Alert June 29, 2010

Dodd-Frank Act Conference Report Finalized by Financial Regulatory Reform Conference Committee

The Congressional conference committee on financial regulatory reform released its 2,319 page conference report reconciling the Wall Street Reform and Consumer Protection Act of 2009 that was passed by the U.S. House of Representatives on December 11, 2009 (the “House Bill”) with the Restoring American Financial Stability Act of 2010 that was passed by the U.S. Senate on May 20, 2010 (the “Senate Bill”).  The final legislation, which was renamed by the conference committee the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), would comprehensively reform the regulation of financial products and services by providing for, among other things, the establishment of a Financial Stability Oversight Council (the “Council”) to monitor systemic risk, the creation of a new resolution process for systemically important financial institutions, the establishment of a Consumer Financial Protection Bureau (the “CFPB”), the registration of private fund advisers and the regulation of derivatives.

After releasing its conference report, the conference committee reconvened to revise the funding provisions of the Act to address concerns regarding a proposed assessment on large financial institutions.  The conference committee agreed to replace the proposed assessment with provisions that would authorize (i) the early termination of the Troubled Asset Relief Program and (ii) require the FDIC to take steps to increase the reserve ratio of the Deposit Insurance Fund from 1.15 percent to 1.35 percent of estimated insured deposits by September 30, 2020, provided that any increased assessment must not be applied to institutions with less than $10 billion in assets.

The Act still must be passed by both chambers of Congress and signed by the President to become effective.  In light of the death of Senator Robert C. Byrd, the Senate has postponed its legislative schedule for the first two days of July, which means that the Act will not be put to a vote in that chamber before the July 4th congressional recess.  Upon passage, the Act requires numerous studies and rulemaking by Federal banking and securities regulators, a process that can be expected to last for several years.  The following are some of the highlights of the Act:

  • Proprietary trading and the sponsorship of hedge funds and private equity funds by banking entities would be restricted under provisions known as the “Volcker Rule.”  Subject to certain limitations, banking entities would be permitted to organize and offer a hedge fund or private equity fund for the provision of “bona fide trust, fiduciary, or investment advisory services” and make and retain an investment in a hedge fund or private equity fund that the banking entity organizes and offers, provided that such investments (i) are reduced to not more than 3% of the total ownership of a fund within one year after the fund’s establishment (with the possibility of a two year extension) and (ii) that such investments do not exceed 3% of the banking entity’s Tier 1 capital. 
  • The OTS would be eliminated but the thrift charter would be preserved.  Thrifts would be supervised by the OCC and savings and loan holding companies would be supervised by the FRB.
  • New capital standards would eliminate trust preferred securities as Tier 1 capital.  Existing trust preferred securities would be grandfathered for banking entities with less than $15 billion of assets.  Larger banking entities would be subject to a three-year phase‑in period beginning on January 1, 2013.
  • New authority would be established for the orderly resolution of large financial companies.  No standing resolution fund for large financial companies would be established under the Act; however, following the resolution of a large financial company, the FDIC would be authorized to recover the costs of such resolution through a special assessment levied on financial firms with more than $50 billion in assets.
  • Deposit insurance coverage levels would be permanently increased to $250,000, retroactive to January 1, 2008.  The Transaction Account Guarantee Program would be extended for two years and would become mandatory for all insured depository institutions.
  • Interest would be permitted on business demand deposit accounts.
  • The CFPB would be established as an independent bureau within the FRB.  The CFPB would prescribe rules applicable to most providers of consumer financial products and services and would have examination powers over depository institutions with total assets of more than $10 billion and certain nondepository providers of consumer financial products and services, such as mortgage brokers and money services businesses.  Auto dealers were granted a controversial exemption from the CFPB’s jurisdiction.
  • On the petition of a member agency of the Council, the Council would be authorized to set aside a final regulation prescribed by the CFPB, or a provision of such a regulation, if the Council decides that the regulation or provision would put the safety and soundness of the United States banking system or the stability of the financial system of the United States at risk.
  • The OCC would only be allowed to preempt, on a case-by-case basis, a state law that “prevents or significantly interferes” with the business of banking and only after notice and an opportunity to comment.
  • The FRB would be authorized to regulate interchange fees for debit card transactions by adopting rules to require that such fees be “reasonable and proportional” to the incremental cost incurred in processing such transactions.  Network fees charged by payments networks and certain prepaid cards, including government-issued cards used to provide health and welfare benefits, would be generally exempt from the rules.  Issuers and payments networks would also be subject to additional restrictions on exclusivity and routing arrangements and merchant practices.
  • New minimum mortgage underwriting standards would be required for residential mortgages.  Lenders would be required to obtain “verified and documented information” that the consumer has a “reasonable ability to repay.”  Compensation paid to mortgage loan originators that varies based on the terms of loans (other than the amount of principal of the loan) would be prohibited.  Regulators would establish a class of qualified loans that would be protected from legal liability, such as the borrower’s right to rescind the loan and seek damages.  Certain loan features such as negative amortization, prepayment penalties and balloon payments, would exclude loans from the safe harbor.  Qualified mortgages would still have to have a net tangible benefit to borrowers.  Lenders packaging qualified mortgages into securities would be exempted from a 5% risk retention provision.
  • Banks would be permitted to trade certain derivatives, such as interest rate and foreign exchange swaps, and use derivatives for hedging directly related to that depository institution’s activities.  Insured depository institutions would, however, be required to spin off to separately capitalized affiliates other derivatives trading practices, including commodities and energy, equity derivatives and uncleared credit default swaps, as well as to comply with prohibitions (under the Volcker Rule) on proprietary trading in derivatives.
  • The Act would create parallel regimes under the CFTC and the SEC for regulating swaps, resulting in dual registration and other compliance requirements for swap dealers and major swap participants.  Joint rule-making by the two Commissions, however, would be required with respect to mixed swaps and books and records requirements for swap dealers, major swap participants, and swap clearing organizations and agencies.   The Act would establish a formal process for determining jurisdiction, status and rule-making authority for new products that includes resolution of disputes between the CFTC and SEC by the Court of Appeals.
  • The Act would impose mandatory clearing of swaps at registered clearing organizations or agencies and exchange trading on registered exchanges for standardized products and transactions with limited exceptions, including for certain end-users that are hedging or mitigating commercial risk.
  • The Act would impose new, heightened duties on swap dealers and major swap participants when acting as advisors or counterparties in transactions with certain “special entities,” including municipalities and other political subdivisions, as well as pension, endowment and retirement plans. 
  • With respect to asset‑backed securities, the Federal banking and securities regulators would be required to adopt rules providing that an issuer or other entity creating an asset‑backed security must retain an economic interest in the credit risk of the security’s underlying assets, including not less than 5% of any particular asset, unless the securitizer meets certain underwriting standards or the underlying assets are “qualified residential mortgages” in accordance with the new rules.  The SEC also would be directed to prescribe regulations requiring an issuer to perform due diligence on an asset‑backed security’s underlying assets and disclose its findings.
  • Advisers to private funds (including hedge funds and private equity funds) with greater than $150 million in assets would be required to register under the Investment Advisers Act of 1940 (the “Advisers Act”) within one year of the enactment of the Act.  Advisers to venture capital funds (to be defined by the SEC), although not subject to registration, would be subject to certain reporting requirements.
  • Family offices would be exempt from registration under the Advisers Act pursuant to rules to be enacted by the SEC consistent with previous exemptions.
  • The SEC would be required to adjust the “accredited investor” standard under Regulation D to exclude a primary residence from net worth and adjust the standard pursuant to periodic reviews.  The “qualified client” standard under the Advisers Act would also be subject to periodic review and adjustment.
  • The SEC would be required to provide a report to Congress within 6 months of enactment that addresses specified issues regarding the provision of personalized advice to retail customers by investment advisers and broker-dealers.  The SEC would be authorized, but not required, to engage in rulemaking establishing a fiduciary duty for broker-dealers with respect to retail and other customers.  The Act also expressly provides for SEC authority to set the standard of conduct for broker-dealers and investment advisers with respect to retail customers.
  • Under the Act, each nationally recognized securities rating organizations (“NRSRO”) would be subject to annual examination by the SEC which would make its inspection reports publicly available.  The SEC would be required to adopt rules mandating that an NRSRO make public disclosures of (a) quantitative and qualitative information underlying each credit rating and (b) the performance of ratings over time.  The Act would enable private actions against an NRSRO over credit ratings and provide 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 SEC would have rulemaking power to prohibit or limit the use by broker-dealers and investment advisers of mandatory arbitration of disputes involving the securities laws and rules of self-regulatory organizations.  The Act would increase protections and incentives for whistleblowers and expand the scope of collateral bars that the SEC could impose as sanctions.  The Act would create express additional aiding and abetting causes of action under the Securities Act of 1933, the Investment Company Act of 1940 and the Advisers Act.
  • The SEC would have rulemaking authority with respect to securities lending and be required to adopt rules designed to increase the transparency of information regarding securities lending available to broker-dealers and investors.
  • The SEC would 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 explain why 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.
  • Shareholders would be granted a non-binding vote on executive compensation and “golden parachute” payments.
  • Stock exchanges would be required to change their listing rules to require that each member of a listed company’s compensation committee be independent and be granted the authority and funding to retain advisors (compensation consultant and legal counsel) who are independent based on specific enumerated factors.
  • Changes in proxy rules would require the disclosure of the relationship between executive pay and financial performance of the issuer, the ratio of the median pay of all employees to the pay of the chief executive officer, and employee and director hedging activities.
  • Stock exchanges would be required to prohibit the listing of any security of an issuer that does not adopt policies governing the claw back of excess executive compensation based on inaccurate financial statements.
  • The Federal financial regulators would be required to impose enhanced disclosure and reporting of compensation arrangements at regulated financial institutions.
  • The Act would create within the Treasury the Federal Office of Insurance, which would monitor the insurance industry and be required to complete a study within 18 months on how to modernize and improve the system of insurance regulation in the United States.
Future editions of the Alert will provide in-depth discussion and analysis of the provisions of the Act and the Alert will continue its coverage of financial regulatory reform throughout the rulemaking process.