After the passage of Dodd-Frank, industry leaders, legislators, and all levels of executive agencies have been divided into two camps: those who hail the massive bill as the answer to financial stability and those who plan and plot for its demise. Perhaps this is too harsh a dichotomy; there are likely others who remain neutral or indifferent, as well.
Regardless, because of the strong support and brazen contempt, a storm has been brewing in both camps as they lay in wait for the perfect moment to surge forward into battle. This battle will not invoke the bloody Greek combat scenes of ancient times, but may be just as epic as lawyers take to the battlefield of federal courtrooms across the country to determine the fate of Dodd-Frank.
The time for such a barrage may be upon us after the federal court of appeals decision in July struck down the Securities and Exchange Commission’s proxy access rule stemming from Dodd-Frank. The rule was implemented purportedly to make it easier for shareholders to nominate company directors. This court decision dealt a major blow to the SEC because the agency spent over 21,000 staff hours over two years drafting the rule. Since the SEC’s defeat, industry watchdogs have been examining legal challenges to other rules required by the Dodd-Frank financial oversight law.
Up until this point, Wall Street and interested industries have relied heavily on the work of lobbyists to sculpt the mandatory rulemakings by agencies like the SEC and CFTC. However, shaping the rules through lobbying may only a loophole here or there, judicial intervention could stop the rulemaking indefinitely.
In recent weeks there has been an influx of comment letters, congressional testimony, and trade group meetings, which appear to be laying the foundation to mount possible legal challenges. Apparently, one such meeting held by the U.S. Chamber of Commerce was dubbed “Dodd-Frank Excesses.” Hal S. Scott, a professor at Harvard Law School and director of the Committee on Capital Markets Regulations forecasts “lots of challenges coming down the pike.”
What Happened to the SEC Proxy Rule?
While the SEC currently weighs its options for appeal, another committee within the agency is examining the case and considering how to make adjustments to other proposed regulations in an effort to prevent future rulemaking catastrophes.
The source of the legal challenge to the proxy rule is a 1996 law requiring the SEC to promote “efficiency, competition and capital formation.” This law provided the power to enable the financial industry to build lawsuits around economic costs of rulemaking, instead of its merits. This rule was first harnessed in 2005, when the U.S. Chamber of Commerce successfully challenged SEC rules for the mutual fund industry. The Chamber has since used this provision in a succession of victories in the U.S. Court of Appeals throwing out three financial regulations over the last six years.
For now, the SEC is ramping the number of economists in its employ to ward off future attacks alleging that it did not fully evaluate economic effects of implemented rules.
Why History May Repeat Itself
Because Dodd-Frank is encompasses so many facets of the financial industry and beyond, there is no reasonable constitutional or statutory to the whole. However, arguments challenging individual sections or rules made pursuant Dodd-Frank are more feasible. The demise of the proxy rule opens up other rules to challenges.
Both the SEC and CFTC have been targets of hostile letters from financial trade groups and industry groups threatening legal action. Several of these groups are considering suits against the new SEC whistleblower program that went live last Friday. The U.S. Chamber of Commerce has argued that the whistleblower program allows tipsters to undermine internal compliance departments. Other groups have their sights set on less well-known provisions.
With industry turning up the heat, regulators have spent significant amounts of time and energy trying to shield their rules from litigation. For example, in May, the CFTC’s general counsel and chief economist issued an agency memorandum setting forth specific guidelines for cost-benefit analyses. The effect has been a slow-down of the rulemaking process and the action garnered praise that the agency has been “proactive” in taking steps to address industry concerns. Regardless of these proactive measures, it is unlikely the CFTC will come out of battle unscathed.
The Most Likely Provisions to Come Under Fire
Based on recent comment letters to the regulators and congressional testimony, Reutersreported on the five most likely targets for challenges:
First up is the conflict minerals issue. Under this rules, the SEC would require companies to make annual disclosure revealing whether they use any “conflict metals” from the Democratic Republic of Congo. Reuters states, “The proposal has become so contention that the SEC had to reopen the comment period and delay the final implementation.” The U.S. Chamber of Commerce has made comments foreshadowing a possible challenge if the SEC fails to address cost concerns. Tiffany & Company took a more direct route and argued in a recent letter to SEC that the conflict minerals rule “would violate the First Amendment.”
Speculative Position Limits
The next likely target focuses on the CFTC’s imposition of speculative position limits, which would cap the number of futures and related swaps contracts that any one speculative trader can control. The CFTC currently takes the stance that it does not need to make a finding that the limits are necessary to reduce price volatility. However in March, the Futures Industry Association (“FIA”) urged the CFTC to abandon its plan to place position limits, arguing that such limits “may be legally infirm.” In May, the FIA raised a procedural concern regarding this rule. In its letter, the FIA states that in telephone calls to CFTC staff members, they indicated an intent to add a provision in the final rule on aggregated position limits that was not included in the proposed rule. Failing to request comment on a significant change, such as aggregated position limits, could be additional grounds for a challenge.
Capital & Margin for Uncleared Swaps
So far, only the CFTC and the Federal Reserve have issued proposals outlining which traders will be required to post collateral to back up their derivatives trades. The SEC has yet to issue its proposal on this matter. Although the plans differ, they both generally impose margin on large dealers and major traders with exemptions for companies that strictly use derivative to hedge against price risk and interest-rate fluctuations. According to Reuters, the concern is that these “rules are going to impose higher costs on a wide swath of financial market players.” In its letter to the CFTC, the Coalition of Derivatives End-Users accuses that CFTC of not doing an adequate cost-benefit analysis.
Real-Time Reporting of Swap Trades
The fourth controversial issue is the CFTC and SEC’s proposals to “bolster price transparency in the swaps markets” through the use of real-time trade reporting. CFTC Commissioner Scott O’Malia has raised concerns regarding a footnote in the proposal, which admits a lack of public information regarding the proposal’s effect on market liquidity. The Chamber of Commerce, Securities Industry and Financial Markets Association (SIFMA), and several large banks have raised concerns about the costs and inflexible reporting framework of such rules.
Incentive-based compensation is the final point of concern. Both the SEC and federal banking regulators have rule proposals requiring companies to reveal their incentive-based compensation plans in addition to placing restrictions on “excessive rewards.” The potential vulnerability in these rules again lies in flaws in the economic analysis underlying the rules. The Chamber of Commerce claims the analysis, particularly the SEC’s, focuses too much on administrative burdens rather than competitive burdens.
While it is unknown what provisions will actually cause a scene in the courtroom, there is sure to be an ensuing legal skirmish. Stay tuned and watch the battle unfold.