Alert March 16, 2010

Senator Dodd Releases Revised Financial Regulatory Reform Bill

Senator Christopher Dodd, the Chairman of the Senate Banking Committee, released a revised version of his comprehensive bill to overhaul the regulation of financial products and services, the Restoring American Financial Stability Act of 2010 (the “Dodd Bill”).  Among other things, the Dodd Bill would create an independent consumer protection bureau within the FRB, grant the FRB authority over all financial firms with more than $50 billion in assets, realign the supervision of banks, form an interagency council to identify and address systemic risks; create a new resolution system for large, complex financial institutions, and impose a host of specific requirements including higher capital and leverage standards on large firms that pose a risk to the economy.  Senator Dodd first proposed a regulatory reform bill in November 2009 (the “November 2009 Draft”), as discussed in the November 17, 2009 Alert.  The Dodd Bill was released after the negotiations between Senator Dodd and Republican Senators Richard Shelby and Bob Corker failed to result in a consensus for a bipartisan financial regulatory reform bill.  In December 2009, the House passed its version of a comprehensive financial regulatory reform bill, the Wall Street Reform and Consumer Protection Act of 2009 (the “House Bill”).  For more on the House Bill, please see the December 17, 2009 Alert

Regulation of Banks and Bank Holding Companies.  Under the Dodd Bill, the prudential supervision of banks would be greatly realigned.  Like the House Bill, the Dodd Bill would eliminate the OTS, and while existing thrifts would be grandfathered, no new thrift institutions could be chartered.  The Dodd Bill, however, would remove certain supervisory powers of the FRB and grant them to the OCC and the FDIC.  The OCC would regulate all national banks and federal thrifts (including national bank and federal thrift subsidiaries of bank holding companies with assets of $50 billion or more) and the holding companies of national banks and federal thrifts with assets of less than $50 billion.  The FDIC would regulate all state-chartered banks and thrifts (including state-chartered bank and thrift subsidiaries of bank holding companies with assets of $50 billion or more) and all bank holding companies of state banks with assets of less than $50 billion.  If a bank holding company owned both federally- and state-chartered depository institutions, the OCC would regulate the holding company if the assets of the holding company’s federally-chartered institutions were greater than those of the company’s state-chartered institutions and the FDIC would regulate the holding company if the assets of the company’s federally‑chartered institutions were greater than those of the company’s state-chartered institutions.  The FRB would regulate bank and thrift holding companies with assets $50 billion or more and certain large firms that are important to clearing, payments and settlement systems. 

Regulation of Systemic Risk.  Similarly to the House Bill, the Dodd Bill would create a Financial Stability Oversight Council (the “Council”) chaired by the Treasury Secretary and consisting of the heads of the FRB, the SEC, the CFTC, the OCC, the FDIC, the FHFA and the new consumer financial protection bureau described below and an independent member appointed by the President with experience in the insurance industry.  The Council would be tasked with identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across the U.S. financial system.  It also would recommend that the FRB implement rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with greater requirements on companies deemed to pose risks to the U.S. financial system.  The Dodd Bill would create an Office of Financial Research within the Treasury to support the Council's data collection and analysis of systemic risks.  The Council, by a two-thirds vote, could require nonbank financial companies that would pose a risk to the financial stability of the U.S., if they failed, to be subject to FRB regulation.  The Dodd Bill provides that a bank holding company with assets of $50 billion or more as of January 1, 2010, that received assistance under TARP would be treated as a nonbank financial company subject to supervision by the FRB if such company ceases to be a bank holding company.  The FRB, with a two-thirds vote by the Council, could require a large, complex financial company to divest certain assets or terminate certain activities if the FRB determined that such company posed a “grave threat to the financial stability of the United States.”

Consumer Financial Protection.  The most contentious proposal of both the Dodd Bill and the House Bill has been the idea of an independent consumer financial protection regulator.  The House Bill would create an independent agency with rulemaking, examination and enforcement powers, the Consumer Financial Protection Agency.  The Dodd Bill, however, would instead establish the Bureau of Consumer Financial Protection (the “Bureau”) as an independent division of the FRB with a director appointed by the President and confirmed by the Senate.  The Bureau would have rule-making authority for banks and nonbanks, but would only have examination and enforcement powers over banks and credit unions with more than $10 billion of assets, all mortgage-related businesses (including mortgage lenders, servicers and brokers) and certain large nonbank financial companies, such as large payday lenders, debt collectors and consumer reporting agencies.  Banks and credit unions with less than $10 billion in assets would continue to be examined by their primary bank regulators.  Under the Dodd Bill, the Bureau would have to coordinate with other regulatory agencies when examining banks to prevent undue regulatory burden.  It would also consult with the other regulatory agencies before promulgating new regulations to ensure such regulations do not conflict with safety and soundness standards.

Volcker Rule.  The Dodd Bill contains provisions that address the Treasury’s proposal to ban proprietary trading by banks, known as the “Volcker Rule.”  For more on the Volcker Rule, please see the January 26, 2010 Alert.  The Dodd Bill would require the Federal banking agencies to prohibit such trading as well as restrict investment and relationships with hedge funds and private equity firms, subject to the recommendations and modifications of the Council.  Certain nonbank financial companies subject to supervision by the FRB would also have restrictions on proprietary trading and hedge fund and private equity investment.  A separate bill to implement the Volcker Rule has also been introduced to the Senate by Senators Merkley and Levin and is discussed below, in this issue of the Alert.

OTC Derivatives.  The Dodd Bill would create an entirely new federal regulatory regime for over-the-counter and other derivatives.  Although the Dodd Bill largely reflects the previous version of Senator Dodd’s proposed reforms for derivatives, as discussed in the November 17, 2009 Alert, Senator Dodd’s office has announced that Senators Jack Reed and Judd Gregg are working on a substitute amendment to Title VII (the derivatives title) that may have a substantial impact on the proposal considered by the full committee.  Like prior proposals from the Treasury, Congressmen Barney Frank and Collin Peterson, Senator Reed and Senator Dodd’s own prior proposal, the Dodd Bill would create parallel regimes for swaps, which would be regulated by the CFTC, and security-based swaps, which would be regulated by the SEC.  Among other things, the Dodd Bill would create (1) extensive new mandatory clearing and exchange trading requirements for swap and security-based swap transactions; (2) registration requirements and position limits for swap and security-based swap traders and major market participants; and (3) reporting requirements for swap and security-based swap participants and transactions.  The Dodd Bill would also require the SEC, the CFTC, the Council and the Treasury to “consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation of swaps” and would permit those agencies to agree to information-sharing agreements.

Asset-Backed Securitization Regulation.  The Dodd Bill would direct the OCC, the FDIC and the SEC to jointly prescribe regulations requiring an issuer or other securitizer to retain an economic interest in a “material portion” of the credit risk of asset-backed securities and otherwise prohibiting a securitizer from directly or indirectly hedging or otherwise transferring such risk.  The regulations would require securitizers to retain not less than five percent of the credit risk for any particular asset.  If such securitizers, however, qualify as underwriters in accordance with the new regulations, they may be eligible for an adjustment to or exemption from this risk retention requirement.  The Dodd Bill differs from the November 2009 Draft, described generally in the November 17, 2009 Alert, which  contained a ten percent risk retention threshold and did not include a partial exemption for underwriters or an exemption for the securitization of assets issued or guaranteed by the federal government or a government-sponsored enterprise such as such as Fannie Mae or Freddie Mac.  The Dodd Bill would further amend the Securities Exchange Act of 1934 and the Securities Act of 1933 to direct the SEC to prescribe regulations requiring disclosure concerning the assets underlying an asset-backed security, as well as the due diligence analysis performed by the issuer.

Resolution of Large, Complex Financial Institutions.  Similar to the House Bill, the Dodd Bill would grant the FDIC the authority to resolve large, complex financial institutions.  Under the Dodd Bill, the Treasury, the FDIC and the FRB must agree to put a financial company into the liquidation process after a panel of three bankruptcy judges agree, within 24 hours, that the financial company is insolvent.  To fund such a resolution, the Dodd Bill would establish a $50 billion resolution fund, which would be funded by assessments on bank holding companies with assets of $50 billion or more and any nonbank financial companies subject to supervision by the FRB.

FRB Emergency Lending Authority.  The Dodd Bill would reform the FRB’s emergency lending authority under Section 13(3) of the Federal Reserve Act by limiting it to “system‑wide support” for healthy institutions or systemically important companies during a major destabilizing event.  Such authority could not be used to support an individual institution.  Under the Dodd Bill, the FRB would be required to disclose within seven days of extending loans under such emergency lending authority the identity of borrowers, collateral, and amounts borrowed “unless doing so would defeat the purpose of the support.”  The FRB would be able to delay such disclosure by up to a year if it would compromise the program or financial stability.

Private Fund Investment Adviser Registration.  The Dodd Bill would (i) effectively require every adviser to “private funds” (including hedge funds, but excluding “venture capital funds” and “private equity funds”) with at least $100 million in assets under management to register with the SEC under the Investment Advisers Act of 1940 (“Advisers Act”), without regard to the adviser’s number of clients, and (ii) impose upon registered advisers enhanced recordkeeping and reporting obligations designed to help the SEC and other government agencies identify and monitor threats to the stability of the economy.  The Dodd Bill represents relatively modest changes to these aspects of the November 2009 Draft, which were discussed in detail in a November 20, 2009 Goodwin Procter Client Alert.  For example, unlike the November 2009 Draft, the Dodd Bill: (i) defines “private funds” solely by reference to the exclusions from the definition of “investment company” under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (and, does not require “private funds” to be either organized under U.S. law or have 10% or more of their outstanding securities owned by U.S. persons); (ii) does not explicitly require “private fund” advisers’ to file reports on their use of leverage, trading practices and side letters (such reports must be maintained, but not necessarily filed); and (iii) grants the SEC authority to require such advisers to “file reports containing such information as the [SEC] deems necessary and appropriate in the public interest for the protection of investors or for the assessment of systemic risk.”  Like the November 2009 Draft, the Dodd Bill provides Advisers Act registration exemptions for advisers to “private equity funds” and “venture capital funds”.  Because the SEC must define each of these categories of funds, the scope of these registration exemptions remains unclear.

Investor Protection.  The Dodd Bill includes a number of investor protection measures with a particular focus on retail investors.   It permanently establishes an Investor Advisory Committee and an Investor Advocate at the SEC, and gives the SEC express authority to conduct testing with investors.  The legislation would authorize the SEC to adopt rules under which broker‑dealers would be required to provide retail investors with disclosures specified by the SEC before they purchase an investment product or service.  The legislation would also require the SEC to conduct studies of (a) the effectiveness of/gaps in legal and regulatory standards of care applicable to investment professionals dealing with retail investors (and conduct subsequent rulemaking to address any gaps discovered), (b) the financial literacy of retail investors and (c) mutual fund advertising. 

Regulatory Enforcement/Remedies.  The Dodd Bill would give the SEC rulemaking power over the use and conduct of mandatory arbitration of disputes involving the securities laws and rules of self-regulatory organizations.  The Dodd Bill also includes provisions designed to increase protections and incentives for whistleblowers and would expand the scope of collateral bars that the SEC could impose as sanctions.

Executive Compensation.  The Dodd Bill addresses the issue of executive compensation in a variety of ways.  It would introduce a requirement for a non-binding shareholder vote on executive compensation when proxy materials include certain information on that topic.  In addition, the SEC would be required to promulgate rules under which the listing standards for exchanges would mandate (a) compensation committee independence standards and (b) clawback of incentive-based compensation in certain circumstances involving an accounting restatement.  The Dodd Bill would also provide for SEC rulemaking to require proxy statement disclosure regarding (i) a compensation committee’s use of a compensation consultant, (ii) the relationship between executive compensation and issuer financial performance and (iii) whether board members and employees of an issuer may take positions that hedge or offset declines in the value of the issuer’s equity securities they hold.

Corporate Governance.  The Dodd Bill would require the SEC to adopt rules under which exchange listing standards would mandate that a director not receiving a majority vote in an uncontested election would have to tender his or her resignation which would then be accepted or rejected by the board according to a specified process.  The SEC would also receive express authority to adopt rules granting proxy access for shareholder nominees, and would be required to adopt rules under which an annual proxy statement would have to include an explanation of the reasons an issuer had chosen to have the same person serve as chief executive officer and chairman of the board, or chosen not to do so.

Securities Lending.  The Dodd Bill would give the SEC rulemaking authority with respect to securities lending and require it to adopt rules designed to increase the transparency of information regarding securities lending available to broker-dealers and investors.

Credit Rating Agency Regulation.  The Dodd Bill addresses a broad range of issues relating to SEC regulation of nationally recognized securities rating organizations (“NRSROs”).  Most significantly, the Dodd Bill would create an Office of Credit Ratings within the SEC that would be required to conduct an annual examination of each NRSRO and make its inspection reports publicly available.  The SEC would be directed to issue rules under which NRSROs would have to (a) adopt procedures for the development, approval and oversight of credit ratings methodologies and (b) implement related internal controls and reporting to the SEC.  The SEC would also be required to adopt rules mandating public disclosures by an NRSRO of (a) quantitative and qualitative information on assumptions, source data and other matters underlying each credit rating (to accompany the rating) and (b) information on the performance of ratings over time.    The Dodd Bill would expand the SEC’s authority to impose limitations and sanctions on NRSROs, and require them to adopt procedures to address conflicts of interest and provide additional related reporting to the SEC.  The Dodd Bill would enable private actions against an NRSRO over credit ratings, stating that the enforcement and penalty provisions of the Securities Exchange Act of 1934 would apply to statements made by a credit rating agency in the same manner and to the same extent as to statements made by a registered public accounting firm or a securities analyst under the securities laws. The Dodd Bill would also provide for General Accounting Office and federal regulatory agency review of how the use of credit ratings in regulations might be reduced.

Insurance.  The Dodd Bill would create an Office of National Insurance (the “ONI”) in the Treasury with limited functions.  Primarily, the ONI would (a) monitor the insurance industry and could recommend to the Council that “an insurer, including the affiliates of such insurer,” be subject to supervision by the FRB as discussed above under “Systemic Risk”; and (b) coordinate federal efforts and develop federal policy on prudential aspects of international insurance matters and assist the Secretary of the Treasury in negotiating bilateral or multi-lateral agreements on behalf of the United States with foreign governments, authorities, and regulatory bodies regarding “prudential measures applicable to the business of insurance or reinsurance” (“International Insurance Agreements on Prudential Measures”).   The ONI would be empowered to determine, following notice and an opportunity to comment, that state insurance measures are preempted by International Insurance Agreements on Prudential Measures.  The Dodd Bill also includes provisions dealing with state regulation of certain aspects of nonadmitted insurance, surplus lines and reinsurance.

The Dodd Bill also contains provisions relating to municipal securities markets regulation, the management, operation and funding of the SEC and the governance of the FRB.  Senator Dodd plans to hold hearings on the Dodd Bill during the week of March 22, 2010, in anticipation of taking a committee vote on the bill by March 26, 2010, then the Senate begins a two week recess period.  The Alert will continue to follow the developments surrounding financial regulatory reform and future issues of the Alert will continue further discussion of the proposals contained in the Dodd Bill and any modification made by the Senate Banking Committee and the full Senate.