Thursday, July 15, 2010

Congress Approves Historic and Sweeping Overhaul of US Financial Regulation

After nearly two years of extensive hearings and intense legislative negotiations, Congress has passed and sent to the President a sweeping overhaul of the regulation of US financial services and markets. The Dodd-Frank Wall Street Reform and Consumer Protection Act overhaul of the US financial regulatory system is based on the themes of regulating systemic risk, enhancing transparency and disclosure, sound corporate governance and executive compensation linked to long-term value creation, expanding consumer protection, and preventing regulatory arbitrage. The Act restructures the foundations of the U.S. financial regulatory system, enhances regulation over more products and actors, creates additional investor protections and consumer safeguards, and promotes greater accountability in capital markets.

The legislation ends the era of too-big-to-fail financial institutions by establishing new regulatory authorities to dissolve and liquidate failing financial institutions in an orderly manner and vesting regulators with the power to limit the activities of financial services firms. Specifically, the Act permits regulators to preemptively break up and take other actions against financial institutions whose size, scope, nature, scale, concentration, interconnectedness, or mix of activities pose a grave threat to the financial stability or economy of the United States.

The legislation provides for the regulation of hedge funds, and OTC derivatives, as well as a new resolution authority to unwind failing financial firms. The legislation ends taxpayer bailouts of financial institutions and by creating a way to liquidate failed firms without taxpayer money.
The Dodd-Frank Act establishes a strong set of consumer protections, including a a new Bureau of Consumer Financial Protection that will be led by an independent director appointed by the President and confirmed by the Senate, with a dedicated budget in the Federal Reserve. The Bureau will write rules for consumer protections governing financial institutions, banks and non-banks, offering consumer financial services or products and oversee the enforcement of federal laws intended to ensure the fair, equitable and nondiscriminatory access to credit for individuals and communities. The Bureau will roll together responsibilities that are now spread across seven different government entities, providing consumers with a single, accountable, and powerful advocate.

The legislation also establishes strong mortgage protections, requiring that lenders ensure that their borrowers can repay their loans by establishing a simple federal standard for all home loans. Lenders also are required to make greater disclosures to consumers about their loans and will be prohibited from unfair lending practices, such as steering consumers to higher cost loans. Lenders and mortgage brokers who fail to comply with new standards can be held accountable by consumers.

The Dodd-Frank Act also creates a process to shut down large failing financial firms whose collapse would put the entire economy at risk. The dissolution of a failing firm will be paid for first by shareholders and creditors, followed by the sale of any remaining assets of the failed company. Any shortfall that results is paid for by the financial industry. Financial institutions will pay assessments based on a company’s potential risk to the whole financial system if they were to fail. Before regulators can dissolve a failing company, a repayment plan must be in place to recoup any cost associated with the shutdown.


The Act introduces a new Volcker Rule that will limit the amount of money a bank can invest in hedge funds. The legislation also discourages financial institutions from taking too many risks by imposing tough new capital and leverage requirements. The legislation effectively ends new lending under the Troubled Asset Relief Program.

This measure will also increase investor protections by strengthening the SEC and boosting its funding level. For the first time ever, the over-the- counter derivatives marketplace will be regulated and hedge funds will have to register with the SEC. The legislation addresses the utter lack of regulation in the enormous derivatives market by mandating the clearing of most derivative contracts on exchanges in order to increase transparency. For those derivatives that are not cleared, new reporting and disclosure requirements ensure that information on the transaction is maintained. At the same time, under an end user exemption, non-financial firms can still use derivatives to hedge and manage the commercial risks associated with their businesses.

The Act modifies, enhances and streamlines the powers and authorities of the SEC to
hold securities fraudsters accountable and better protect investors. For example, the SEC
will have the authority to impose collateral bars on individuals in order to prevent wrongdoers in one sector of the securities industry from entering another sector. The SEC will also gain the ability to make nationwide service of process available in civil actions filed in federal courts, consistent with its powers in administrative proceedings. Dodd-Frank further facilitates the ability of the SEC to bring actions against those individuals who aid and abet securities fraud.

The Securities 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 cases. The Act provides the SEC with the power to bring similar actions for aiding and abetting violations of the Securities Act of 1933 and the Investment Company Act. In addition, the measure not only clarifies that the knowledge requirement to bring a civil aiding and abetting claim can be satisfied by recklessness, but it also makes clear that the Investment Advisers Act of 1940 expressly permits the imposition of penalties on those individuals who aid and abet securities fraud. The Act also provides new authority of the SEC and the Justice Department to bring civil or criminal law enforcement proceedings involving transnational securities frauds.

The SEC, after it conducts a study, may issue new rules establishing that every financial intermediary who provides personalized investment advice to retail customers will have a fiduciary duty to the investor. The SEC is also authorized to set up an investor protection fund to pay whistleblowers whose tips lead to successful enforcement actions. The House bill would have imposed a uniform federal fiduciary duty on brokers and advisers, while the Senate bill directed the SEC to conduct a study on the matter. The House-Senate conference committee struck a compromise, vetted by Senator Tim Johnson, a senior member of the Banking Committee, under which the SEC will conduct a study under what Senator Johnson called strict parameters and the SEC is also authorized to impose a uniform federal fiduciary standard on brokers and investment advisers.

Thus the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to conduct a study to evaluate the effectiveness and efficacy of the existing standards of care for brokers and investment advisers and whether there are regulatory gaps in the protection of retail customers with regard to the standards

The legislation modifies the SEC’s structure by creating a number of new units and positions, like an Office of the Investor Advocate, an office to administer the new whistleblower bounty program, and an Office of Credit Ratings. Dodd-Frank mandates an expeditious, independent, comprehensive study of the securities regulatory regime by a high caliber body with expertise in organizational restructuring to identify deficiencies and reforms, and ensure that the SEC and other regulatory entities put in place further improvements designed to provide superior investor protection. The Act also includes deadlines generally forcing the SEC to complete enforcement, compliance examinations, and inspections within 180 days, with some limited exemptions for complex cases.

Responding to problems laid bare by the Madoff fraud, Congress authorized the PCAOB to examine the auditors of broker-dealers. In addition, the Act increase the credit line at the U.S. Treasury from $1 billion to $2.5 billion to support the work of the Securities Investor Protection Corporation and raises SIPC’s maximum cash advance amount to $250,000 in order to bring the program in line with the protection provided by the Federal Deposit Insurance Corporation. This bill additionally increases the minimum assessments paid by SIPC members from $150 per year, regardless of the size of the SIPC member, to 2 basis points of a SIPC member’s gross revenues in order to ensure that SIPC has the reserves it needs in the future to meet its obligations.


The Act greatly increases the accountability of credit rating agencies. By imposing structural, regulatory, and liability reforms on rating agencies, the Act will change the way nationally recognized statistical rating organizations behave and ensure that they effectively perform their functions as market gatekeepers. The Act also takes steps to reduce market reliance on the credit rating agencies and impose a liability standard on the agencies.

The legislation also permanently exempts small public companies from the Sarbanes- Oxley Act’s requirement to obtain an external audit on the effectiveness of internal financial reporting controls.

According to Senator Warner, systemic regulation sanctioned by the Act will mean that regulatory arbitrage can no longer take place. The silo-approach to risk regulation was ended and a new Financial Stability Oversight Council is authorized to regulate systemic risk wherever it occurs across the financial system. The legislation recognizes that systemic risk is not about size alone, but about leverage, risk management, and interconnectedness. Contingent capital is an important risk management tool, he said. (Senate debate on HR 4173 conference report, July 15, 2010).

The Dodd-Frank Act sets up a new office in the SEC to oversee and examine the work of the credit rating agencies. It requires the agencies to disclose their methodology and their track records. It allows investors to file private causes of action against agencies that fail to thoroughly investigate products they rate. The Act also tasks the SEC with examining the clear conflict of interest involved in Wall Street firms shopping for the highest rating among the various rating agencies. Senator Carl Levin hopes that, at the end of this study, the SEC will adopt the approach taken in the Franken Amendment that won bipartisan support in the Senate, and establish an intermediary that will separate the credit rating firms from the investment banks that press them for high ratings in return for lucrative compensation.

The Bureau of Consumer Financial Protection will bring new scrutiny to the practices of financial companies, providing important oversight that can end the kinds of abusive and even fraudulent practices used by some mortgage lenders. Other provisions will require those who create mortgage backed securities to retain a portion of the risk of securities backed by high risk loans, such as subprime mortgages, so that securitizers will no longer be able to offload all that risk onto the market and walk away from losses that occur down the road. Still another set of provisions bans so-called “liar loans,” which allowed firms to sell loans without any documentation of a borrower’s income or ability to repay.


The legislation gives the SEC and CFTC the authority to regulate over-the- counter derivatives to stop irresponsible practices and excessive risk taking. It requires central clearing and exchange trading for derivatives that can be cleared. It requires margin for uncleared trades in order to offset the greater risk they pose to the financial system and encourage more trading to take place in transparent, regulated markets. It increases data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding.

OTC derivatives will now have to be cleared, said Senator Maria Cantwell, and thus a third party will have to validate that there is real money behind the transaction. Senator Cantwell said that she received written assurance from CFTC Chair Gary Gensler, that the bill explicitly requires that swap dealers, major swap participants and financial entities use a clearinghouse for standardized or clearable derivatives transactions. Dodd-Frank also includes a narrowly-crafted exemption that will allow legitimate commercial end-users, such as farmers and manufacturers, to continue to hedge business risks without being subject to the clearing and exchange trading requirements.

The Act mandates aggregate position limits across all exchanges, foreign and domestic, for commodity contracts and all economically equivalent contracts that could be used to speculate in a particular commodity, so speculator can’t evade the rules by trading like contracts on different exchanges. The CFTC is directed to use position limits to diminish, eliminate, or prevent excessive speculation, disrupt market manipulation, and ensure price discovery is not disrupted. According to Senator Cantwell, these key improvements will stop speculators from driving up the price of oil and other commodities, creating a more stable price environment for US businesses. The Act also closes the London loophole by giving the CFTC authority to require registration of Foreign Boards of Trade that provide direct access to U.S. customers.

Dodd-Frank also authorizes the SEC and the Justice Department to bring civil or criminal law enforcement proceedings involving transnational securities frauds. These are securities frauds in
which not all of the fraudulent conduct occurs within the United States or not all of the
wrongdoers are located domestically. The Act creates a single national standard for protecting
investors affected by transnational frauds by codifying the authority to bring proceedings
under both the conduct and the effects tests developed by the courts regardless of the jurisdiction of the proceedings.

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