Corporate & Securities Law

By Jim Hamilton

Senate Passes Historic and Sweeping Overhaul of US Financial Regulation

The Senate has passed the Restoring American Financial Stability Act (S3217) providing for a sweeping overhaul of the regulation of US financial services and markets. The overhaul of the US financial regulatory system is based on the themes of regulating systemic risk, enhancing transparency and disclosure, delinking executive compensation from excessive risk, expanding consumer and investor protection, and preventing regulatory arbitrage. 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 securities firms by creating a way to liquidate failed firms without taxpayer money.
The measure shines the light of disclosure on dark markets by regulating the derivatives markets and the shadow banking system of hedge funds and other private vehicles that grew up around it. The legislation provides for major corporate governance reforms, such as shareholder advisory votes on compensation and enhanced compensation committees. The legislation also envisions a completely reformed securitization process playing an important role in the financial markets. A new independent regulator would be created with authority to make sure that consumer protection regulations are written and enforced

The legislation would provide for joint SEC-CFTC regulation of derivatives, make the SEC self-funding, strengthen the SEC?s powers to better protect investors, and efficiently and effectively regulate the securities markets The Restoring American Financial Stability Act would also reform the credit rating agency process by, among other things, establishing a new Office 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. The legislation also establishes a systemic risk regulator based on the council of systemic risk regulators model employed in the European Union legislation and in the House legislation.

Systemic Risk Regulator

The financial crisis demonstrated that large, interconnected financial firms that pose a systemic risk to the entire financial system need to be under a consistent and conservative regulatory regime. These standards cannot simply address the soundness of individual institutions, but must also ensure the stability of the system itself.

Any financial institution that is big enough, interconnected enough, or risky enough that its distress necessitates government intervention is an institution that necessitates oversight by a federal agency responsible for managing the overall risk to the financial system. In a world where financial innovation is pervasive and where market conditions constantly change, regulators must be authorized to take a holistic view of the playing field, identifying gaps, pointing to unsustainable trends, and raising questions about new kinds of interactions.

Thus, the legislation would enact an early warning system by creating a regulator to police all systemically important firms and markets as a broad consensus develops on the need for Congress to create a systemic risk regulator. This regulator would be authorized to take proactive steps to prevent or minimize systemic risk. The legislation seeks to guarantee holistic regulation of the financial system as a whole, not just its individual components.

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 Financial Stability Oversight Council, chaired by the Treasury Secretary and comprised of key regulators such as the Fed, SEC and CFTC, would monitor emerging risks to U.S. financial stability, recommend heightened prudential standards for large, interconnected financial companies, and require nonbank financial companies such as hedge funds to be supervised by the Federal Reserve if their failure would pose a risk to U.S. financial stability.

The Federal Reserve would establish and implement the heightened prudential standards and would have additional authority to require (with Council approval) a large financial company to restrict or divest activities that present grave threats to U.S. financial stability. With respect to bank holding companies, the heightened prudential standards would increase in stringency gradually as appropriate in relation to the company?s size, leverage, and other measures of risk for those that have assets of $50 billion or more. This graduated approach to the application of the heightened prudential standards is intended to avoid identification of any bank holding company as systemically significant. These heightened prudential standards would also apply to nonbank financial companies.

By a two-thirds vote, the Council can determine that a nonbank financial company will be supervised by the Fed and be subject to heightened prudential standards, if the Council determines that material financial distress at such financial company would pose a threat to the financial stability of the United States. Each determination will be based on a consideration of enumerated factors by the Council, including, among others, the degree of leverage, a typical mutual fund could be an example of a nonbank financial company with a low degree of leverage, amount and nature of financial assets; amount and types of liabilities, including degree of reliance on short-term funding; extent and type of off-balance-sheet exposures; extent to which assets are managed rather than owned and to which ownership of assets under management is diffuse. Section 113.

Size alone should not be dispositive in the Council?s determination. In its consideration of the enumerated factors, the Council should also take into account other indicia of the overall risk posed to U.S. financial stability, including the extent of the nonbank financial company?s interconnections with other significant financial companies and the complexity of the nonbank financial company. It is not intended that a Council determination be based on the exchange functions of securities or futures exchanges regulated by the SEC and the CFTC, to the extent that as part of these functions the exchanges act as administrators of marketplaces and not as counterparties.

Further, it is not intended that the activities of securities and futures exchanges overseen by the SEC and the CFTC that consist of, or occur prior to, trade execution be considered a clearing, settlement or payment business, provided that such activities do not include functioning as a counterparty. See Senate Banking Committee Report, p42. This interpretation dovetails with House legislative history, which indicates that, while derivatives and securities exchanges would technically meet the definition of a financial company under Title I, the House intended the legislation to address the players in the marketplace rather than the administration of the marketplace. [Peterson-Frank colloquy, Cong. Record, Dec. 9, 2009, H14425].
Office of Financial Research

The legislation establishes an executive agency to collect and standardize data on financial firms and their activities to aid and support the work of the federal financial regulators. The Office of Financial Research, headed by a Director appointed by the President for a six-year term, would provide the Council and financial regulators with the data and analytic tools needed to prevent and contain future financial crises by developing tools for measuring and monitoring systemic risk. The logic behind the Office is that it makes no sense to pass legislation creating a systemic risk regulator when there are no standardized tools for measuring systemic risk. The Office is patterned on an executive agency envisioned by the National Institute of Finance Act of 2010, S 3005, sponsored by Senator Jack Reed, Chair of the Securities Subcommittee.

The Office would not only develop the metrics and tools financial regulators need to monitor systemic risk, it would also help policymakers by conducting studies and providing advice on the impact of government policies on systemic risk. Thus, the Office would be required to provide independent periodic reports to Congress on the state of the financial system. This will ensure that Congress is kept apprised of the overall picture of the financial markets. The legislation provides for the Office to house a data center that would collect, validate and maintain key data to perform its mission.

Regulation of Derivatives
The financial crisis revealed that massive risks in derivatives markets went undetected by both regulators and market participants. In 2000, the Commodity Futures Modernization Act (CFMA) explicitly exempted OTC derivatives, to a large extent, from regulation by the CFTC. Similarly, the CFMA limited the SEC's authority to regulate certain types of OTC derivatives. As a result, the market for OTC derivatives has largely gone unregulated.

According to the Obama Administration, the downside of this lax regulatory regime became disastrously clear during the recent financial crisis when many institutions and investors had substantial positions in credit default swaps tied to asset backed securities. Excessive risk taking by AIG and certain monoline insurance companies that provided protection against declines in the value of such asset backed securities, as well as poor counterparty credit risk management by many banks, saddled the financial system with an enormous unrecognized level of risk. The sheer volume of these contracts overwhelmed some firms that had promised to provide payment on the credit default swaps and left institutions with losses that they believed they had been protected against. Lacking authority to regulate the OTC derivatives market, regulators were unable to identify or mitigate the enormous systemic threat that had developed. Financial Regulatory Reform: A New Foundation, June 2009

In an effort to address the systemic risk to the financial markets posed by derivatives, the Senate legislation would mandate, for the first time, the federal regulation of derivatives under a dual SEC-CFTC regime that emphasize transparency. The CFTC would regulate swaps and the SEC would regulate security-based swaps.

The legislation includes mandatory clearing and trading requirements and real-time reporting of derivatives trades. Banks engaging in risky swaps transactions will be forced to spin off their swap dealer desks or be barred from receiving any federal assistance, including deposit insurance. Swaps dealers will have a fiduciary duty, just like investment advisers, that will require the interests of municipalities and pension retirement funds be put first. Foreign exchange swaps will be regulated and regulators would be given broad enforcement authority to punish bad actors that knowingly help clients defraud third parties or the public.

The CFTC must consult with the SEC and the prudential regulators on the development of certain rules and orders. The CFTC will not have jurisdiction over security-based swaps or associated entities unless specifically mentioned in legislation, while the SEC will not have jurisdiction over other swaps or associated entities unless specifically mentioned in the legislation. Similarly, no futures association registered under the CFTC has authority over any security-based swap and no national securities association registered under the Securities Exchange Act has jurisdiction over any swap. The SEC and the CFTC may appeal to the DC Circuit Court if either determines that the other has issued a rule or order that conflicts with their authority. The CFTC and SEC must consult with each other and adopt rules regarding the maintenance of records of all activities pertaining to uncleared swaps and sharing with each other information regarding swaps or security-based swaps under their respective jurisdictions. The CFTC or the SEC must individually, not jointly, promulgate rules and regulations required due to enactment of this Act within 180 days. The CFTC and SEC may use emergency and expedited procedures to carry out the derivatives title if, in its discretion, it deems it necessary to do so. Section 712

Portfolio Margining
The SEC, CFTC, and prudential regulators are directed to make recommendations to Congress on laws intended to facilitate portfolio margining of securities and commodity futures and options, commodity options, swaps, and other financial instruments within 180 days after the date of enactment. Section 713

Abusive Swaps

The legislation empowers the CFTC and SEC to investigate and report on any swap or security-based swap that is found to be detrimental to the stability of financial markets or their participants. The CFTC and SEC may by rule or order collect any information they find necessary to conduct these investigations. Section 714

End User Exemption

Commercial end users are exempted from mandatory swap clearing. Such end users are defined by nature of their primary business activity. Financial entities may not claim this exemption. These end users can opt out of the clearing requirement for the swaps only if they are hedging commercial risk. If they opt to clear, they can choose which derivatives clearing organization at which the swap is cleared. Affiliates of commercial end users may opt out of the clearing requirement for swaps if the affiliate is using the swap to hedge risk of the parent or affiliates of the parent. Affiliates cannot use the parent?s exemption if they are themselves swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, issuers that would be investment companies but for certain exemptions in the Investment Company Act, a commodity pool, a bank holding company with over $50 billion in consolidated assets, or affiliates of certain of these entities. Section 723

Foreign Entities

The CFTC and SEC, in consultation with the Secretary of the Treasury, can generally ban foreign entities from participating in US swaps or security-based swaps markets if it is determined that the regulation in the foreign entity?s country undermines the US financial
system. Section 715.

Disruptive Trading
The legislation contains a provision making it unlawful for any person to engage in disruptive derivatives trading practices, including violating bids or offers, recklessly disregarding the orderly execution of transactions, or spoofing. Section 747 also makes it unlawful to enter a swap knowing that a counterparty could use the swap as a device to defraud a third party or the public. These provisions are augmented by the Cantwell Amendment, which added a new and versatile standard for deceptive and manipulative practices under the Commodity Exchange Act, allowing the CFTC to go after manipulation and attempted manipulation in the swaps and commodities markets. It also addresses false reporting and authorizes private rights of action that will aid the CFTC in its enforcement effort. Cong, Record, May 6, 2010, S3349.

Bank Trading of Derivatives

Section 716 prohibits federal assistance (including federal deposit insurance, and access to the Federal Reserve discount window) to swaps entities in connection with their trading in swaps or securities-based swaps. Section 716 would prohibit federal assistance, including federal deposit insurance and access to the Fed discount window to swap entities in connection with their trading in swaps or securities-based swaps. This section would effectively require most derivatives activities to be conducted outside of banks and bank holding companies.

According to Senator Lincoln, Section 716 has two goals. The first goal is getting banks back to performing the duties they were meant to perform, such as taking deposits and making loans for mortgages, small businesses, and commercial enterprise. The second goal is separating out the activities that put these financial institutions in peril. Section 716 makes clear that engaging in risky derivatives dealing is not central to the business of banking. Cong. Record, May 5, 2010, p. S3140.

Sen. Lincoln refuted the suggestion that this provision will push derivatives trading off into the dark without oversight. The legislation makes it abundantly clear that all swaps activity will be vigorously regulated by the SEC and CFTC. Just because these swaps desks will no longer be overseen by the FDIC does not mean that they will not be subject strong regulation by the SEC and CFTC under Title VII of the Restoring American Financial Stability Act.

Similarly, Sen. Lincoln refuted the suggestion that Section 716 will prevent banks from using swaps to hedge their risks. Banks that have been acting as banks will be able to continue doing business as they always have under the reform legislation, she assured, with banks using swaps still being allowed to hedge their interest rate risk on their loan portfolio. Most important, Congress wants them to do so. Banks offering swaps in connection with a loan to a commercial customer are also still in the business of banking and will not be impacted.

Corporate Governance

Say on Pay

The legislation would enhance corporate governance and mandate increased transparency of executive compensation. Shareholders would be given the right to a non-binding vote on executive compensation. The advisory vote on executive compensation is designed to give shareholders a powerful opportunity to hold accountable executives of the companies they own, and a chance to disapprove where they see the kind of misguided incentive schemes that threatened individual companies and, in turn, the broader economy. Section 951.

The shareholder advisory vote on executive pay will not overrule a decision by the company or the board, or create or imply any change to, or addition to, the fiduciary duties of the directors, or restrict the ability of shareholders to make inclusion in proxy materials related to executive compensation.

Proxy Access

The legislation authorizes, but does not require, the SEC to grant shareholders proxy access to nominate directors. The measure also require directors to win by a majority vote in uncontested elections, which should help shift management?s focus from short-term profits to long-term growth and stability. Section 972

Majority Voting

Most public companies currently elect directors using the plurality standard, by which shareowners may vote for, but not against, a nominee. If shareowners oppose a particular nominee, they may only withhold their votes. As a consequence, a nominee only needs one ?for? vote to be elected and unseating a director is virtually impossible. Plurality voting in uncontested situations results in ?rubber stamp? elections. Majority voting ensures that shareowners? votes count and makes directors more accountable to shareowners.

The legislation therefore requires the SEC to adopt rules providing that in an uncontested election a director receiving a majority of the votes cast must be deemed to be elected. If a director fails to win a majority of the vote in an uncontested election, the director must tender his or her resignation to the board. Upon accepting the director?s resignation, the board must set a date on which the resignation will take effect in a reasonable period of time and publish such date within a reasonable period of time as established by SEC rule. If the board declines to accept the resignation, the board must disclose the specific reasons why it decided not to accept the resignation and why that decision was in the best interest of the company and its shareholders. Section 971.

The Commission is authorized to exempt a company from any or all of these requirements based on the company?s size, its market capitalization, the number of shareholders of record, or any other criteria, as the Commission deems necessary and appropriate in the public interest or for the protection of investors.

Dual Roles

It is widely acknowledged that a sound corporate governance practice is to bifurcate the roles of board chairman and CEO. Thus, the SEC is directed to adopt rules requiring a company to disclose in the annual proxy sent to investors the reasons why it has chosen the same person to serve as chairman of the board of directors and chief executive officer or why it has chosen different individuals to serve as board chair and chief executive officer. Section 973

Compensation Committees

In a major corporate governance improvement, the legislation mandates independent board compensation committees. The SEC must adopt rules for exchange listing requiring that compensation committees include only independent directors and have authority to hire compensation consultants. This provision is designed to strengthen their independence from the executives they are rewarding or punishing. In determining the independence of compensation committee members, SEC rules must require exchanges to consider the source of compensation and any affiliation with the company or any of its subsidiaries. Section 952.

SEC rules must also allow an exchange to exempt a particular relationship from the independence requirements, taking into consideration the size of an issuer and any other relevant factors.

The compensation committee has sole discretion to hire and obtain the advice of a compensation consultant and is directly responsible for the compensation and oversight of the work of the consultant. However, the compensation committee cannot be required to implement or even act consistently with the advice or recommendations of the compensation consultant. At the end of the day, nothing can affect the ability or the obligation of a compensation committee to exercise its own judgment in the fulfillment of its duties.

Further, proxy or consent solicitation materials for an annual or special meeting of shareholders must disclose if the compensation committee retained or obtained the advice of a compensation consultant; and whether the work of the compensation committee has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed.

The legislation directs companies to provide appropriate funding, as determined by the compensation committee, for the payment of reasonable compensation to a compensation consultant; and to independent legal counsel or any other adviser to the committee.

Clawbacks

The Act also requires public companies to set policies to claw back executive compensation if it was based on inaccurate financial statements that don?t comply with accounting standards. The measure also directs the SEC to clarify disclosures relating to compensation, including requiring companies to provide charts that compare their executive compensation with stock performance over a five-year period. Section 954.

Hedging

The SEC is also directed to adopt rules requiring a company to disclose whether any employee or director is permitted to purchase financial instruments, including derivatives such as equity swaps, that are designed to hedge or offset any decrease in the market value of equity securities granted to the employee or director by the company as part of the compensation of the employee or directors or held directly or indirectly by the employee or director. Section 955.

Executive Compensation Disclosure

The SEC is required to amend Item 402 of Regulation S-K to mandate disclosure of the median of the annual total compensation of all employees, except the CEO; the annual total compensation of the CEO; and the ratio of the two. The annual total compensation of an employee must be determined by reference to Item 402 of Regulation S-K. This disclosure is required in annual reports and proxy statements, among other filings. Section 953.

Voting by Brokers

In addition, exchange rules must prohibit members that are not beneficial owners of a security from granting a proxy to vote the security in connection with a shareholder vote for the election of directors, executive compensation, or any other significant matter as the SEC may determine by rule, unless the beneficial owner of the security has instructed the member to vote the proxy in accordance with the voting instructions of the beneficial own. Section 957.

Hedge Fund and Private Equity Fund Advisers

Similar to the House legislation, the Senate legislation would require SEC registration of hedge fund advisers and disclosure of information to the Commission under a confidentiality regime. 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, and any side arrangements or side letters that treat fund investors more favorably than other investors.

The legislation brings hedge fund advisers under SEC regulation by eliminating the exemption in section 203(b)(3) of the Investment Advisers Act for advisers with fewer than 15 clients. Under current law, a hedge fund is counted as a single client, allowing hedge fund advisers to escape the obligation to register with the SEC. The legislation exempts foreign private advisers, as well as containing a limited intrastate exemption, and an exemption for small business investment companies licensed by the Small Business Administration. Section 403.

There are also exemptions for venture capital fund advisers and also for unleveraged private equity funds whose activities do not pose risks to the financial markets through credit or counterparty relationships. Section 407. The legislation directs the GAO to study the feasibility of creating a self-regulatory organization to oversee private funds, which can include hedge funds, private equity funds, and venture capital funds. Section 414.

Under the legislation, the SEC must require advisers to private funds to file specific reports, which the SEC must share with the Financial Stability Oversight Council. The filings shall describe the amount of assets under management, use of leverage, counterparty credit risk exposure, trading and investment positions, valuation policies, types of assets held, and other information that the SEC, in consultation with the Council, determines is necessary and appropriate to protect investors or assess systemic risk. Reporting requirements may be tailored to the type or size of the private fund. Frequency of reporting is at the SEC?s discretion. Section 404.

The SEC must make available to the Financial Stability Oversight Council any private fund records it receives that the Council considers necessary to assess the systemic risk posed by a private fund. These records must be kept confidential, and the Council must observe the same standards of confidentiality that apply to the SEC. Private fund records, including those containing proprietary information, are not subject to disclosure pursuant to the Freedom of Information Act. The SEC must also report annually to Congress on how it has used information collected from private funds to monitor markets for the protection of investors and market integrity. The SEC is authorized to require investment advisers to disclose the identity, investments, or affairs of any client, if necessary to assess potential systemic risk.

Family offices provide investment advice in the course of managing the investments and financial affairs of one or more generations of a single family. Since the enactment of the Investment Advisers Act, the SEC has issued orders to family offices declaring that those family offices are not investment advisers within the intent of the Act and thus not subject to registration. The legislation essentially codifies the SEC position by excluding family offices from the definition of investment adviser under Section 202(a)(11) of the Advisers Act. The SEC must adopt rules of general applicability defining family offices for purposes of the exemption. The rules must provide for an exemption that is consistent with the SEC?s previous exemptive policy and that takes into account the range of organizational and employment structures employed by family offices. Section 409

The legislation raises the asset threshold above which investment advisers must register with the SEC from the $25,000,000 set in 1996 by the National Securities Markets Improvement Act to $100,000,000. States will have responsibility for regulating advisers with less than $100,000,000 in assets under management. A primary reason for raising the asset under management threshold is to allow the SEC to focus its examination and enforcement resources on the largest investment advisers and thus improve its record in uncovering major cases of investment fraud. Section 410.

Accredited Investors

Accredited investor status, defined in SEC regulations, is required to invest in hedge funds and other private securities offerings. Accredited investors are presumed to be sophisticated, and not in need of the investor protections afforded by the registration and disclosure requirements of the federal securities laws. For individuals, the accredited investor thresholds are dollar amounts for annual income ($200,000 or $300,000 for an individual and spouse) and net worth of $1 million, including the value of a person?s primary residence). These amounts have not been adjusted since 1982. Thus, the Senate legislation directs the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the person?s primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence. Section 412.
The legislation also directs the SEC, four years after enactment, and once every 4 years thereafter, to review the definition of accredited investor to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy. Upon completion of the review, the SEC may adjust the term accredited investor.

Clearing and Settlement

In order to mitigate systemic risk in the financial system and promote financial stability, the legislation provides the Financial Stability Oversight Council with a role in identifying systemically important financial market utilities and the Federal Reserve Board with an enhanced role in supervising risk management standards for systemically important financial market utilities and for systemically important payment, clearing, and settlement activities conducted by financial institutions. Section 805.

The Fed is authorized, in consultation with the Council and the SEC or other appropriate regulator, to prescribe risk management standards governing the operations of designated financial market utilities and the conduct of designated payment, clearing, and settlement activities by financial institutions. The statute sets out the objectives, principles, and scope of such standards.

The Fed is also authorized to maintain an account for a designated financial market utility and to modify or provide an exemption from reserve requirements that would otherwise be applicable to such utility. A designated financial market utility must provide advance notice of and obtain approval of material changes to its rules, procedures, or operations. Section 806.

The supervisory agency must conduct safety and soundness examinations of a designated financial market utility at least annually and can take enforcement actions against the utility. The Fed can participate in the examinations and is also authorized to take enforcement actions against a designated financial market utility if there is an imminent risk of substantial harm to financial institutions or the broader financial system. Section 807.

The SEC or other primary financial regulator is authorized to examine a financial institution engaged in designated payment, clearing, or settlement activities and to enforce the provisions of the Act and the rules prescribed by the Fed against such an institution. The Fed is required to collaborate with the primary financial regulator to ensure consistent application of the rules. The Fed is granted back-up authority to conduct examinations and take enforcement actions if it has reasonable cause to believe a violation of its rules or of the Act has occurred. Section 808.

SEC Self Funding
The legislation 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.

SEC Collateral Bars

Currently, a securities professional barred from being an investment adviser for serious misconduct could still participate in the industry as a broker-dealer. Noting that improved sanctions would better enable the SEC to enforce the federal securities laws, the Obama Administration sought authority for the SEC to impose collateral bars against regulated persons across all aspects of the industry rather than in a specific segment of the industry. The interrelationship among the securities activities under the SEC?s jurisdiction, the similar grounds for exclusion from each, and the SEC?s overarching responsibility to regulate these activities support the imposition of collateral bars. Section 925.

Thus, the legislation authorizes the SEC 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.

SEC Fair Fund

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 to recompense victims of the fraud even if the SEC does not obtain an order requiring the defendant 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 929B.

Updating SIPA

The legislation updates the Securities Investor Protection Act, including provisions on increasing the borrowing limit, the distinction between securities and cash insurance, portfolio margin, and liquidation. The line of credit has not been increased since SIPA was enacted in 1970, and an increase is necessary to provide the Securities Investor Protection Corporation with sufficient resources in the event of the failure of a large broker-dealer. This line of credit is used in the event that SIPC asks for a loan from the SEC and the SEC determines that such a loan is necessary for the protection of customers of brokers or dealers and the maintenance of confidence in the US securities markets. The legislation also eliminates the distinction in the statute between claims for cash and claims for securities since the distinction between claims for cash and claims for securities has become blurred in recent years and was confusing investors. Section 929C.

PCAOB

The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. Thus, the legislation brings broker-dealers under the PCAOB oversight regime. The PCAOB is given authority over audits of registered brokers and dealers that is generally comparable to its existing authority over audits of issuers. This authority permits the Board to write standards for, inspect, investigate, and bring disciplinary actions arising out of, any audit of a registered broker or dealer. It enables the PCAOB to use its inspection and disciplinary processes to identify auditors that lack expertise or fail to exercise care in broker and dealer audits, identify and address deficiencies in their practices, and, where appropriate, suspend or bar them from conducting such audits. Section 982,
The PCAOB must allocate, assess and collect its support fees among brokers and dealers as well as issuers. The PCAOB is expected to reasonably estimate the amounts required to fund the portions of its programs devoted to the oversight of audits of brokers and dealers, as contrasted to the oversight of audits of issuers, in deciding the total amounts to be allocated to, assessed, and collected from all brokers and dealers. The implementation of a program for PCAOB inspections of auditors of brokers and dealers is not intended to and should not affect the PCAOB?s program for the inspections of auditors of issuers. Cost accounting for each program is not required. See Senate Banking Committee Report, Apr 30, 2010.

The legislation also authorizes the PCAOB to share confidential inspection and investigative information with foreign audit oversight authorities under specified circumstances. Information sharing may occur if the PCAOB makes a finding that it is necessary to accomplish the purposes of the Sarbanes-Oxley Act or to protect investors in U.S. issuers and the foreign authority has provided the assurances of confidentiality requested by the PCAOB, described its information systems and controls; described its jurisdiction?s laws and regulation that are relevant to information access. The Board must also determine it is appropriate to share such information. Section 981.

The information about information controls and relevant law is to assist the PCAOB in making an independent determination that the foreign authority has the capability and authority to keep the information confidential in its jurisdiction. The PCAOB may rely on additional information in making the determining that the information will be kept confidential and used no more extensively than the same manner that the federal and state entities may use the information, which is an important consideration of determining the appropriateness of such sharing

Investor Protection for Seniors

Similar to the House legislation, 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. Section 989A.

The legislation 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.

Financial Literacy and Underserved Investors

The three vital components of financial literacy are education, consumer protection, and economic empowerment, and the legislation includes essential provisions in all three of these areas for consumers and investors. See remarks of Sen. Daniel Akaka, Cong. Record, Apr 30, 2010, p. S2996. With regard to education, the legislation requires a the SEC to conduct a financial literacy study and develop an investor financial literacy
strategy intended to bring about positive behavioral change among investors. Section 916. In addition, an Office of Financial Literacy is created within the new Consumer Financial Protection Bureau and is tasked with implementing initiatives to educate and empower consumers. Section 1013.

A strategy to improve the financial literacy among consumers, that includes measurable goals and benchmarks, must be developed.
With regard to the second key component of financial literacy, consumer protection, the Act strengthens the ability of the SEC to better represent the interests of retail investors by creating an Investor Advocate within the SEC. Section 911. The Investor Advocate is tasked with assisting retail investors to resolve significant problems with the SEC or the self-regulatory organizations. The Investor Advocate?s mission includes identifying areas
where investors would benefit from changes in Commission or SRO policies
and problems that investors have with financial service providers and investment
products. The Investor Advocate will recommend policy changes to the Commission and Congress in the interests of investors.

The legislation also authorizes the SEC to effectively require disclosures to retail investors prior to the sale of financial products and services. Section 918. This provision will ensure that investors have the relevant and useful information they need when making decisions that determine their future financial condition. The information to be disclosed by SEC rule must be in summary format and contain concise information about investment objectives, strategies, costs, and risks, as well as any compensation or financial incentive received by the financial intermediary in connection with the purchase of the retail investment product.

The measure authorizes the SEC to gather information from and communicate with investors and engage in such temporary programs as the Commission determines are in the public interest for the purpose of evaluating any rule or program of the SEC. Section 912. In the past, the SEC has carried out consumer testing programs, but there have been questions of the legality of this practice. This legislation gives clear authority to the SEC for these activities.

The legislation modifies the Electronic Fund Transfer Act to establish remittance
consumer protections. It would require simple disclosures about the costs of sending remittances to be provided to the consumer prior to and after the transaction. A complaint and error resolution process for remittance transactions would also be established. Section 1076.

On the third component, economic empowerment, the legislation intends to increase
access to mainstream financial institutions for the unbanked and the underbanked. The legislation authorizes programs intended to assist low- and moderate-income individuals establish bank or credit union accounts and encourage greater use of mainstream financial services. Title XII would also encourage the development of small, affordable loans as an alternative to more costly payday loans.

Credit Rating Agencies

Credit rating agencies market themselves as providers of independent research and in-depth credit analysis. But in the financial crisis, instead of helping people better understand risk, they failed to warn people about risks hidden throughout layers of complex securitized structures.

Flawed methodology, weak oversight by regulators, conflicts of interest, and a total lack of transparency contributed to a system in which AAA ratings were awarded to complex, unsafe asset-backed securities and other derivatives, adding to the housing bubble and magnifying the financial shock caused when the bubble burst. When investors no longer trusted these ratings during the credit crunch, they pulled back from lending money to municipalities and other borrowers.

The legislation establishes an independent office within the SEC dedicated to improving the quality of regulation of credit rating agencies. The Office of Credit Ratings, headed by a direct report to the SEC Chair, will promote accuracy in credit ratings and keep conflicts of interest from unduly influencing ratings. Section 932.

The Office of Credit Ratings must also conduct annual examinations of each credit rating agency, including a review of its policies, procedures, and rating methodologies and whether it follows these policies, the management of conflicts of interest, the implementation of ethics policies; the internal supervisory controls of the agency, the governance of the agency; the activities of its compliance officer; the processing of complaints, and the policies of the agency governing the post-employment activities of former staff.

The SEC will annually publish the essential findings of all examinations, including the responses of rating agencies to material regulatory deficiencies identified by the SEC and to recommendations made by the SEC.

The legislation mandates that each nationally recognized statistical rating organization must establish, enforce, and document an effective internal control structure governing the implementation of policies and methodologies they use to determine credit ratings. Further, the SEC must adopt rules requiring credit rating agencies to submit to the Commission an annual internal controls report, containing a description of the responsibility of the management of the rating agency in establishing and maintaining effective internal controls. In addition, the rating agency must assess the effectiveness of the internal controls and the CEO must attest to it. Section 932.

The legislation authorizes the SEC to fine a rating agency for violations of law or regulations. The Act eliminates the effect of the inherent conflict of interest in the much criticized issuer pays model in the credit rating industry. The conflict of interest arises because rating agencies want to provide the highest rating to keep the issuer?s business and are less willing to publish a lower rating. The Act addresses this conflict by directing the SEC to write rules preventing sales and marketing considerations from influencing the production of ratings. Violation of these rules will lead to suspension or revocation of rating agency status if the violation affects a rating.

The legislation promotes sound corporate governance by prohibiting compliance officers at rating agencies from participating in the production of ratings, the development of ratings methodologies, or the setting of compensation for agency employees.

The legislation eliminates the effect of the inherent conflict of interest in the issuer-pays model of the credit rating industry under which issuers of structured securities have the incentive to use the rating agency that provides the highest rating. A conflict of interest thus arises because rating agencies want to provide the highest rating to keep the issuer?s business and are less willing to publish a lower rating. The Act addresses this conflict by directing the SEC to adopt rules preventing sales and marketing considerations from influencing the production of ratings. Violation of these rules will lead to suspension or revocation of NRSRO status if the violation affects a rating. Section 932. Also, rating agencies must consider information about an issuer that they receive from a source other than the issuer, that the agency finds credible and potentially significant to a rating decision. But the measure does not require a rating agency to initiate a search for such information.

The Franken Amendment further attacks the conflict of interest problem by creating a board overseen by the SEC that will assign credit rating agencies to provide initial ratings on a rotating basis. The SEC will create a credit rating agency board, a self-regulatory organization, tasked with developing a system in which the board assigns a rating agency to provide a product?s initial rating. Requiring an initial credit rating by an agency not of the issuer?s choosing will put a check on the accuracy of ratings, in the Senator?s view. The amendment does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing. The amendment leaves flexibility to the Board to determine the assignment process. Thus, the new board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn?t get to choose its rating agency. Cong. Record, May 10, 2010, S3465.

The SEC must also adopt rules separating the ratings from sales and marketing. Specifically, the rules must prevent the sales and marketing considerations of
a rating agency from influencing the production of ratings. The SEC rules must provide for exceptions for small rating agencies when the Commission determines that the separation of the production of ratings and sales and marketing activities is not appropriate.

Reform of Securitization

In many ways, the financial crisis was at root a crisis of securitization. While traditional securitization was a successful tool for bundling loans into asset-backed securities, in the last decade it morphed into the short-term financing of complex illiquid securities whose value had to be determined by theoretical models. The inherent fragility of this new securitization model was masked by the actions of market intermediaries, particularly credit rating agencies. Predatory mortgages and securitization of those mortgages on Wall Street built a house-of-cards economy. The predatory subprime mortgages were done at the retail level, but the securitization and selling of those packages occurred on Wall
Street. Remarks of Senator Jeff Merkley, Cong. Record May 6, 2010, S3319.

The collapse of structured securitization revealed the ugly reality that, far from managing and dispersing risk, it had increased leverage and concentrated risk in the hands of specific financial institutions. The Obama Administration proposed the reform securitization by changing the incentive structure of market participants; increasing transparency to allow for better due diligence; strengthening credit rating agency performance; and reducing the incentives for over-reliance on credit ratings. Provisions of the draft legislation would implement these goals.

One of the most significant problems in the securitization markets was the lack of sufficient incentives for lenders and securitizers to consider the performance of the underlying loans after asset-backed securities were issued. Lenders and securitizers had weak incentives to conduct due diligence regarding the quality of the underlying assets being securitized. This problem was exacerbated as the structure of those securities became more complex and opaque. Inadequate disclosure regimes also exacerbated the gap in incentives between lenders, securitizers and investors.

There is a growing consensus that we have ``crossed the Rubicon?? into originate and distribute securitization and there is no turning back to originate and hold. Indeed, restarting private-label securitization markets, especially in the United States, is critical
to limiting the fallout from the credit crisis and to the withdrawal of central bank and
government interventions. However, no one wants policies that would take markets back to their high octane levels of 2005?07. Thus, the legislation aims to put securitization on a solid and sustainable footing.

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 toxic securities to investors, because they have to keep some of it for themselves. The Senate 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 941. In addition, the legislation would require issuers to disclose more information about the assets underlying asset-backed securities and to analyze the quality of the underlying assets. Section 942.

Specifically, the legislation directs the federal banking agencies and the SEC to jointly prescribe regulations to require any securitizer to retain a material portion of the credit risk of any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party. When securitizers retain a material amount of risk, they have skin in the game, thereby aligning their economic interests with those of investors in asset-backed securities. Securitizers who retain risk have a strong incentive to monitor the quality of the assets they purchase from originators, package into securities, and sell.

While the legislation provides a baseline risk retention amount of five percent of the credit risk in any securitized asset, that figure may be set higher at the regulators? discretion, or it may be reduced below 5 percent when the assets securitized meet standards of low credit risk to be established by rule for the various asset classes. The legislation gives the SEC and the banking regulators flexibility in setting risk retention levels in order to encourage the recovery of the securitization markets and to accommodate future market developments and innovations. But it must be remembered that in all cases the amount of risk retained should be material so that it creates meaningful incentives for sound and sustainable securitization practices

Whistleblower Protections

Section 922 of the Act allows the SEC to reward whistleblowers who provide the Commission with information on securities law violations. The provision, found in new Exchange Act Section 21F, applies to any judicial or administrative action brought by the SEC under the securities laws that result in monetary sanctions exceeding $1,000,000. Whistleblowers will also enjoy more protections from retaliation under the Act.

Currently, the SEC may reward individuals for providing information leading to the recovery of civil penalties for insider trading. New Section 21F will allow the payment of rewards for information that leads to the successful enforcement of any judicial or administrative action brought by the SEC under all provisions of the securities laws. For example, whistleblowers in financial fraud and Foreign Corrupt Practices Act cases, which often generate substantial civil penalties, would be eligible for awards.

The Senate measure, unlike the House bill, provides a minimum award of 10 percent of the funds collected as sanctions. Both bills cap awards at 30 percent of collected funds. Whistleblowers may appeal the SEC's award decision to the appropriate circuit court for review under an abuse of discretion standard. The statute prohibits payments to specified administrative and law enforcement personnel, auditors and individuals convicted of a crime connected to the judicial or administrative action in question.

The Act expands the whistleblower protections in the Sarbanes-Oxley Act. While the two statutes prohibit similar conduct, there are significant differences in both the scope of the measures and in the available relief.

Section 929A of the t amends Sarbanes-Oxley Act Section 806(a) to clarify that the whistleblower protections apply to both parent companies and their subsidiaries and affiliates if their financial information is included in the consolidated financial statements of the parent company. Victims of retaliatory discrimination may also immediately and directly file suit against the employer in federal district court. Under Section 806, claimants had to file a complaint with the Department of Labor, and could only seek district court review if the Secretary of Labor failed to reach a determination within 180 days. Both statutes provide for reinstatement and for the recovery of lost wages and costs. Under the Senate bill, however, injured persons may recover twice their lost wages, while the Sarbanes-Oxley Act allowed only the recovery of actual wages lost.

The Cardin-Grassley Amendment extended whistleblower protection to employees of credit rating agencies, which are the nationally recognized statistical rating organizations, NRSROs, which issue credit ratings that the SEC permits other financial firms to use for certain regulatory purposes.

Securities Lending

The legislation directs the SEC to adopt rules that are designed to increase the transparency of information available to brokers, dealers, and investors with respect to loaned or borrowed securities. Section 984 also makes it unlawful for any person to effect, accept, or facilitate a transaction involving the loan or borrowing of securities in contravention of the SEC rules.

Resolution Authority

According to Treasury, the lack of a federal regulatory regime and resolution authority for large systemic financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises. As demonstrated by AIG, severe distress at large global non-depository financial institutions can pose systemic risks to the financial markets just as distress at banks can.

Thus, the legislation establishes an orderly liquidation authority to give the U.S. government a viable alternative to the undesirable choice it faced during the financial crisis between bankruptcy of a large, complex financial company that would disrupt markets and damage the economy, and bailout of such financial company that would expose taxpayers to losses and undermine market discipline. The new orderly liquidation authority would allow the FDIC to safely unwind a failing nonbank financial firms or bank holding companies, an option that was not available during the financial crisis. The process includes several steps intended to make the use of this authority very rare. There is a strong presumption that the Bankruptcy Code will continue to apply to most failing financial companies. Section 203.

Once a failing financial company is placed under this authority, liquidation is the only option; since the failing financial company may not be kept open or rehabilitated. The financial company?s business operations and assets will be sold off or liquidated, the culpable management of the company will be discharged, shareholders will have their investments wiped out, and unsecured creditors and counterparties will bear losses.

The Dodd-Shelby Amendment, in conjunction with the Boxer Amendment, ends the idea that any firm can be too big to fail. Pursuant to the Dodd-Shelby Amendment, the legislation creates an orderly liquidation mechanism for the FDIC to unwind failing systemically significant financial companies. This mechanism represents a fundamental change in federal law that will protect taxpayers from the economic fallout of the collapse of a large interconnected systemically significant financial firm. Senator Chris Dodd, Cong Record, May 5, 2010, S3131.

Shareholders and unsecured creditors will still bear losses and management at the failed firm will be removed. In fact, the Dodd-Shelby Amendment empowers regulators to bar culpable management and directors of failed firms form working in the financial sector. According to Senator Dodd, it makes sense that if someone has been involved in the mismanagement of a company and caused such disruption in the economy they should be banned from engaging in further economic activities. Senator Chris Dodd, Cong Record, May 5, 2010, S3131.

Subject to due process protections, regulators can ban from the financial industry senior executives and directors at failed financial firms upon determining that they violated a law or regulation, a cease and desist order, or an agreement with a federal financial regulator; or breached their fiduciary duty; or engaged in an unsafe or unsound practices. In addition, the executive must have benefitted from the violation or breach, which must also involve personal dishonesty or a willful or continuing disregard for the firm?s safety or soundness. The length of the industry ban is in the regulator?s discretion, but must be at least two years. Section 212.

There will also be clawbacks of excess payments to creditors, such that creditors will be required to pay back the government any amounts they received above what they would have received in liquidation. Those who directly benefitted from the orderly liquidation will be the first to pay back the government at a premium rate.

Congress must approve the use of debt guarantees by the Fed or Treasury. The Fed can only use its Section 13(3) emergency lending authority to help solvent companies.

The Dodd-Shelby Amendment also requires post-resolution reviews to determine if regulators did all they were supposed to do to prevent the failure of a systemically significant institution. According to Senator Shelby, this post-resolution review is essential to hold regulators accountable for their actions or inactions as the case may be. Cong. Record, May 5, 2010, S3140.

The Boxer Amendment puts to rest any doubt that the legislation ends federal bailouts of financial firms. The amendment means that no financial company is going to be kept alive with taxpayer money. Remarks of Senator Boxer, Cong. Record, May 4, 2010, S3063.

Specifically, the Boxer Amendment states that all financial companies put into receivership under the legislation must be liquidated and no taxpayer funds can be used to prevent the liquidation of any financial company. Further, all funds expended in the liquidation of a financial company must be recovered from the disposition of assets of such financial company, or must be the responsibility of the financial sector, through assessments. According to Senator Warner, the Boxer Amendment reaffirms that entry into the resolution regime will mean that the financial firm will go out of business, that
equity will be toast, management will be toast, the unsecured creditors will
be toast. This wil

Full post as published by Jim Hamilton's World of Securities Regulation on May 21, 2010 (boomark / email).