By James Hamilton, J.D., LL.M.
The Senate Banking Committee has released draft legislation that would provide a sweeping overhaul of the regulation of US financial services and markets. The draft would provide for joint SEC-CFTC regulation of derivatives, make the SEC self-funding, strengthen the Commission’s powers, better protect investors, and efficiently and effectively regulate the securities markets The Restoring American Financial Stability Act of 2009 would also reform the credit rating agency process by, among other things, establishes a new Office of Credit Rating Agencies at the SEC to enhance rating agency regulation and mandating new rules for internal controls, independence, transparency and penalties for poor performance in order to restore investor confidence in these ratings.
Following the council of systemic risk regulators model employed in the European Union legislation and in the House draft, the Senate legislation would create an independent agency with a board of regulators to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the financial system. The new Agency for Financial Stability could require companies that threaten the economy to divest some of their holdings. The Agency would be composed of, among others, the Chairs of the Fed, SEC and CFTC, with an independent Chair appointed by the President and confirmed by the Senate.
The failures to detect the Madoff and Stanford Financial frauds demonstrated deep deficiencies in the existing securities regulatory structure. The Restoring American Financial Stability Act would provide dozens of new enforcement powers and regulatory authorities. Thus, the SEC will be able to enhance its enforcement programs and gain the tools needed to better protect investors and police the markets.
The draft also provides for strong corporate governance protections, incorporating many of the provisions of Senator Schumer’s corporate governance bill, The Shareholder Bill of Rights Act, S 1074. The draft would require public companies to hold an annual advisory vote on executive compensation policies, as well as require shareholder approval of executive golden parachutes.
Similar to the House legislation, the Senate draft would mandate, for the first time, the federal regulation of derivatives. It would authorize the SEC and CFTC to regulate over-the-counter derivatives so that irresponsible practices and excessive risk-taking can no longer escape regulatory oversight. The draft uses the Administration’s outline for a joint rulemaking process with the new systemic risk regulators, the Agency for Financial Stability stepping in if the SEC and the CFTC cannot agree. The draft mandates central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared. It requires the SEC and the CFTC to pre-approve contracts before clearing houses can clear them.
Similar to the House draft, the 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. Similar to the House draft, the Senate bill would exempt advisers to venture capital funds from SEC registration. The SEC must require hedge fund advisers to disclose the amount of assets under management, their use of leverage and counterparty credit risk exposure, as well as their trading and investment positions, their valuation methodologies of the fund, and any side arrangements or side letters that treat fund investors more favorably than other investors.
The Senate draft orders the Comptroller General to conduct a study and submit a report to Congress on the feasibility of forming a self-regulatory organization to oversee hedge funds, private equity funds, and venture capital funds
The draft would also realize a goal of SEC self-funding. The legislation would allow the SEC to fund its own operations by using the transaction and registration fees it collects in place of a Congressionally-mandated budget. Self-funding will give the SEC access to millions more than is allocated through the Congressional appropriations process.
The SEC is one of only two federal financial regulators that must go through the annual Congressional appropriations process. Federal banking regulators such as the Federal Reserve and the FDIC, on the other hand, can use what they collect in fees, deposit insurance and interest income to fund their operations.
Under the current system, the SEC staff is struggling to keep up with the more sophisticated actors in the market, and the federal government cannot keep starving the SEC’s budget or the agency will ``remain a shadow of its former self,” said Senator Schumer, a key member of the Banking Committee, who noted that the Commission’s ability to retain experienced personnel is an ongoing problem since Wall Street firms are increasingly able to lure the agency’s experts with higher salaries. Mr. Schumer emphasized that the SEC’s chronic under-funding must be addressed in a comprehensive way.
Currently, the SEC raises millions more dollars every year in registration and transaction fees (not including enforcement penalties or settlements) than it is allocated through the appropriations process, he noted, but its budget is limited to the amount approved by Congress. In 2007, though the SEC brought in $1.54 billion in fees, it secured just $881.6 million in funding. Had the agency simply been able to hold onto all the fees it collected, reasoned the senator, it would have represented a 75 percent increase over the budget it was allotted through the appropriations process. SEC Chair Mary Schapiro has already signaled her support for self-funding.
The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. The $65 billion Ponzi scheme also exposed faults in the Securities Investor Protection Act, the law that returns money to the customers of insolvent fraudulent broker-dealers. The Investor Protection Act closes these loopholes and fixes these shortcomings.
Broker-dealers are brought 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 draft 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.
Acting on a recommendation of the Obama Administration, the House draft mandates a federal fiduciary standard for brokers and investment advisers in their dealings with retail customers. Under this harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first. The Senate draft mandates uniform standards for anyone providing customers investment advice, eliminating different standards for broker‐dealers and investment advisers
Similar to the House draft, the Senate legislation would reorder federal-state regulation of investment advisers by raising the SEC registration trigger of assets under management to $100 million. This would effectively move the regulation of thousands of investment advisers from the SEC to the states. The drafts would raise the assets under management trigger from $25 million to $100 million. Thus, the drafts set 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.
Because mandatory arbitration of brokerage disputes has limited the ability of defrauded investors to seek redress, the House and Senate drafts would authorize the SEC to bar these clauses in brokerage firm customer contracts.
Similar to the House draft, the Senate legislation contains specific provisions dealing with senior investor protection. The NASAA has long been concerned with the use of misleading professional designations that convey an expertise in advising seniors on financial matters. Many of these designations in reality reflect no such expertise but rather are conveyed to individuals who pay to attend weekend seminars and take open book, multiple choice tests. NASAA has adopted a model rule designed to curb abuses in this area.
The drafts recognize the harm to seniors posed by the use of such misleading activity and establishes a mechanism for providing grants to states as an incentive to adopting the NASAA model rule. The grants are designed to give states 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.
In addition, the Senate draft directs the SEC to adopt rules increasing the financial threshold for an accredited investor under the Securities Act of 1933, bycalculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the SEC determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living. The Comptroller General is ordered to conduct a study and report to Congress on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in hedge funds.
The Senate draft would provide for safe and efficient arrangements for the clearing and settlement of securities, and other financial transactions.