The Road To Financial Reform Will Be Filled With Landmines

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:

Conflict Metals

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

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.

Focusing Only on Dodd-Frank? Then You Might Be Missing Something

Because the Dodd-Frank financial reform bill grabs headlines every day, other regulations are entering the scene almost undetected. Broker-dealers and registered investment advisors may not be aware of new upcoming regulations, which could impact their business.

The Dodd-Frank reform bill has shaken the marketplace and the regulatory bodies. In its aftermath, there have been a flurry of mandated studies, proposals and rulemakings, but it has also spurred other agencies and organizations into action. As such, new regulations are on the horizon besides just those implemented under Dodd-Frank authority.

Last summer, in addition to passing Dodd-Frank, Congress also passed the Foreign Account Tax Compliance Act (FACTA), which imposes stricter IRS filing requirements on those having overseas assets of more $50,000 US dollars. This legislation has significant effect on institutions that hold assets for U.S. investors. FACTA will take effect in 2013.

FINRA revised its suitability rule (currently NASD Rule 2310), which is slated to go into effect on July 9, 2012. The revised rule adds five new elements that broker dealers and firms must consider: client liquidity, age, investment experience, time horizon, and risk tolerance.

FINRA also has implemented new trade-reporting requirements. In May 2011, FINRA began requiring brokerage firms to start using its Trade Reporting and Compliance Engine (TRACE) system to report trades of asset-backed securities. This coming October, broker dealers will have to begin reporting more trades and additional, previously undisclosed data into FINRA’s Order Audit Trading System.

The Department of Treasury’s Financial Crimes Enforcement Network (Fincen) has been discussing the possibility of subjecting registered investment advisory firms and hedge funds to its anti-money laundering rules. Although nothing has been implemented yet, Fincen is considering making it a requirement for these firms to file suspicious-activity reports (SARs) like banks and broker dealers.

With all of these new regulations and those yet come, it is important to have legal counsel that knows and understands the changing regulatory environment.

District Court Retroactively Applies Dodd-Frank Ban on Pre-dispute Arbitration in SOX Whistleblower Claims

The U.S. District Court for the District of Massachusetts applied the Dodd-Frank Act (“the Act” or “Dodd-Frank”) prohibition on pre-dispute arbitration agreements under the Sarbanes-Oxley (“SOX”) whistleblower protection retroactively. In a March 1 ruling, in Pezza v. Investors Capital, et al, Judge Douglas P. Woodlock, reasoned that retroactive application was appropriate due to the lack of clear Congressional intent to restrict the temporal scope and procedural nature of Section 922.

Section 922 of the Act, among other things, confers jurisdiction on the courts, rather than to a Financial Industry Regulatory Authority (FINRA) arbitration panel, by voiding arbitration provisions in employment agreements that purport to force an employee to arbitrate, rather than litigate disputes arising under Section 806 of SOX.

The suit arose from a claim of wrongful retaliation (in violation of SOX) against the plaintiff after he raised concerns about the defendant’s misconduct in connection with securities transactions. (The plaintiff had previously filed the requisite complaints with the Department of Labor.) The defendants, Investors Capital Corp., Investors Capital Holdings, Inc., and Timothy Murphy, argued that the plaintiff was required to submit his dispute to arbitration, not the courts, pursuant to a pre-dispute arbitration provision in his employment agreement. However, while the defendant’s motion to compel arbitration was under advisement, Congress enacted Dodd-Frank, which included the prohibition on pre-dispute arbitration agreements for whistleblower claims brought under SOX.

In determining whether to apply Section 922 retroactively, the court used the framework setup by the Supreme Court in Fernandez-Vargas v. Gonzales, which essentially instructs a court to first look to whether there is any Congressional intent allowing for retroactive application. If there is no clear indication by Congress, the court then must look to whether retroactive application would result in a disfavored consequence affecting a substantive right. If the court answers in the negative, retroactive application is appropriate.

Here, Section 922 did not include any express provisions or clear statements of Congressional intent regarding retroactivity. Further, after applying the standard rules of statutory construction, the court found nothing that indicated Congress intended for the provision to apply to existing arbitration agreements. The court also found it insufficient that Congress vested the authority to limit future pre-dispute arbitration provisions with the new Bureau of Consumer Financial Protection and the CFTC. Thus the court determined that the result regarding retroactivity under Fernandez-Vargas was inconclusive.

However, under Landgraf v. USI Film Prods, the Supreme Court recognized that jurisdictional statutes may be applied retroactively absent specific legislative authorization without raising retroactivity issues. As a result, the District Court construed Section 922 to be a jurisdictional statute and relied on the holding from Landgraf instead of the retroactivity test under Fernandez-Vargas. Accordingly, the court denied the defendants’ motion to compel arbitration and concluded that Section 922 should be applied retroactively to combat bad conduct arising prior to the enactment of Dodd-Frank.

COGNITIVE DISSONANCE: STATES WITH EXPANDED INVESTMENT ADVISER REGULATORY RESPONSIBILITIES LIKELY TO RECEIVE STAGNANT OR REDUCED FUNDING

This coming summer over 4,000 mid-size investment advisory firms will fall under the auspices of a new regulator: their home state. No longer will they be regulated by the SEC, which managed to conduct regulatory examinations of less than 15% of the approximately 12,000 investment advisers it regulated in 2010. The Dodd-Frank Act's shift of a segment of this nearly unregulated group was intended to improve this situation. But over one-third of the 4,100 investment advisers making the migration will have a new state regulator with either no regular examination program or with an umbilical cord to one of the worst budget crises in the nation: New York, California, Illinois and Massachusetts. And while the regulatory staffs in each of these states are among the best of the best, the situation begs for an answer better than: “we will be able to handle it.” Not only does this answer strain credulity, it seems to ignore the initial premise behind the regulatory shift and expansion of power advocated by state regulators: that they would improve investor protection by doing more and by doing it better than the SEC in the area of regulatory audits for mid-market advisers.

The current lack of a convincing and comprehensive public answer or plan by state regulators in response to the skeptics left the door open for the brokerage industry's self-regulatory organization to insert its foot. Apparently FINRA has recommended that it, or a SRO sister-to-be-created, should fill the feared void. Trade associations haven't missed the opportunity to join the turf war either, with the Financial Services Institute backing FINRA and the Investment Adviser Association siding with the state regulators. This author for one, has no interest in joining the fray and is confident that the data for a more informed evaluation and decision making process will be available in a year or two.

Assuming the states will find a way to digest the new regulatory burdens on the way, investment advisers should begin preparing for the advent of more frequent exams, audits, follow-up inquiries, remedial plans and enforcement actions. Lest I miss the opportunity for a plug – Cosgrove Law, LLC has experience assisting mid-market advisers with compliance issues, regulatory inquiries and enforcement actions.

For more information, or a different take on what I discussed in this entry, see The Wall Street Journal's January 3^rd article on the issues and NCSL.org.

SEC Claims New Information Disclosure Restriction in Financial Regulation Law will Simply Validate its Current Practices: So What's the Good News?

According to a recent Wall Street Journal article, a 2009 report by the SEC's inspector general revealed that the agency is far stingier then other federal agencies when it comes to responding to the public's requests for information under the Freedom of Information Act (“FOIA”). For example, the SEC fully granted information requests at a measly rate of 10.5% and granted partial responses at a rate of 3%. And yet despite what one must assume were legally valid outright rejections of the remaining 85% of all FOIA requests, the SEC garnered a provision in the new financial regulation overhaul law that empowers them to reject any request implicating documents it has received from members of the financial industry pursuant to SEC surveillance and risk assessments “or other regulatory oversight activities.”

The SEC's response to the uproar over this provision has been both anemic and incomplete - arguing that they didn't really need what they supposedly really needed. According to a recent FOX Business report, an SEC spokesman explained that the provision was tied to the SEC's expanded examination program, and the new provision simply “makes certain that we can obtain documents from registrants for risk assessment and surveillance under similar conditions that already exists by law.” Of course, prohibiting the SEC from using its regulatory authority to comb through a company's records to turn around and disgorge them out of context to the public is hardly outrageous. But the SEC seems unable to provide any justification for the the true source of the uproar; the final clause of the new provision: “or other regulatory...activities.” The final clause has nothing to do with confidential records gathered during examinations of industry participants. And yet it would provide the SEC ample justification to ramp up its FOIA swat-down rate from 85% to 100%.

The SEC receives and generates a lot of information outside of its exam function as a part of its “regulatory oversight activities.” Perhaps new legislation can be drafted to protect a legitimate interest in protecting the industry's confidential information without completely emasculating the right to access provided by the FOIA.

Senate and House Strike Deal on Fiduciary Duty Issue

On June 24, 2010, lawmakers from the House and Senate working to merge two versions of the financial-regulation overhaul into a single bill agreed to let the SEC impose a fiduciary duty on brokers once the regulator completes a six-month review. House lawmakers had earlier proposed implementing stiffer rules without a study period, prompting opposition from senators led by Tim Johnson, a South Dakota Democrat.

Johnson proposed language that could have, among other things, maintained the study requirement. However, Johnson's proposal made it even more difficult for the SEC to act on its findings by allowing the SEC to set new rules regarding the fiduciary duty standard only if the agency concluded after its study that regulatory gaps between certain brokers and investment advisors could not be addressed through other approaches.

A fiduciary duty would obligate brokers to act in the best interest of their clients and to disclose all conflicts of interest. Brokers now only have to ensure a product is suitable before marketing it to a customer. As discussed in an earlier blog post, the expansion of the fiduciary duty has met resistance from the broker-dealer and insurance industries whose sales practices would be subject to the new fiduciary duty standard. Whereas consumer advocates have said the fiduciary obligation is needed because investors can be misled into buying products they don’t understand and are often confused by the titles used by financial advisers.

However, the debate is not over just yet, even if federal lawmakers pass the legislation. Once the job of conducting the study and making the rules goes to the SEC, the debate over the details of just how the new rules will apply will likely continue.

A copy of the Businessweek article discussing this development can be found here, and an article from Financial Advisor Magazine can be found here.

The Uncertain Future of Mandatory Arbitration Provisions

On May 20, 2010, the U.S. Senate passed its version of the financial reform bill. The U.S. House of Representatives passed its financial reform legislation earlier this year. The two bills have varying degrees of regulation and differences on how to regulate. One such difference involves mandatory arbitration provisions included in brokerage firm and investment advisory contracts. Currently, most brokerage or investment advisory firms require customers sign a contract in order to open an account. The contract usually requires all claims arising out of or related to the contract to be submitted to arbitration. These mandatory arbitration provisions often specify the arbitral venue and the arbitration rules that will apply.

According to Senate Bill 3217, the Securities and Exchange Commission (“SEC”) would be given the authority to determine the permissibility of mandatory arbitration provisions to govern the arbitrability of securities claims. The Senate specifically gives the SEC the option to reaffirm, prohibit, or impose certain conditions on the use of mandatory arbitration provision in broker-dealer and investment advisor agreements.

On the other hand, the House legislation does not give the SEC the authority to reaffirm current practices regarding mandatory arbitration. Rather, HR 4173 only permits the SEC to restrict or prohibit the use of mandatory arbitration provisions in such contracts. Therefore, without the ability to reaffirm the status quo, it would seem that mandatory arbitration provisions included in brokerage and advisory contracts would no longer restrict a defrauded investor from choosing to seek redress in a judicial forum. Further, the House legislation requires the U.S. Government Accountability Office (“GAO”) to report to Congress on the costs to parties in an arbitration proceeding versus the costs to parties in litigation and the percentage of recovery in both forums. The inclusion of the GAO report is to address concerns that arbitration may not be less costly to the parties or more expedient than litigation and that arbitration may actually undermine investor interests.

The U.S. Department of Treasury in its report last June takes the most stringent approach to mandatory arbitration provisions in brokerage agreements. In its financial reform proposal, the Treasury recommends that legislation should be enacted to prohibit mandatory arbitration provisions in these contracts and that the SEC should be given “clear authority” to enforce arbitration provision violations. Like the House, the Treasury proposal also suggests that a study should be conducted to determine whether investor rights are undermined because of an inability to seek redress in court.

Historically, violations of federal securities laws were considered a non-arbitrable issue. In 1953, the U.S. Supreme Court articulated this view in Wilko v. Swan when it held that an agreement to arbitrate a claim under Section 12(a)(2) of the Securities Act of 1933 was unenforceable. 346 U.S. 427 (1953). Over 35 years later, the Supreme Court overruled its position in Wilko in Rodriguez v. Shearson/American Express, Inc. 490 U.S. 477 (1989). The Court in Rodriguez held that a predispute agreement to arbitrate claims under the Securities Act of 1933 is enforceable and resolution of the claims only in a judicial forum is not required because arbitration does not inherently undermine a person’s substantive rights under federal securities laws. Id. at 485-86. It is important to note that since the decision in Wilko, arbitration had become more common and the Federal Arbitration Act had been significantly amended strengthening judicial and legislative favor toward the use of arbitration to settle disputes, which further justified the Supreme Court’s overruling. Id. However, the Supreme Court has also held that a predispute arbitration agreement that effectively deprives a claimant of statutory remedies violates public policy and is unenforceable, thus limiting the scope of Rodriguez. Mitsubishi Motors Corp. v. Soler Chrysler Plymouth, Inc., 473 U.S. 614, 637, n. 19 (1985).

SENATE PASSES SWEEPING FINANCIAL REGULATORY REFORM BILL

On May 20, 2010, after much debate, the Senate passed the most sweeping financial regulatory legislation since the Great Depression. The Senate’s 59-39 vote was the last major stepping stone in making the Obama administration’s proposed financial regulatory overhaul a reality. In December 2009, the House of Representatives passed its own version of the legislation by a 223-202 vote. Now, the Senate and the House have the ever important task of reconciling their two versions of the bill, which are largely the same but have important distinctions.

The financial regulatory legislation aims to curtail a repeat of the 2008 economic crisis that nearly crippled the U.S. economy. The Senate’s version of the legislation encompasses over 1,500 pages and includes major overhauls to the current laws and regulations governing the financial industry. Some of the key measures include, but are not limited to:

• A major overhaul in the regulation of banks and financial firms which were previously deemed “too big to fail,” including creating more powers for regulators to break up financial firms that are so large that they pose a threat to the stability of the entire financial system;

• Limiting the scope of banks’ investment activities by in part banning banks from trading on their own accounts and from trading derivatives;

• Empowering the Federal Reserve to supervise large financial companies to help ensure that the government understands the risks these companies pose to the economy;

• Creating a new and independent Consumer Financial Protection Bureau within the Federal Reserve charged with adopting and enforcing new regulations targeting abusive practices in consumer loans and credit cards; and

• Giving regulators the power to oversee and regulate the derivatives market that many experts believe crippled AIG and Lehman Brothers.

Both the Senate and the House have expressed a desire to come to a final resolution of the financial regulatory overhaul legislation by the Fourth of July. The bill will then be sent to President Obama for a final review before he signs it into law.

The financial industry overhaul will have large implications for financial firms throughout the country. The attorneys of Cosgrove Law, LLC have years of experience in the financial industry and will be available to assist you or your firm in maintaining proper compliance with the new financial regulatory legislation.

GAO Releases Transcript of Testimony Regarding Report on Buildup of Leverage Before Financial Crisis

On May 6, 2010, the Government Accountability Office released the testimony of Orice Williams Brown, Director Financial Markets and Community Investment, before the House of Representatives Subcommittee on Oversight and Investigations, Committee on Financial Services. In Mr. Brown’s testimony, he noted that while the causes of the recent financial crisis remain subject to debate, some researchers and regulators have suggested that the buildup of leverage before the financial crisis and subsequent disorderly deleveraging compounded the crisis.

Mr. Brown noted that many financial institutions use leverage to expand their ability to invest or trade in financial assets and to increase their return on equity. A firm can use leverage through a number of strategies, including by using debt to finance an asset or entering into derivatives. Brown stated that greater financial leverage, as measured by lower proportions of capital relative to assets, can increase the firm’s market risk, because leverage magnifies gains and losses relative to equity. Leverage also can increase a firm’s liquidity risk, because a leveraged firm may be forced to sell assets under adverse market conditions to reduce its exposure. Although commonly used as a leverage measure, Brown noted that the ratio of assets to equity captures only on-balance sheet assets and treats all assets as equally risky.

Brown pointed out that federal financial regulators impose capital and other requirements such as leverage measures on their regulated institutions to limit leverage and ensure financial stability. For example, the SEC uses its net capital rule to limit broker-dealer leverage. Other important market participants, such as hedge funds, also use leverage. Although hedge funds typically are not subject to regulatory capital requirements, market discipline, supplemented by regulatory oversight of institutions that transact with them, can serve to constrain their leverage.

Mr. Brown found that the crisis revealed limitations in the financial regulatory capital framework’s ability to restrict leverage and to mitigate crisis. First, he noted that regulatory capital measures did not always fully capture certain risks. As a result, institutions did not hold capital commensurate with their risks and some faced capital shortfalls when the crisis began. Brown acknowledged that federal regulators have called for reforms, including international efforts to revise the Basel II capital framework (an international risk-based capital framework which sets requirements for how much capital banks need to put aside to guard against certain types of financial and operational risks). Brown noted that the planned U.S. implementation of Basel II would increase reliance on risk models for determining capital needs for certain large institutions. He stated that the crisis underscored concerns about the use of such models for determining capital adequacy, but regulators have not assessed whether proposed Basel II reforms will address these concerns. Brown noted that such an assessment is critical to help ensure that changes to the regulatory framework address the limitations revealed by the recent crisis.

Second, Brown noted that regulators face challenges in neutralizing cyclical leverage trends. For example, according to regulators, minimum regulatory capital requirements may not provide adequate incentives for banks to build loss-absorbing capital buffers in benign markets when it would be less expensive to do so. When market conditions deteriorated, minimum capital requirements became binding for many institutions that lacked adequate buffers to absorb losses and faced sudden pressures to deleverage. Brown stated that regulators are considering several options to counteract potentially harmful cyclical leverage trends, but implementation of these proposals presents a challenge by itself.

Finally, with multiple regulators responsible for individual markets or institutions, none has clear responsibility to assess the potential effects of the buildup of systemwide leverage or the collective effects of institutions’ deleveraging activities. To ensure that there is a systemwide approach to addressing leverage-related issues across the financial system, Brown stated that the GAO has asked Congress to consider, as it moves toward the creation of a systemic risk regulator, the merits of tasking this entity with the responsibility for measuring and monitoring systemwide leverage and evaluating options to limit the positive correlation between leverage trends and the overall state of the economy. Brown also noted that the GAO recommended to the financial regulators that an assessment should be made regarding the extent to which Basel II reforms may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches used for capital purposes.

A complete copy of Mr. Brown’s testimony can be found here.

FINANCIAL REGULATION WOES CONTINUE IN THE SENATE BUT THE OUTLOOK IS OPTIMISTIC

In June 2009, in the wake of the 2008 financial crisis, the Obama administration announced the most sweeping overhaul of the country’s financial regulatory system since the Great Depression. From the outset, the proposed financial reform has been met with criticism from both sides—some critics arguing that the reformation calls for too much regulation, while others arguing that it does not call for enough fundamental change in the financial systems. As we discussed in our June 24, 2009 article, the Obama Administration’s plan provided a broad outline for a refined regulatory system, but left much of the details to be filled in by Congress.

In December 2009, and after much debate, the House of Representatives passed its version of the reform legislation, marking a milestone in the Obama administration's efforts to rein in the abuses that contributed to the 2008 financial crisis and to prevent similar failures in the future. Now in the Senate for approval, the financial system overhaul has again been met with division among party lines.

On both Monday and Tuesday of this week, the proposed legislation was blocked from moving forward on the Senate floor, and there has been no visible sign that either party will budge. However, despite partisan maneuverings, both sides have expressed confidence that they will eventually work out a proposed legislation that gains bipartisan support. Lawmakers from both parties have emphasized that nobody wants to experience a repeat of the 2008 financial crisis that nearly collapsed the U.S. economy.

Importantly, should the Senate pass its version of the financial regulatory legislation, the difficulties will not end there. Indeed, there are potentially significant differences between the House and the Senate versions of the legislation, and the two Congressional chambers will have to work out those differences once the Senate passes its own version of the legislation.

Although the Obama administration’s financial system regulatory overhaul has been met with criticism in its details, one thing remains constant: our country’s financial industry needs some sort of regulatory reform to help prevent a repeat of the 2008 economic meltdown and the bailouts that necessarily followed.

NEW PROPOSED SECURITIES RULES IN FLORIDA

The Florida Office of Financial Regulation (“Office”) recently updated some of its securities rules. The Office submitted notice for several proposed rule changes that are primarily to keep its rules up-to-date with the most current federal laws and cross references. For example, references to NASD had to be switched to FINRA after the SEC approved their consolidation back in 2007. Despite these “housekeeping” changes, there are a few noteworthy proposals that are substantive in nature. The substantive proposals come pursuant to House Bill 483 that passed during the 2009 Florida legislative session. The purpose of the bill was to increase investor protection through an expansion of certain agency powers. House Bill 483 became effective July 1, 2009, but the Office of Financial Regulation is beginning to submit its proposals for the supplementary rules.

One such substantive change is Proposed Rule 69W-1000.001, which creates a set of disciplinary guidelines in accordance with House Bill 483. The rule expands the disciplinary power of the Office of Financial Regulation to impose additional sanctions against individuals and firms that are subject to regulation under the Florida Securities and Investor Protection Act (“Securities Act”). Under the new rule, the Office has the power to impose cease and desist orders in conjunction with any sanction laid out in the Securities Act and raises the levels of minimum fines. The rule also sets out an extensive and comprehensive factors list to determine the appropriate sanction.

Proposed Rule 69W-600.0011 was also added pursuant to House Bill 483. Under this proposed rule, applicants could be subject to registration disqualifying periods for dealers, issuer dealers, investment advisors, as well as “relevant persons.” “Relevant persons” for purposes of the rule include “any direct owner, principal, or indirect owner that is required to be reported on behalf of the applicant on a Form BD or a Form ADV.” A Form BD is required for the application for broker-dealer registrations, and a Form ADV is required for applications for investment advisor registration. Grounds for disqualifying periods are based upon criminal convictions, pleas of nolo contendere, and pleas of guilt, regardless of whether there was an adjudication. The disqualifying periods range from five years to fifteen years depending on whether the crime is a classified as “Class A” or “Class B.” Class A crimes are felonies involving an act of fraud, dishonesty, breach of trust, money laundering, and any other crime involving a question of “moral turpitude.” Class B crimes are misdemeanors involving “fraud, dishonest dealing or any other act of moral turpitude.” Pleas receive a disqualifying period of three years. There is also a provision allowing registrants to submit any evidence of mitigating factors that may reduce the length of disqualification.

The Office of Financial Regulation is charged with safeguarding private financial interests of the public through licensing, chartering, examining, and regulating depository and non-depository financial institutions and financial service companies in Florida. It also serves to protect consumers from financial fraud and preserve the integrity of Florida’s markets and financial service industries.

CFTC CHAIRMAN DISCUSSES OVER-THE-COUNTER DERIVATIVES REFORM: A SUMMARY OF DERIVATIVES REGULATIONS THAT MAY BE YET TO COME

On March 1, Commodities and Futures Trading Commission (“CFTC”) Chairman, Gary Gensler, spoke to the Institute of International Bankers about over-the-counter (“OTC”) derivatives reform. On March 2, he spoke before the Women in Housing and Finance organization. In his addresses, Mr. Gensler discussed the history of derivative markets, the need for comprehensive regulation in these markets, and the regulatory reforms that should be implemented. The CFTC is charged with monitoring and regulating the futures and commodity options exchanges in order to protect market participants and promote fair trading.

In 1981, the first derivatives transaction took place. Throughout the 1980s, these instruments were tailored one at a time to meet specific risk management requirements of two sophisticated parties—usually a dealer and a corporate customer. Parties negotiated a deal each time they needed to hedge a specific financial risk; they were not widespread public investment tools. Because these transactions did not take place on regulated exchanges, but rather existed purely in company accounting books, the information available to the public about pricing was not readily available. Further, this lack of information made it difficult to understand the magnitude of interconnectedness between financial institutions. Over the next decades, the notion of derivatives as a hedging tool became increasingly popular, causing contracts to be more standardized and easier to negotiate and trade. Upgrades in technology further influenced the popularity of derivatives by facilitating easy electronic trading. At its peak, before the financial crisis, the derivatives market had a notional value of $300 trillion in the U.S., whereas in the 1980s, the notional value of the derivatives market was only $1 trillion.

Since their inception, these financial hedging tools remained largely unregulated. In the aftermath of the financial meltdown, it became known how OTC derivatives can increase risk when unregulated, instead of functioning properly as a risk hedger. Their risk-added is even more dangerous when coupled with the limited availability of pricing information and a lack of transparency. It is for these reasons that Chairman Gensler advocates comprehensive reform of OTC derivatives.

According to Chairman Gensler, there are three main components that will result in effective reform:

1. Explicitly Regulate Derivatives Dealers
2. Implement Transparent Trading Requirements
3. Organize Clearinghouses to Clear Standard Derivatives

Derivative Dealer Regulations. Chairman Gensler believes that having an explicit regulatory framework of derivatives dealers will lower risk. First, the regulations should impose certain capital and margin requirements to mitigate risk to the public. Second, business conduct standards should be put in place to protect against fraud, market manipulation and abuse, which will in turn promote market integrity. Finally, derivatives dealers should have standardized recordkeeping and reporting requirements. Such requirements would bring transparency to the system and provide more accurate pricing information to the public.

Transparency in Trading. Chairman Gensler asserts that trading must be transparent in order to improve how current markets function, create better market liquidity and lower hedging costs. In order to have trading transparency, he advocates that there must be centralized trading venues. These venues would be better equipped to asses and manage risk of OTC derivatives and provide transparency because all derivatives trading would have to have cleared positions based on a reliable market price. The reliable market price would be a by-product of having central trading venues.

Central Clearinghouse for Standard Derivatives. Currently, derivatives are primarily listed on company books, not with a central source, which creates unknown levels of interconnectedness between financial institutions and contributes to the issue of “too big to fail.” Therefore, Chairman Gensler believes that it is imperative to have a central clearinghouse to understand how institutions are connected, because a central clearinghouse would provide transparency about these relationships and reduce interconnectedness of banks since derivatives would flow through the clearinghouse instead of bank balance sheets. It is estimated that 75% of derivatives traded are standard derivatives transactions. Such transactions, because of standardization, can therefore be monitored and cleared though one central clearinghouse. Those derivatives transactions that are highly specialized and tailored would remain outside the scope of the clearinghouse (but within the dealer regulations) and would still be allowed to trade bilaterally. Further, Gensler concedes that there would be other exceptions, but exceptions should remain narrow and explicit.

In closing, Chairman Gensler reiterated the necessity for OTC derivatives regulations because “the central lesson from the crisis is that an interconnected financial system facilitates the spread of risk from institution to institution, threatening the entire economy.”

Currently, the House of Representatives is considering H.R. 3300, the Derivative Trading Accountability and Disclosure Act, which would implement many of the changes Chairman Gensler suggests. The Senate also introduced Senate Bill 3714, Derivatives Trading Integrity Act of 2008, which focused primarily on introducing a regulated exchange for certain types of derivatives. However, that bill was never reconsidered.