|June 24, 2009|
Schiff Hardin LLP Securities and Futures Regulation and Financial Institutions Alert
Obama Administration Proposes Financial Regulatory Reform
On June 17, 2009, the Obama Administration, through a Department of the Treasury white paper, issued wide-ranging recommendations for reform of the financial regulatory system: Financial Regulatory Reform A New Foundation: Rebuilding Financial Supervision and Regulation. A summary of some of the more important recommendations follows. Although bills pending in Congress and several proposed agency regulations relate to some of the issues addressed in the white paper, the Administration recommendations were not accompanied by proposed legislation or rules, and most of the recommendations speak in very general terms. There is, however, no doubt that these legislative and regulatory proposals will be the subject of intense policy debate, lobbying and formal comment, not to mention political tussles, over the coming months.
The white paper identifies many of the causes of the recent financial crisis. Some of the recommendations, though by no means all of them, are explicitly directed at some perceived shortcoming in regulation that was exposed in the crisis. Thus, in an effort to avert another financial crisis, the reforms seek to "[p]romote robust supervision and regulation of financial firms," "[e]stablish comprehensive supervision of financial markets," "[p]rotect consumers and investors from financial abuse," "[p]rovide the government with the tools it needs to manage financial crises," and "[r]aise international regulatory standards and improve international cooperation." In the judgment of the Administration, this necessitates a broad restructuring of the financial regulatory system and enhancement of regulatory powers.
Systemic Risk Regulation and the Proposed Expanded Role of the Federal Reserve
There has been a great deal of discussion over the past year about the desirability of creating a systemic risk regulator for the financial system and who that regulator should be. The white paper endorses the empowerment of a central risk oversight authority, recommending that the Federal Reserve, rather than a committee of agencies, have primary responsibility for assessing and triggering remediation of systemic risk. Not only would the Federal Reserve become the "consolidated supervisor" of large firms, as discussed below, but it would also have limited power to examine any financial firm above a minimum size.
The white paper recommends legislative creation of a Financial Services Oversight Council (FSOC) replacing the President's Working Group, which had been created by executive order. The FSOC would consist of the Secretary of the Treasury (chairman), the Chairman of the Board of Governors of the Federal Reserve System, and the chair or director of six federal financial regulatory agencies, including the chairs of the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and Federal Deposit Insurance Corporation (FDIC). The FSOC would gather information from any financial firm and refer issues of emerging risks to the appropriate regulator to take action to avert a problem. If other proposed reforms are adopted, the FSOC would serve additional functions, generally in a consultative role.
This new systemic oversight framework would cover any financial entity, including a broker-dealer or the holding company parent of one, designated by the Federal Reserve Board as a Tier 1 FHC (financial holding company) irrespective of whether it is, or owns, an insured depository institution. Whether a firm qualifies as a Tier 1 FHC "should consider the impact the firm's failure would have on other large financial institutions, on payment, clearing and settlement systems, and on the availability of credit in the economy." This would thus extend regulation by the Federal Reserve to entities that are comparable in function to, but not within the definition of, a bank holding company (BHC) already regulated by the Federal Reserve. The Federal Reserve, in consultation with the Treasury, would establish flexible rules for identifying Tier 1 FHCs, and the FSOC could recommend entities to be designated Tier 1 FHCs. The capital, liquidity and risk management standards for a Tier 1 FHC would be "stricter and more conservative" than those imposed on other firms, in recognition of the greater risk posed by a Tier 1 FHC. The white paper proposes that the Federal Reserve have the power to impose more stringent capital requirements on a regulated subsidiary of a Tier 1 FHC, after consultation with the subsidiary's primary regulator, such as the SEC.
Capital requirements would be addressed at the holding company as well as at the regulated subsidiary level. A functionally regulated or depositary institution subsidiary of a Tier 1 FHC would continue to be supervised by its functional or bank regulator, such as the SEC in the case of broker-dealer. Accordingly, much of the information about a Tier 1 FHC on which the Federal Reserve would base its regulatory action would come from reports generated by, or for, the regulators of the subsidiaries. As part of its systemic oversight role, the Federal Reserve should require each Tier 1 FHC to report on the extent to which other major financial firms are exposed to it. The Federal Reserve should also have power to obtain limited information from other entities.
The Federal Reserve would be empowered to mandate prompt corrective action by a Tier 1 FHC if its capital level declines, similar to the power over insured depository institutions granted by the Federal Deposit Insurance Corporation Improvement Act. This apparently could entail a requirement to raise additional capital. (As noted above, the Federal Reserve would have the power to require a regulated entity to have more capital than its primary regulator requires.)
Proposed Regulation of Private Capital
The white paper recommends that all advisers to hedge funds, private equity funds and venture capital funds whose assets under management "exceed some modest threshold" be required to register with the SEC under the Investment Advisers Act. The advisers would then be required to report information on the funds they manage on a confidential basis "that is sufficient to assess whether any fund poses a threat to financial stability." The SEC would be required to share the reports with the Federal Reserve so that the latter could determine if a particular fund or fund family should be regulated as a Tier 1 FHC.
All investment funds advised by an SEC-registered investment adviser would, under the proposal, be subject to recordkeeping requirements, requirements with respect to disclosures to investors, creditors and counterparties, and regulatory reporting requirements. The SEC would then conduct examinations of the funds themselves to monitor compliance.
While the proposal was expected to include some regulatory or reporting requirement for hedge funds or their advisors, the coverage of private equity funds or venture capital funds was not generally anticipated. The white paper acknowledges that different requirements may be imposed on these different "types of private pools." Schiff Hardin has previously commented on prior efforts of the SEC to regulate hedge fund advisors. See SEC Proposes New Rules Affecting Hedge Funds; SEC Requires Registration of Hedge Fund Advisers; and SEC Proposes Registration for Hedge Fund Advisers.
Proposed Regulation of OTC Derivatives
There has been much discussion in Congress, regulatory agencies, and the press over the role that over-the-counter (OTC) derivatives, most notably credit default swaps (CDS), played in contributing to the financial crisis. It was expected that the Administration would recommend some degree of regulatory oversight over those products. The white paper goes far in this regard in that it recommends that all OTC derivatives, including CDSs, should be subject to comprehensive regulation, to prevent undue risk to the financial system, to promote transparency, to prevent market manipulation and to ensure that OTC derivatives are not marketed to unsophisticated buyers.
To these ends, the white paper recommends that the Commodity Exchange Act (CEA) and the federal securities laws be amended to mandate clearing of all standardized OTC derivatives through regulated central counterparties (CCP). The white paper also favors that, to the extent possible, standardized derivatives be traded on a fully-regulated exchange. For clearing of OTC derivatives to be effective, the CCPs must be required to have "robust margin requirements as well as other necessary risk controls." The proposal would not prohibit customized that is, non-standardized derivative contracts, but they could not be used as a means to circumvent the requirement for CCP involvement in standardized derivatives. Thus, "if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared."
The white paper suggests that all OTC derivative dealers and other firms whose activities in those markets create large exposures to counterparties should be subject to supervision and regulation, including conservative capital requirements and business conduct standards. This would protect those who participate in transactions in derivatives that are not accepted by a CCP.
To achieve these objectives, the white paper proposes that statutory amendments be enacted to authorize the SEC and CFTC to impose recordkeeping and reporting requirements with respect to all OTC derivatives. CCPs and trade repositories would be required to make public aggregate data on open positions and volume, as is done by registered securities and commodities exchanges for the securities and commodities traded on the exchanges. The Administration also advocates that the SEC and CFTC be given full authority to police fraud, manipulation and other misconduct in the entire derivatives market. The CFTC would be given authority to set position limits for trading significant OTC derivatives. Where SEC and CFTC jurisdiction is, or becomes, concurrent, each would continue to act consistent with its respective statutory mission.
Harmonization and Improvement of CFTC and SEC Regulation
One sure-to-be controversial measure is legislation which the Administration directs be developed and proposed jointly by the CFTC and SEC to harmonize regulation of futures and securities markets. Among other goals, this would remove current restraints under which financial instruments with similar characteristics are forced to trade on different exchanges that are subject to different regulatory regimes. Removing the restraints would permit a broader range of instruments to trade on any regulated exchange and would prevent turf battles that impede swift introduction of new products with novel features. The agencies are to make their recommendations by the end of September, and if they fail to do so the task will be undertaken by the new FSOC (presuming it has been created by Congress by then). The white paper did not make the once-expected recommendation to merge the two agencies, though that may be a longer-term goal of the Administration.
The Administration seeks harmonization between the CFTC's principles-based approach and the SEC's rules-based approach to regulation, so that there will be regulatory principles that are sufficiently precise to be enforced but sufficiently flexible to allow for innovation. The harmonization of regulations would not, however, require eliminating or modifying provisions relating to futures and options contracts on agricultural, energy and other physical commodity products. While most of the proposals in the white paper would add regulation, this recommendation might actually be deregulatory to the extent it lessens the SEC's reliance on a rules-based approach.
The white paper recommends that the SEC respond more expeditiously to proposals for new products and submission of rule proposals by self-regulatory organizations (SRO) such as securities exchanges. This has been suggested to the SEC for close to a decade, yet the SEC has not moved toward this objective other than a panned rulemaking proposal on SRO rule filings several years ago. The white paper goes in the opposite direction for the CFTC, suggesting that it require prior approval for more types of exchange rule changes rather than mere certification of the rule change by the exchange.
Other Proposals Regarding the SEC
The white paper presents a number of proposals for enhanced SEC authority. One proposal would be legislative authority granting the SEC the power to establish a fiduciary duty for broker-dealers offering investment advice, with harmonization of regulations of broker-dealers and investment advisers where they serve substantially the same function. The proposals also recommend granting the SEC the power to require disclosure at the time of sale rather than after the fact, as with mutual fund and other public offering prospectuses; to ban forms of compensation that encourage intermediaries to put investors into products that, while profitable for the intermediary, are not in the investor's best interest; to prohibit certain conflicts of interest; and to ban mandatory arbitration clauses in contracts with broker-dealers and investment advisors, if the SEC judges that to be appropriate action.
In the enforcement and liability areas, the white paper proposes that the SEC have authority to establish a fund to pay whistleblowers whose tips lead to significant financial awards (something that currently exists only in insider trading cases) and appears to endorse the SEC's proposal to amend the federal securities laws to provide a uniform standard among the federal circuits for primary liability in private suits for damages.
The Administration proposes adoption of legislation and regulations that would require all public companies to hold non-binding shareholder votes on senior management compensation and require that compensation committees be more independent, comparable, it appears, to the independence granted audit committees under the Sarbanes-Oxley Act. The white paper recommends that the SEC be given the power to set standards for ensuring the independence of compensation consultants. For financial firms, including broker-dealers, the white paper proposes that the SEC consider imposing standards for compensation for executives and employees.
Proposed Federal Reserve Oversight of Payment, Clearing and Settlement Systems
The role of the Federal Reserve would be expanded to include oversight of "systemically important" payment, clearing and settlement systems and activities of financial firms, that is, a payment, clearing, or settlement system the failure or disruption of which could create or increase the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threatening the stability of the financial system. Existing primary regulators, such as the SEC and CFTC, would retain their oversight roles, although the Federal Reserve would have the right to participate in agency examination of the systems. The Federal Reserve would set risk management standards for systemically important systems. If a system does not meet the standards, the Federal Reserve would have the power to recommend that the primary regulator take action. If the Federal Reserve and the primary regulator cannot agree, the Federal Reserve would have emergency authority to take enforcement action, albeit only after consultation with the FSOC.
A systemically important system would be given access to the Federal Reserve discount window in the event that the commercial bank on which the system typically relies is unable or unwilling to provide necessary liquidity.
Proposed Enhancements of Regulation of Securitization Activities
Banks that package and sell assets that are securitized should be required by the banking regulatory agencies to "retain an economic interest in a material portion [i.e., five percent] of the credit risk of securitized credit exposures," and they should be prohibited from hedging the retained risk. In other words, they should have some "skin in the game" as an incentive to exercise more due diligence in making loans that are resold. The Administration recommends that compensation of participants in the securitization process be linked to longer-term performance of the securitized assets, rather than to the initial production. Apparently this would be accomplished through regulation by the banking agencies and the SEC. Congress should enact legislation to grant the necessary authority to the SEC to require more disclosure by issuers of asset backed securities.
Proposed Enhancements to Banking Regulation
The white paper proposes creation of a new National Bank Supervisor (NBS) to undertake chartering and prudential supervision of all federally chartered depository institutions, as well as federal branches of foreign banks. The NBS would thus supplant the Office of the Controller of the Currency, but the Federal Reserve and FDIC would retain their roles with regard to state-chartered banks. (The Office of Thrift Supervision would be abolished along with the proposed elimination of the federal thrift charter.) This and several other proposals are designed to eliminate regulatory arbitrage, where an institution organizes (or reorganizes) so as to become supervised by the agency deemed most desirable (that is, lax) by the institution. Remaining restrictions on interstate branch banking would be abolished.
Regulatory capital requirements for all banks and BHCs should be strengthened. The white paper does not make specific proposals, for the most part directing studies of these issues to be completed in a matter of months. There should be federal "standards and guidelines" in order to "better align executive compensation practices of financial firms with long-term shareholder value and to prevent compensation practices from providing incentives that could threaten the safety and soundness of supervised institutions," a concern driven by the conclusion that compensation practices were a "significant cause[ ] of the financial crisis." Among the general recommendations, "compensation plans should properly measure and reward performance" and "be structured to account for the time horizon of risks," as well as be "aligned with sound risk management" with greater "transparency and accountability" in the process of setting compensation.
The white paper recommends reforms with respect to setting loan loss reserves, so that they are more forward-looking more likely resulting in higher reserves earlier in the credit cycle. Perceived loopholes in restrictions on transactions between banks and their affiliates would be closed, including additional restraints on the ability of banks to engage in OTC derivative and security financing transactions with affiliates. Existing differences in regulation and supervision among national banks, state member banks and non-member banks would be reduced.
The Proposed Extension of Financial Holding Company Regulation
Companies that own thrifts or other financial businesses that do not qualify the parent as a BHC would now be subjected to the same supervision and regulation by the Federal Reserve as BHCs have been. A Tier 1 FHC that is not a BHC would be required to terminate activities that are currently prohibited for BHCs. The exclusion from BHC regulation enjoyed by owners of credit card banks and industrial loan companies, for example, would be repealed, so that the owner would have to register as a BHC.
Proposed New Procedures for the "Resolution" of Failing Institutions
There should be an improved regime for an orderly wind-down of the operations of a failed BHC, modeled on procedures employed by the FDIC. Bankruptcy proceedings would remain the dominant tool for handling the failure of a BHC except when the special resolution regime is triggered because of concerns about financial stability. The Secretary of the Treasury would decide whether to invoke the special procedures, after a recommendation of the Federal Reserve Board and FDIC Board (in the case of a broker-dealer, the SEC in place of the FDIC), in all cases by a two-thirds vote of the members or commissioners. (The white paper seems not to have taken into account that the SEC and FDIC governing bodies each have five members, so that a two-thirds vote effectively requires a four-fifths vote.) The FDIC or, where appropriate the SEC, would act as conservator or receiver.
Tier 1 FHCs would be required to have a plan "for the rapid resolution of the firm in the event of severe financial distress." While some extraordinary efforts were taken by the Federal Reserve to save institutions using the broad powers granted in Section 13(3) of the Federal Reserve Act, the white paper proposes that the statute be amended to require approval of the Secretary of the Treasury for any extensions of credit in "unusual and exigent circumstances," enacting into law the practice that was followed when emergency powers were exercised in the recent past.
Proposed Credit Rating Agency Reform
The SEC should move forward with efforts to regulate credit rating agencies, including requiring disclosure of conflicts of interest and strengthening the integrity of the ratings process. In particular, credit rating agencies should "publicly disclose, in a manner comprehensible to the investing public, precisely what risks their credit ratings are designed to assess (for example, likelihood of default and/or loss severity in event of default)." Further, "Credit rating agencies should disclose sufficient information about their methodologies for rating structured finance products . . . to allow users of credit ratings and market observers to reach their own conclusions about the efficacy of the methodologies."
Proposed Consumer Financial Protection Agency
The Administration recommends creation of an independent Consumer Financial Protection Agency (CFPA). This agency would have broad rule-making and enforcement authority to protect consumers in dealing with consumer financial products and services, such as consumer loans, savings vehicles, credit cards and debit cards, but it will not regulate investment products and services regulated by the SEC or CFTC. The goal of this new framework is to achieve greater transparency, simplicity and access to products, as well as to impose duties of care on financial intermediaries for consumer financial products and services, which would extend to insured depositary institutions. (Most of what the Federal Reserve had done in this area would thus be shifted to the CFPA.)
Proposed Enhanced International Regulation and International Coordination
The white paper includes recommendations to raise international regulatory standards and improve international cooperation, only a few of which are noted here. These include improvement of the Basel II standards, standardization of OTC derivative markets, enhanced supervision of global financial firms and better compensation practices. The Administration also recommends that the bodies that set accounting standards adopt consistent rules for fair value accounting, including the impairment of financial instruments. The white paper recommends that progress be made toward a "single set of high quality global accounting standards," which may entail merging current U.S. standards with the International Financial Reporting Standards.
The Obama Administration promised sweeping proposals for financial reform. It has fulfilled that promise. The recommendations impact almost every aspect of federal regulation of financial institutions and, in one way or another, virtually all financial products and services, including some that have not been regulated at the federal level. Almost every proposal implicates important policies about the scope and purpose of federal regulation. It is not possible to anticipate which proposals will be on the front burner of a Congress that already has a heavy agenda, although it seems likely that systemic financial risk regulation, hedge fund regulation and OTC derivative regulation at least credit default swaps will be considered.
ABOUT SCHIFF HARDIN LLP
Schiff Hardin is proud to have nationally recognized expertise in the regulation of securities and commodity exchanges and markets and the professional participants in those markets.
Schiff Hardin provides services to banks, savings associations and other types of financial institutions nationwide and internationally. In addition to our traditional strengths in mergers and acquisitions, securities and financings, bank regulatory compliance, and trust department counseling, we have a particular and increasing focus on corporate governance and fiduciary litigation.
For more information, contact us.