetting violations than for the primary fraud violation, which would include recklessness. The legislation clarifies that recklessness is sufficient for bringing an aiding and abetting action, thus harmonizing the standard for aiding and abetting and the primary violation. Thus, the SEC would not be at a disadvantage charging someone as an aider and abettor rather than a primary violator (Section 7215).
The Exchange Act and the Investment Advisers Act presently permit the SEC to bring actions for aiding and abetting violations of those statutes in civil enforcement actions. The legislation would authorize the SEC to bring similar actions for aiding and abetting violations of the Securities Act and the Investment Company Act. In addition, the legislation would clarify that the knowledge requirement to bring an aiding and abetting claim can be satisfied by recklessness. The Act also clarifies that the Investment Advisers Act expressly permits imposition of penalties on aiders and abettors.
SEC Use of Grand Jury Information
Under existing law, the SEC may access grand jury information only in the rare case in which it can demonstrate that it has a particularized need for the information and that the information is sought preliminarily to or in connection with a judicial proceeding. As a practical matter, the particularized need standard and the required nexus with an ongoing or imminent judicial proceeding severely limit the situations in which the Department of Justice can share with the SEC even the most critical information relevant to parallel investigations.
In most cases, the SEC must therefore conduct a separate, duplicative investigation to obtain the same information. This both entails an inefficient use of government resources and frequently burdens private parties and financial institutions with the need to provide essentially the same documents and testimony in multiple investigations. The need for the SEC to conduct a separate investigation also can result in substantial delays. The legislation works a narrow modification of the grand jury secrecy rule to aid the SEC in its investigations and greatly enhance the efficient use of the law enforcement resources devoted to those investigations (Section 7214).
This modification is modeled on Section 964 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 providing banking and thrift regulators with access to grand jury information. The legislation authorizes government attorneys to seek court authorization to release certain limited grand jury information to SEC personnel for use in matters within the SEC’s jurisdiction.
The legislation permits the sharing of information only with regard to conduct that may constitute violations of the federal securities laws. With regard to that information, however, the measure lessens the burden in obtaining court approval. The court could approve the sharing of the information upon a showing of a substantial need in the public interest rather than the higher particularized need standard. In addition, the judicial proceeding requirement would not apply to the SEC, permitting information to be shared at an earlier stage in an investigation and in connection with an SEC administrative proceeding.
Information Sharing
The legislation would allow the SEC to share information with domestic regulators, foreign securities regulators, the PCAOB, and state securities agencies engaged in the investigation and prosecution of violations of applicable securities laws without waiving any privileges the SEC may have with respect to such information (Section 7213). The language is modeled on a provision in the Federal Deposit Insurance Act that enables the federal bank regulatory agencies to share information with other regulators without waiving their privileges with respect to such information. Also, the SEC cannot be compelled to disclose privileged information obtained from any foreign securities regulator or law enforcement authority if such authority has in good faith determined that the information is privileged.
Reporting Timeframes
With regard to beneficial ownership reporting and short-swing profit reporting, the legislation authorizes the SEC to adopt rules shortening current reporting timeframes and help the markets receive more timely information concerning substantial ownership interests in issuers that may be important for purposes of obtaining the accurate pricing of listed securities (Section 7105).
The legislation would expand the scope of records to be maintained and subject to examination by the SEC under both the Investment Company Act and the Investment Advisers Act to custodians or others who have custody or use of the investment company’s or the investment adviser’s clients’ securities, deposits, or credits (Section 7419).
PCAOB Reforms
Closing a statutory loophole revealed by the Madoff scandal, the Public Company Accounting Oversight Board will gain the power needed to flexibly examine the auditors of broker-dealers. Thus, the legislation would bring auditors of broker-dealers under the PCAOB oversight regime. The Board will inspect the audit reports on broker-dealer financial statements; and will have investigatory, examination and enforcement authority over the auditors of broker-dealers. In addition, brokers and dealers would be brought into the Board’s funding scheme by paying a fee allocation in proportion to their net capital compared to the total net capital of all brokers and dealers that are not issuers, in accordance with the rules of the Board. The Act also authorizes the Board to refer an investigation concerning a broker or dealer’s audit report to the relevant self-regulatory organization. Moreover, the Board is authorized to share with the SRO all information and documents received in connection with an investigation or inspection without breaching its confidential status (Section 7601).
The House legislation would also change the name of the Public Company Accounting Oversight Board to Auditor Oversight Board. (Section 7610) In addition, the Act would create an ombudsman within the Auditor Oversight Board to act as a liaison between the Board and registered accounting firms and issuers with regard to the issuance of audit reports (Section 7609).
Securities Investor Protection Act Reforms
The $65 billion Madoff fraud also exposed faults in the Securities Investor Protection Act (SIPA), the law that returns money to the customers of insolvent fraudulent broker-dealers. The legislation attempts to fix these shortcomings. The legislation increases the Securities Investor Protection Corporation (SIPC) cash advance limits to levels of coverage that are similar to those provided by the FDIC. Currently, under SIPA, any amount advanced in satisfaction of customer claims may not exceed $500,000 per customer. If part of the claim is for cash, the total amount advanced for cash payment must not exceed $100,000. The legislation increases the maximum cash advance amount to $250,000 and authorizes SIPC, subject to the approval of the SEC, to make inflationary adjustments every 5 years to that amount starting in 2010.(Section 7503).
The Act also updates SIPA to increase the minimum assessments paid by members of the Securities Investor Protection Corporation to the SIPC Fund. Currently, SIPA provides that the minimum assessment of a SIPC member must not exceed $150 per year, regardless of the size of the SIPC member. The Act strikes this current minimum assessment level and sets a new minimum assessment at 2 basis points of a SIPC member’s gross revenues (Section 7501).
The Act would extend SIPC insurance to futures positions held in a customer portfolio margining account under a program approved by the SEC. This provision is intended to address the possibility that current law would treat a portfolio margining customer as a general creditor with respect to the proceeds from such customer’s futures positions, while the same portfolio margining customer would have priority for their securities holdings in the case of insolvency of their broker-dealer (Section 7509).
Whistleblower Protections
The legislation authorizes the SEC to establish a fund to pay whistleblowers for information that leads to enforcement actions resulting in significant financial awards using funds collected in enforcement actions not otherwise distributed to investors. The SEC currently has such authority to compensate sources in insider trading cases, and this provision would extend the Commission’s power to compensate whistleblowers that bring substantial evidence of other securities law violations. SEC determinations on whistleblower awards are final and not subject to judicial review (Section 7203).
The legislation also closes a loophole in Sarbanes-Oxley Act whistleblower protection by including any subsidiary or affiliate of company whose financial information is included in the consolidated financial statements of the company. Sarbanes-Oxley created federal whistleblower protections for employees when they disclose information about fraudulent activities within their companies. The Act would eliminate a defense now raised in a substantial number of actions brought by whistleblowers and apply the Sarbanes-Oxley whistleblower protections to both companies and their subsidiaries and affiliates (Section 7607). A letter from Senator Patrick Leahy, author of the Sarbanes-Oxley whistleblower statute, to the Department of Labor emphasized that federal whistleblower protection extends to employees of subsidiaries of companies and that the DOL should not interpret the statute to exclude employees working for company subsidiaries.
Investment Advisory Committee
The Act codifies the Investment Advisory Committee that the SEC recently administratively established to advise the Commission on regulatory priorities, including issues concerning new products, trading strategies, fee structures, and the effectiveness of disclosure; initiatives to protect investor interest; and initiatives to promote investor confidence in the integrity of the marketplace. The membership on the Investor Advisory Committee consists of individuals representing the interests of individual and institutional investors who use a wide range of investment approaches. The advisory panel must meet at least twice a year, and its members will receive compensation for participation in meetings and travel expenses. Funding, as is necessary, is authorized to support the work of the Committee (Section 7101).
Consumer Testing
In a congressional endorsement of the benefits that can accrue from field testing, consumer outreach, and testing of disclosures to individual investors, the legislation clarifies the SEC’s authority to gather information, such as through focus groups, communicate with investors or other members of the public through telephonic or written surveys, and engage in temporary experimental programs, such as pilot programs to field test disclosures, in order to inform the Commission’s rulemaking and other policy functions (Section 7102).
International Reach of Federal Securities Laws
The rapid globalization of financial markets in recent years has cast into stark relief issues surrounding the international reach of U.S. securities laws. Since the federal securities laws are silent on their international reach, federal courts have developed tests, including the conduct test, which focuses on the nature of the conduct within the U.S. as it relates to carrying out the alleged fraudulent scheme
The legislation authorizes the SEC and the United States to bring civil and criminal law enforcement proceedings involving transnational securities frauds, which are securities frauds in which not all of the fraudulent conduct occurs within the United States and not all of the wrongdoers are located domestically. Specifically, the legislation would amend the Securities Act and the Exchange Act to provide that US district courts have jurisdiction over violations of the antifraud provisions that involve a transnational fraud if there is conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors (Section 7216).
The "Revolving Door"
In an effort to address the revolving door problem, the legislation directs the US Comptroller General to conduct a study to review the number of SEC employees who leave the Commission to work for financial institutions regulated by the SEC and file a report within one year with Congress. The report must review the length of time these employees work for the SEC before they leave to work for regulated financial institutions (Section 7414).
Importantly, the Comptroller General must determine if greater post-employment restrictions are needed in order to prevent SEC employees from being employed by regulated firms when they leave the SEC, as well as whether the number of former SEC employees going to the industry has led to SEC enforcement inefficiencies. The report must also identify any information sharing engaged in by the SEC employees while they worked for the Commission.
SEC Enforcement Actions
To expedite cases against violators of securities laws, the SEC will generally need to complete enforcement investigations, compliance inspections and exams, within 180 days. (Section 7209) Also, the legislation would allow subpoenas to be served nationwide in SEC enforcement actions in federal court. Currently, the Commission can issue a subpoena only within the federal district where a trial takes place or within 100 miles of the courthouse. Witnesses in civil cases brought by the Commission are, however, often located outside of a trial court's subpoena range. The SEC has nationwide service of process of subpoenas in administrative proceedings (Section 7210).
The SEC would also be authorized to impose collateral bars against regulated persons. The Commission would have the authority to bar a regulated person who violates the securities laws in one part of the industry, such as a broker-dealer who misappropriates customer funds, from access to customer funds in another part of the securities industry, for example, an investment adviser. By expressly empowering the SEC to impose broad prophylactic relief in one action in the first instance, this provision would enable the SEC to more effectively protect investors and the markets while more efficiently using SEC resources (Section 7206).
The legislation expressly authorizes the SEC to bring actions against persons formerly associated with a regulated or supervised entity, such as an investment company or an SRO, for misconduct that occurred during that association. This provision closes a loophole in the securities laws that had allowed those who engage in misconduct while working for an entity regulated by the SEC, like a stock exchange, to resign and avoid being held accountable for their wrongdoing (Section 7212).
Many provisions of the federal securities laws that authorize the sanctioning of a person who engages in misconduct while associated with a regulated or supervised firm explicitly provide that such authority exists even if the person is no longer associated with that firm. Several provisions, however, do not explicitly address this issue. The legislation amends those provisions that do not explicitly address this issue to make it clear that the SEC, or in applicable cases the PCAOB, may sanction or discipline persons who engage in misconduct while associated with a regulated or supervised firm even if they are no longer associated with that firm.
The legislation streamlines the SEC’s existing enforcement authorities by permitting the SEC to seek civil money penalties in cease-and-desist proceedings under federal securities laws. The measure would ensure appropriate due process protections by making the SEC’s authority in administrative penalty proceedings coextensive with its authority to seek penalties in federal court. As is the case when a federal district court imposes a civil penalty in a SEC action, administrative civil money penalties would be subject to review by a federal appeals court (Section 7208).
The Fair Fund provisions of the Sarbanes-Oxley Act take the civil penalties levied by the SEC as a result of an enforcement action and direct them to a disgorgement fund for harmed investors. The legislation would increase the money available to compensate defrauded investors by revising the Fair Fund provisions to permit the SEC to use penalties obtained from a securities fraudster to recompense victims of the fraud even if the SEC does not obtain an order requiring the fraudster to disgorge ill-gotten gains. Currently, in some cases, a defendant may engage in a securities law violation that harms investors, but the SEC cannot obtain disgorgement from the defendant because the defendant did not personally benefit from the violation (Section 7605).
Post-Madoff Report
Within six months, the SEC must report to Congress describing the implementation of reforms in the wake of the Madoff fraud. The report must include an analysis of how many post-Madoff reforms have been implemented and how extensively. The SEC must publish the report on its website (Section 7306).
State Regulation of Investment Advisers
The legislation could move the regulation of thousands of investment advisers from the SEC to the states by raising the assets under management trigger for federal regulation from $25 million to $100 million and authorizing the SEC to move it even higher. The Act sets up state oversight of investment advisers with up to $100 million in assets under management. The $25 million trigger for state regulation was set in the National Securities Markets Improvement Act of 1996 (Section 7418).
As part of the 1996 Act, Congress determined that the SEC should regulate larger investment advisers while States should oversee smaller investment advisers. The legislation would eliminate any remaining application of federal law to investment adviser firms that the states now solely regulate.
Equal Treatment of SRO Rules
Section 29(a) of the Exchange Act voids any condition, stipulation, or provision binding any person to waive compliance with any provision of the Exchange Act, any rule or regulation under it or any rule of an exchange. The legislation would extend this safeguard to the rules of FINRA and registered clearing agencies (Section 7404). This change is consistent with provisions of the Exchange Act that encourage allocation of self-regulatory responsibilities among SROs to avoid overlapping and duplicative regulation. The change is particularly important now that FINRA has taken over the regulation of NYSE members’ conduct in relation to customers.
The legislation also amends the Exchange Act to require fingerprinting for the personnel of registered securities information processors, national securities exchanges, and national securities associations. This change would bring these entities in line with the entities already listed in the statute, and would aid in ensuring that the entities are aware of whether their personnel have criminal backgrounds (Section 7403).
SEC, FASB, PCAOB Testimony on Financial Accounting
The legislation would require the SEC, FASB and the PCAOB to provide oral testimony to Congress by their respective chairs beginning in 2010, and annually for 5 years, their efforts to reduce the complexity in financial reporting to provide more accurate and clearer financial information to investors. The testimony must discuss how the complexity of accounting and auditing standards has added to the costs of financial reporting, as well as the development of principles-based accounting standards (Section 7407).
Senior Investor Protection
The legislation would create a new grant program to provide states with the tools they need to prosecute securities fraud against seniors. (Title V, Subtitle C, Part 5). The legislation recognizes the harm to seniors posed by the use of misleading professional designations by salespersons and advisers and establishes a mechanism for providing grants to states designed to give them the flexibility to use funds for a wide variety of senior investor protection efforts, such as hiring additional staff to investigate and prosecute cases; funding new technology, equipment and training for regulators, prosecutors, and law enforcement; and providing educational materials to increase awareness and understanding of designations.