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Obama Administration Enacts Sweeping Financial Regulatory ReformJuly 21, 2010
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Act”) into law. The Act represents the most comprehensive reform of the U.S. financial regulatory framework in generations. Although many important details have been left to individual agencies and bureaus to define through administrative rulemaking, the broad contours of the new regulatory framework are now apparent. This Alert provides a high-level overview of major features of the Act and its likely impact on the U.S. financial services industry:
- Proprietary Trading. The Act curtails in certain respects the ability of banks, bank holding companies and their affiliates and subsidiaries to engage in proprietary trading and invest in or sponsor private equity and hedge funds.
- Consumer Financial Protection Bureau. The Act creates an independent bureau within the Federal Reserve Board (“FRB”) that consolidates federal rulemaking and enforcement authority over a wide range of consumer financial products and services.
- Systemic Risk Regulation and Resolution Authority. The Act creates an interagency Financial Stability Oversight Council (“Council”), supported by an Office of Financial Research, to monitor and respond to systemic risks to the financial system. The Act provides the Council with authority to bring “systemically” important nonbank financial companies under the supervision of the FRB, and to recommend to primary financial regulators heightened prudential regulatory standards (e.g., leverage limits, risk-based capital requirements, etc.) for institutions or activities contributing to systemic risk. The Act establishes a new orderly liquidation authority for liquidating financial companies in certain circumstances. Under the new authority, which is modeled in large part on the Federal Deposit Insurance Act, the Treasury Secretary may appoint the Federal Deposit Insurance Corporation (“FDIC”) as receiver of any financial company (including nonbank financial companies) if certain conditions are satisfied.
- Regulation of Advisers to Hedge Funds and Private Equity Funds. The Act requires U.S. and foreign advisers to hedge funds and private equity funds to register with the Securities and Exchange Commission (“SEC”), maintain books and records and file reports with the SEC, and comply with the Investment Advisers Act of 1940 (the “Advisors Act”).
- Interchange Rate Regulation and Other Payment Card-Related Provisions. The Act authorizes the FRB to promulgate regulations governing the reasonableness of interchange fees charged by issuers with respect to electronic debit transactions. The statutory language essentially equates “reasonable” with the incremental cost incurred by the issuer with respect to each individual debit transaction. In addition, merchants will now be allowed to offer discounts preferring a particular form of payment, whether cash, credit, or debit, thus paving the way for the elimination of industry-wide bans on surcharges and credit card minimums.
- Swaps and Derivatives Reform. The Act requires banks to establish non-federally insured affiliates for the purpose of trading certain “risky” derivatives and establishes a clearing house structure to be approved and monitored by the SEC and the Commodities Futures and Exchange Commission (“CFTC”).
- Securitization. With certain exceptions, the Act generally requires securitizers to retain not less than 5% of the credit risk of any asset transferred, sold or conveyed through the issuance of an asset-backed security.
Credit Rating Agencies. The Act strengthens SEC oversight, mandates significant corporate governance and employee conflict of interest standards, and requires increased disclosure of rating agency methodologies and performance.
I. Proprietary Trading (“The Volcker Rule”).
Section 619 of the Act, commonly referred to as the “Volcker Rule,” generally prohibits banks and bank holding companies with U.S. operations, their affiliates and subsidiaries (collectively, “banking entities”) from engaging in most proprietary trading activities and from investing in or sponsoring private equity and hedge funds (collectively, “private funds”). A banking entity may, however, sponsor and invest in a private fund if the banking entity’s total investment in the fund does not exceed 3% of the fund’s equity and the banking entity’s total outstanding investments in all private funds does not exceed 3% of the banking entity’s Tier 1 capital. A banking entity may provide capital in excess of the 3% single fund cap when seeding a private fund with start-up capital but must reduce its investment to meet the 3% cap within a year of the private fund’s initial closing through dilution, redemption, or other means. In no event, however, may a banking entity invest in a private fund if it would (a) involve or result in a conflict of interest between a banking entity and its clients, customers or counterparties, (b) materially expose the banking entity to high-risk assets or trading strategies, (c) pose a threat to the safety and soundness of the banking entity, or (d) pose a threat to the financial stability of the banking entity or the United States.
The Volcker Rule also limits the types of transactions banking entities and their affiliates may enter into with private funds they manage, advise or sponsor. With a limited exception for certain prime brokerage accounts, these transactions will now be subject to the same limitations imposed on transactions between member banks and their affiliates under Sections 23A and 23B of the Federal Reserve Act. Subject to these limitations, banking entities may continue to act as investment managers to private funds.
The Volcker Rule will not apply to systemically significant non-bank financial companies; however, such companies will be subject to additional capital requirements and quantitative limits on fund investment and sponsorship activities promulgated by the FRB.
The Volcker Rule will become effective on the earlier of (a) 12 months after the date regulators issue final implementing rules or (b) two years after the date the Act is enacted. Banking entities and nonbank financial companies will then have up to two additional years to bring their activities and investments into compliance, with the possibility of up to three one-year extensions if granted by regulators. A banking entity may apply for an additional 5-year extension for any one fund if the banking entity had a contractual obligation in effect on May 1, 2010 to invest in or provide capital to an “illiquid fund,” generally defined as private funds that invest in private equity, real estate, and venture capital investments. Whether any of these extensions will run concurrently is unclear from the text of the statute and will be left to regulators to determine. Regulators may impose additional capital requirements and other restrictions on banking entities’ private fund investment activities during the transition period.
Ultimately, the ramifications of the Volcker Rule for banking entities and nonbank financial companies will depend greatly on the scope of the final rules and regulations implemented by federal regulators. Some banking entities undoubtedly will elect to divest certain fund interests, thereby creating opportunities for suitable buyers. Further, opportunities for banking entities to continue sponsoring such funds may be limited if investors insist on capital commitments by fund sponsors greater than the Volcker Rule will allow, or if investors see greater value in investing with sponsors that have the ability to make additional cash infusions when a fund is in danger of failing.
II. Consumer Financial Protection Bureau.
The Act creates a new financial regulator, the Consumer Financial Protection Bureau (“CFPB”), with authority to enact consumer protection rules governing all financial institutions —including banks and non-banks—that offer consumer financial products or services. The CFPB will have enforcement authority over banks and credit unions with assets in excess of US$10 billion, as well as all mortgage-related businesses (e.g., originators, servicers and brokers), pay day lenders, student loan originators, debt collectors and consumer reporting agencies. The CFPB consolidates the consumer protection responsibilities previously held by several federal agencies, including the Office of the Comptroller of the Currency (“OCC”), the Office of Thrift Supervision (abolished by the Act), Federal Deposit Insurance Corporation (“FDIC”), the FRB, National Credit Union Administration (“NCUA”), the Department of Housing and Urban Development (“HUD”), and the Federal Trade Commission (“FTC”). The CFPB will have responsibility for overseeing the enforcement of existing federal consumer financial services and fair lending statutes.
Autonomous and Independent Bureau. Although the CFPB is designated as a bureau within the FRB, the CFPB is fully autonomous with a director appointed by the U.S. President and subject to Senate confirmation. The Act expressly prohibits the FRB from intervening in any proceeding or enforcement action before the CFPB, and no rules or orders promulgated by the CFPB are subject to Fed review or approval. The U.S. Treasury Secretary will serve as interim director until the new director is appointed.
Authority to Regulate “Abusive” Practices. The Act provides the CFPB authority to enforce existing federal consumer financial protection statutes and, in addition, provides the new bureau a supplemental grant of authority to regulate “abusive practices” with respect to consumer financial products and services. Although it is difficult to know how the CFPB may interpret what constitutes an “abusive practice,” this formulation represents a potentially significant expansion of existing federal consumer protection regimes prohibiting “deceptive acts and practices.” Industry participants subject to CFPB regulation and oversight should expect to see expanded prohibitions on consumer financial services and products beyond the existing case law and prior FTC and federal banking agency precedent.
Shift from Disclosure-Based to Prohibition-Based Regulation. The Act directs the CFPB to adopt new disclosure rules to assist consumers of financial services and products to understand the “costs, benefits, and risks associated with the product or service” and expressly prohibits certain consumer financial products and practices. This legislative judgment to ban products (as opposed to simply mandating more robust disclosures) represents a major departure from prior consumer protection regimes with perhaps unintended consequences. As a result of banning some products outright, some consumers can expect to pay higher prices and have fewer financial services and products available to them.
Preemption and the Potential Expansion of State Regulation of Consumer Financial Services. Individual states may bring civil actions to enforce the provisions of the Act against state-chartered entities, national banks or Federal savings associations. In addition, states may adopt their own consumer financial services laws, so long as the state law affords consumers “greater protection” than is otherwise provided by the Act. Stated differently, the Act establishes a regulatory floor for consumer financial protection, but permits the states to enact and enforce different or stricter substantive rules. Here again, industry participants should expect an increase in state enforcement activities as a result of the Act, and brace for the possibility of an even more complex web of overlapping or conflicting state law consumer financial protection regimes that require state-specific compliance strategies. Coupled with the increase in statutory penalties under certain federal consumer financial services statutes authorized by the Act, the potential expansion of liability under the CFPB is significant.
That said, the Act provides several bright spots for industry participants. First, the Act saves from preemption only “state consumer financial laws,” that is, state laws that “directly and specifically” regulate the “manner, content, or terms and conditions of any financial transaction.” State law consumer protection regimes of generally applicability, such as state unfair and deceptive acts and practices statutes, would seem to be preempted to the same extent as before adoption of the Act. In effect, then, the Act adopts a clear statement principle, requiring states to specifically enact consumer financial protection laws to avoid preemption. Second, state attorneys general (or their equivalents) are prohibited from bringing enforcement actions against national banks or federal savings associations except to enforce the specific provisions of the Act or its implementing regulations. Third, the Act preempts state law in accordance with the standard announced in Barnett Bank v. Nelson, 517 U.S. 25 (1996) and as determined by any court or by regulation or order of the OCC.
III. Systemic Risk Regulation.
One of the key concerns animating the desire for regulatory reform was the perception that the government had been compelled to “bail-out” institutions that were “too big to fail,” i.e., institutions the failure of which, due to size, leverage and interconnectedness, threaten the financial system. The framers of the Act sought to establish a framework for the identification and regulation of such institutions and, ultimately, for their resolution in the even of a failure. Congress’s approach to financial and systemic stability centers around a new multi-agency Financial Stability Oversight Council (“Council”) composed of the Secretary of the Treasury (who serves as chair), the Chairman of the Board of Governors of the FRB System, the Comptroller of the Currency, the Director of the CFPB, the Chairman of the SEC, the Chairperson of the FDIC, the Chairperson of the CFTC, the Director of the FHFA, the Chairman of the NCUA, and an independent member appointed by the U.S. President (all of the foregoing, voting members).
The role of the Council is to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace, and to respond to such risks. To support the Council’s role, the Office of Financial Research is given the authority to collect data on the activities of bank holding companies and large nonbank financial companies—including insurance companies and hedge funds—to assess their systemic significance.
By two-thirds vote (including the Treasury Secretary), the Council may determine that a U.S. nonbank financial company shall be supervised by the FRB and subject to prudential standards if the Council determines that material financial distress of the company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company, could pose a threat to the financial stability of the United States. The factors to be considered in making such a determination include leverage; off-balance-sheet exposures; transactions and relationships of the company with other significant companies; the importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system; the extent to which assets are managed rather than owned by the company; the extent to which ownership of assets under management is diffuse; the nature, scope, size, scale, concentration, interconnectedness of the company; and the degree of reliance on short-term funding. Any entity that was a bank holding company on January 1, 2010, with more than US$50 billion in assets (including certain successor entities as defined by the FRB in consultation with the Council) that ceases to be a bank holding company at any time after January 1, 2010 would continue to be treated as a nonbank financial company supervised by the FRB. The Council may also take similar actions with respect to foreign nonbank financial companies.
As a practical matter, the Council acts through the FRB. The FRB will have the operational responsibility for implementing the Council’s direction and recommendations. In particular, the FRB is given the authority to require each nonbank financial company supervised by the FRB, and any subsidiary thereof, to submit reports under oath, as well as having examination authority and the power to promulgate expanded prudential requirements. The FRB has broad powers to respond to entities that threaten to introduce systemic instability, including the power to force complex companies to divest certain assets or operations to facilitate an orderly resolution of the company in bankruptcy.
The Council may make recommendations to the FRB concerning the establishment and refinement of increasingly strict rules for capital, leverage, liquidity, risk management, and reporting and disclosure requirements for FRB-supervised nonbank financial companies and large, interconnected bank holding companies applicable to companies related to their size and complexity, with the most significant requirements on companies that pose immediate risks to the financial system. No authority is granted to supervise nonfinancial activities of nonbank financial companies. The Act grants the FDIC resolution authority with respect to systemically important financial companies.
IV. Regulation of Advisers to Hedge Funds, Private Equity Funds, and Securitization Vehicles.
The Act includes the Private Fund Investment Advisers Registration Act of 2010 (the “PFIARA”), which will regulate investment advisers to private investment funds, including hedge funds, private equity funds and most securitization vehicles. The PFIARA and the rules to be promulgated thereunder by the SEC will require, among other things, many U.S. and foreign advisers to such funds and investment vehicles to register with the SEC, maintain books and records, file reports with the SEC and comply with the Investment Advisers Act of 1940, as amended (the “Advisers Act”).
Many such advisers (including advisers or managers based outside of the U.S.) currently rely upon the “private adviser exemption” to avoid registering as an investment adviser with the SEC under the Advisers Act. The private adviser exemption provides that if an adviser has less than 15 clients during the preceding 12 months and does not hold itself out to the public as an investment advisor, the adviser is exempt from registration under the Advisers Act. The PFIARA eliminates the private adviser exemption in its entirety and, in its place, provides several limited registration exemptions.
The PFIARA provides a limited exemption from registration for foreign advisers and greatly restricts their ability to solicit U.S. capital without first registering under the Advisers Act. The PFIARA exempts from registration “foreign private advisers,” defined as investment advisers that:
Have no place of business in the U.S.;
Do not generally hold themselves out to the public in the U.S.;
Have fewer than 15 clients and investors in the U.S.; and
Have less than US$25 million of aggregate assets under management attributable to clients and investors in the U.S. in private funds.
Because few foreign advisers to private funds have less than 15 clients and investors in the U.S. and less than US$25 million of assets under management attributable to U.S. clients and investors, most foreign advisers to private funds will be required to register with the SEC.
In addition to foreign private advisers, advisers to “venture capital funds” will be exempt from registration and the SEC will have one year to adopt final rules defining the term “venture capital fund” and crafting the exemption. Investment advisers with assets under management in the U.S. of less than US$150 million and that solely advise private funds are also exempt.
Registering with the SEC under the Advisers Act will have a significant impact on advisers and will raise many transition issues for unregistered investment advisers. Once registered, the investment adviser is required to have a Chief Compliance Officer who is competent and knowledgeable regarding the Advisers Act and to develop a written supervisory procedures manual and a code of ethics that are reasonably designed to prevent violations of the Advisers Act. The registered adviser will also be required to comply with the Advisers Act and related regulations including, by way of example, regulations governing advertising and marketing, custody of client assets, books and records, cross trades and principal trades, and client solicitations.
The PFIARA provides for a one-year transition period before becoming effective. As a result, unregistered advisers that cannot rely upon one of the limited exemptions should begin preparing for registration by:
- Assessing the impact that compliance with the Advisers Act will have on current practices and whether there are any transition issues that need to be discussed with the SEC staff before registering;
- Preparing a written supervisory procedures manual and code of ethics that is tailored to their business. Preparing the manual can take a significant amount of time and should be started in advance of registration;
- Reviewing their business activities to identify potential conflicts of interest, such as outside business activities of firm employees, allocation policies between funds with overlapping investment objectives, and conflicts in dedicating time among the adviser’s funds; and
- Reviewing their existing compliance infrastructure to determine whether additional resources or compliance personnel are necessary to comply with the Advisers Act and related regulations.
V. Interchange Rate Regulation and Other Payment Card-Related Provisions.
The Act authorizes the FRB to make regulations governing the reasonableness of interchange fees charged by issuers with respect to electronic debit transactions. The statutory language defines “reasonable” in relation to the incremental cost incurred by the issuer with respect to each individual debit transaction. Other costs not specific to the individual transaction may not be considered, except for a small adjustment for costs related to fraud prevention. The Act does not regulate network fees, except to say that network fees may not be used to circumvent interchange fee regulations; small issuers, government-administered payment programs, and reloadable prepaid cards are exempt from regulation under this section.
The FRB is also required to make regulations that prohibit issuers or payment card networks from: (1) requiring that any individual electronic debit transaction be processed exclusively through one network or one group of affiliated networks, and (2) inhibiting a merchant’s ability to choose which payment card network to use to process any given transaction.
Finally, although surcharges are expressly forbidden, merchants will now be allowed to offer discounts preferring a particular form of payment, whether cash, credit, or debit. Merchants may not, however, use these discounts to discriminate between individual issuers or networks—for example, by discounting debit transactions cleared over the Visa network but not those cleared over the MasterCard network. And merchants will now be able to set credit card minimum purchase amounts at their discretion, up to $10.00. Networks may not contractually forbid or otherwise penalize merchants for engaging in either of these practices. As such, the Act paves the way for the elimination of industry-wide bans on surcharges and credit card minimums.
VI. Swaps and Derivatives.
The Act significantly modifies the structure of the derivatives market and potentially changes the risk and cost dynamics of the derivatives business. The Act will provide greater transparency to the over-the-counter (“OTC”) market and provide regulators with more tools for understanding positions and risk concentrations both at individual firms and in the financial markets generally. However, the additional regulatory burden and compliance requirements likely will diminish trading profits, increase costs, and may exacerbate certain counterparty and trading risks. The full impact of the legislation on swap dealing and trading will not be understood until the applicable agencies complete their respective rulemakings.
Changes in Regulatory Jurisdiction. The Act gives the CFTC jurisdiction over the trading and clearing of swaps (other than security-based swaps). Security-based swaps, which are swaps based on underlying securities, are to be regulated by the SEC. The Act creates two new regulated entities: the swap dealer and major swap participant (and security-based swap dealer and major security-based swap participant for security-based swaps). FX Forwards and FX Swaps are to be regulated by the CFTC as swaps unless the Treasury, after review subject to certain conditions, determines otherwise. Spot FX is excluded from the new regulatory construct.
OTC Swaps Push Out. The Act requires all banks to move OTC swaps trading involving commodities, energy, metals (excluding gold and silver), agriculture, equities, below investment-grade credit default swaps (“CDS”), and all non-cleared CDS to be conducted in separately capitalized bank holding company affiliates which would not benefit from federally insured deposits and other forms of federal assistance (including future government bail outs). Banks have a transition period of up to two years (which may be extended another year by applicable federal banking authorities) to shift these activities into separately capitalized bank holding company affiliates. Banks are permitted to maintain OTC trading in more traditionally bank trading activities such as interest rates, foreign exchange, investment-grade CDS that are cleared, gold and silver, and any transaction to “used to hedge risk.”
The likely impact of these provisions will depend on the implementing regulations promulgated by the SEC, CFTC and FRB. For example, if interpreted broadly, the provision allowing banks to maintain OTC trading in transactions to “hedge risk” could allow banks to retain a significant percentage of their swap activities within the bank.
Standardized Swaps Clearing and Execution; Margining. The Act significantly restructures swap trading and execution. Swap dealers, security-based swap dealers, major swap participants and major security-based swap participants will be required to clear all standardized swaps approved by the CFTC and SEC through clearinghouses that have been registered with the CFTC and SEC. This requirement will not apply to swaps entered into prior to the enactment of the Act or entered into prior to the application of the clearing requirement provided they have been reported to the CFTC or SEC, as applicable, or to a swaps data repository. Similarly, all standardized swaps that are subject to the clearing requirement must be traded through a designated contract maker, a swap execution facility or an exchange. Any end-user (i.e., any entity that uses swaps to hedge risk from exposure to commodities or other risks) will be exempt from these requirements for any swap used to hedge such risk provided it notifies the CFTC or SEC, as applicable, as to how it generally meets its financial obligations associated with the non-cleared swaps.
All non-cleared swaps, including potentially those entered into by end-users, are subject to initial and variation margin to be determined by the SEC and CFTC in consultation with the prudential regulator. This requirement, which also relates to existing swaps, has caught the attention of both the dealer and end-user community as estimates of the new capital required to collateralize these positions have ranged as high as US$1 trillion dollars. Congressional testimony in connection with the Act clarifies that non-cleared swaps with end-users are not intended to be subject to the initial and variation margin requirement for non-cleared swaps. Margin requirements for non-exchange traded swaps are likely to exceed the required clearinghouse/exchange-traded margin as a motivation to increase trading in standardized swaps.
The use of clearinghouses will lower, but not eliminate, the risk of counterparty default, and will also create certain new risks and costs. While each end-user is exempt from the central clearing requirements, its counterparty in most swap transactions will be a bank or major swap participant who will be required to post margin to the clearinghouse. The margin requirements likely will be higher than the collateral levels typically posted by dealers to clients in the OTC market, and this increased cost could decrease the availability of hedge transactions and increase the price charged to end-users or require greater collateral requirements from the end-user to the dealer than presently existing in the market. Further, exchange-traded derivatives are by definition standardized, which significantly impairs the ability to perfectly hedge risk. Therefore, parties could be forced to either accept some unhedged risk or suffer the higher costs (and for swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, higher margin requirements) of executing a bespoke OTC transaction to fully hedge these exposures.
In addition, end-users may need to limit trading to avoid inadvertently becoming a “major swap participant” or “major security-based swap participant” defined generally to include one who (i) maintains a substantial net swap position, excluding positions held primarily for hedging, reducing, or otherwise mitigating commercial risk, or (ii) whose failure to perform under the swaps would cause significant credit losses to its counterparties. The clearinghouse structure will not fully eliminate the risk of counterparty failure, as end-users will not be using the central clearing system and thus dealers will retain the credit risk of such parties. The market will also retain the risk of performance failure by the clearinghouse itself, potentially requiring government assistance in the event of a significant financial crisis. However, the requirement for standardized swaps to clear through a clearinghouse and trade on an exchange will improve market transparency and provide regulators important tools for monitoring and responding to market risks and conditions.
Fiduciary Duties with Respect to Certain Plans, Funds and Government Entities. The Act requires banks acting as a counterparty to pension or endowment funds, or federal, state or local governments, to disclose the capacity in which they are acting and have a reasonable basis to believe that the fund or governmental entity has an independent representative advising them. This requirement will shift responsibility for selecting these independent financial advisors to banks and may create unforeseen liability for banks. As a result, banks may be less willing to trade with these entities, thus limiting their ability to hedge certain risks.
CDS Not to be Treated as Insurance by State Insurance Regulators. In an apparent response to recent state insurance regulatory proposals to regulate credit default swaps as insurance under local state law, the Act states that swaps are not insurance contracts and may not be regulated by local state insurance regulators.
Prohibition of Futures Contracts or Options on Motion Picture Box Office Receipts. The Act prohibits futures or commodity options on motion picture box office receipts (or any index, measure, value or data related to such receipts), making movie receipts and onions the only two commodities on which futures contracts and options are prohibited.
Reporting and Oversight. The Act significantly increases the government’s right to information and control of required capital limits. All swap dealers, security-based swap dealers, major swap participants and major security-based swap participants must register with the appropriate commission, comply with new code of conduct rules, maintain books and records including trading reports, and report all swap transactions (i.e., those swaps not executed on an exchange or cleared through a clearinghouse) traded by such entity. In addition, the Act requires the SEC and CFTC, as applicable, to establish position limits that may be held by an entity on particular swap positions (other than swaps used for hedging). Finally, the SEC is allowed to adopt rules to require security-based swaps be subject to Sections 13 and 16 of the Securities Exchange Act of 1934.
The Act generally requires securitizers to retain not less than 5% of the credit risk of any asset transferred, sold or conveyed through the issuance of an asset-backed security. Securitizers may be permitted to retain less than 5% of the credit risk if the originators of the underlying assets meet certain underwriting standards to be imposed by regulators. Regulators may prescribe rules allocating these risk retention obligations between the securitizer and the originator. The Act prohibits securitizers from directly or indirectly hedging or otherwise transferring the risk required to be retained.
Regulators will establish specific risk retention rules for different asset classes, including residential mortgages, commercial mortgages, commercial loans, auto loans, and any other class of assets that the regulators deem appropriate. Exempted asset classes initially will include any residential, multi-family or health care facility mortgage loan asset, or a securitization based directly or indirectly on such an asset, which is insured or guaranteed by the federal government or an agency of the federal government, with the exception of Fannie Mae, Freddie Mac and the federal home loan banks. Loans insured, guaranteed or administered by HUD, the Rural Housing Service and the Department of Veterans Affairs also will be exempt, as will “qualified residential mortgages,” a term to be defined by regulation.
Regulators will have sweeping power to provide for a total or partial exemption of any securitization, as may be appropriate in the public interest and for the protection of investors.
The Act also requires increased disclosure and reporting requirements for publicly issued asset-backed securities. New regulations will require disclosure of asset-level data necessary for investors to independently perform due diligence, in a format that facilitates comparison of the data across securities in similar types of asset classes, as well as broker or originator compensation and the amount of risk retention by the originator and the securitizer. Securitizers of these assets will be required to disclose fulfilled and unfulfilled repurchase requests across all trusts aggregated by them. The Commission also will prescribe regulations on the use of representations and warranties in the market for asset-backed securities that require credit rating agencies to include in any report accompanying a credit rating a description of representations, warranties and enforcement mechanisms available to investors and how they differ from the representations, warranties and enforcement mechanisms in issuances of similar securities.
Further, any underwriter, placement agent, initial purchaser or sponsor of a securitization, and any of their subsidiaries or affiliates, will be prohibited from engaging in any transaction during the first year following initial issuance that would present a material conflict of interest for any investor in the securitization. Certain risk-mitigating hedging transactions and trading of asset-backed securities for market-making and liquidity purposes will be exempt.
The effects on the securitization markets of these new risk retention and disclosure rules are expected to vary by asset class and cannot adequately be evaluated in isolation. Once definitive rules are adopted, they will require harmonization with proposed rulemaking by the FDIC concerning risk retention and prospective changes to Regulation AB. For securitizations structured as off-balance sheet financing arrangements, the proposals by the Financial Accounting Standards Board concerning expanded use of market values for financial assets, such as loans, will be yet another area to watch.
VIII. Credit Rating Agencies.
The Act creates a significant new monitoring, disclosure and oversight regimes for credit rating agencies, including the Nationally Recognized Statistical Ratings Organizations (“NRSROs”). Structurally, the Act creates a new Office of Credit Ratings at the SEC, with its own dedicated compliance staff and enforcement authority. The SEC is required to examine the NRSROs on an annual basis and may suspend or deregister any NRSRO that does not have adequate financial and managerial resources to “consistently produce credit ratings with integrity.”
Enhanced Disclosure of Ratings Methodologies and Performance. The Act requires NRSROs to disclose their ratings methodologies (including underlying assumptions and qualitative and quantitative inputs) and use of third parties diligence in connection with the rating of any asset-backed security. Among other things, NRSROs must identify the “volatility” of the credit rating, including the expected probability of default and expected magnitude of loss in the event of default. The Act directs the SEC to promulgate new disclosure rules requiring NRSROs to provide their initial rating determination with respect to any obligor, security or money market instrument such that investors can compare ratings performance across NRSROs.
Governance and Reporting Requirements. The Act adopts new governance and compliance requirements for NRSROs. Among other things, the Act requires at least half (and no fewer than two) of the directors of any NRSRO to be independent, and prohibits NRSRO compliance officers from working on ratings, ratings methodologies or sales. The Act further requires NRSROs to conduct a one-year look back on any employee who goes to work for an obligor or underwriter of a security or money market instrument that is subject to NRSRO rating. The Act also requires NRSROs to report to the SEC any employee who goes to work for an entity which the NRSRO has rated in the last twelve months. NRSROs should use the one-year implementation period under the Act to enact new internal governance and compliance frameworks to reflect these new requirements.
Liability for Ratings. The Act creates new potential liabilities for credit rating agencies. Specifically, the Act creates an explicit private right of action for investors against credit rating agencies for knowing or reckless failure to conduct a reasonable investigation of the facts underlying a rating decision, or failure to obtain such analysis from an independent source. In addition, the Act nullifies Rule 436(g), promulgated under the Securities Act of 1993, which had provided an exemption for credit rating agencies from certain liability in connection with registered offerings. (The SEC previously had sought public comment on whether to rescind or significantly modify the rule.) The Act also eliminates the credit rating agency exemption from Regulation FD, potentially exposing NRSROs to enforcement actions in connection with the disclosure of material non-public information in connection with securities offerings.
Rating agencies should expect to see an increase in private litigation and/or enforcement actions as a result of these changes. Particularly with respect to Regulation FD and Rule 436(g) issues, NRSROs should consider proactively implementing compliance programs to train personnel on the requirements of those rules and regulations.
If you would like to discuss this matter further, please contact Brian Brooks, Chair of the Financial Services Practice Group, at (202) 383-5127, any of the following lawyers, or your primary contact at O’Melveny & Myers LLP.
The Act defines “abusive” practices to include any act or practice that: “(1) materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service; or (2) takes unreasonable advantage of— (A) a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service; (B) the inability of the consumer to protect the interests of the consumer in selecting or using a consumer financial product or service; or (C) the reasonable reliance by the consumer on a covered person to act in the interests of the consumer.” Sec. 1031(d).
The Act creates other potential price distortions in its exclusion of certain entities, specifically motor vehicle dealers and community banks, from CFPB rules and enforcement authority. To the extent the excluded entities are allowed to issue the same products and services as CFPB-regulated entities, we can expect to see pricing differentials emerge across the same products and, potentially, see industry participants change their corporate forms to take advantage of the regulatory exclusions.
 Nonvoting members include the Director of the Office of Financial Research (a newly created office within Treasury), the Director of the Federal Insurance Office (a newly created agency), a State insurance commissioner, to be designated by a selection process determined by the State insurance commissioners, a State banking supervisor, to be designated by a selection process determined by the State banking supervisors, and a State securities commissioner (or an officer performing like functions), to be designated by a selection process determined by such State securities commissioners.
The Act defines a “private fund” as a fund that would be an investment company under Section 3 of the Investment Company Act of 1940, as amended (the “1940 Act”) but for the exceptions in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act.
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