Congress Passes Financial Reform Legislation

19 July 2010 Publication
Authors: Heidi H. Jeffery George T. Simon Kathryn M. Trkla

Legal News Alert

On July 16, 2010, the U.S. Senate approved the conference version of the financial reform legislation, entitled the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act); this follows House approval on June 30. President Obama is expected to sign the legislation into law this week. The Act is approximately 2,000 pages, amends many federal laws, and covers a large number of issues. As a service to our clients, we are providing a short summary of portions of the legislation that we feel will be of particular interest to them. We will be supplementing this Legal News Alert in the future with more detailed analyses of various sections of the bill.

1. Regulation of Advisors to Hedge Funds

a. Subject to certain exceptions, the Act requires the registration of any person that acts as an investment adviser to any “private fund.” A private fund is defined to include any company that would be an investment company except for the provisions of Section 3(c)(1) (owned by less than 100 persons) or 3(c)(7) (owned entirely by qualified purchasers).

b. Exclusions are provided for:

i. Foreign private advisers that a) have no place of business in the United States, b) have fewer than 15 clients/investors in the United States in private funds advised by the investment adviser, c) have assets under management attributable to U.S. clients in private funds advised by the investment adviser of less than $25 million, or such higher amount as the Securities and Exchange Commission (SEC) may determine by rule, and d) neither holds itself out generally in the United States as an investment adviser nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940.

ii. Any investment advisor registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor unless its business predominantly becomes the provision of securities-related advice to a private fund.

iii. Any investment adviser that solely advises small business investment companies under the Small Business Investment Act of 1958.

iv. Any venture capital fund adviser that acts as an investment adviser solely to one or more “venture capital funds” as defined by the SEC within one year.

v. Any investment adviser that acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million.

vi. Any family office as defined by the SEC in a manner that is consistent with the previous exemptive policy for family offices.

c. The Act enables the SEC to require investment advisers to maintain records and file reports with the SEC regarding private funds advised by the investment adviser and to make available to the Financial Stability Oversight Council (Council) the reports, records, or information subject to the confidentiality provisions.

d. The records and reports required to be maintained by the investment adviser may include, for each private fund: 1) the amount of assets under management and use of leverage, including off-balance sheet leverage, 2) counterparty and credit risk exposure, 3) trading and investment positions, 4) valuation policies/practices of the fund, 5) types of assets held, 6) side arrangements/letters whereby certain investors obtain more favorable rights or entitlements, 7) trading practices, and 8) such other information the SEC and Council deem necessary.

e. The investment adviser provisions become effective one year after the date of the enactment of the Act.

2. Regulation of Derivatives

a. The Act provides for comprehensive regulation of swaps, through extensive amendments to the Commodity Exchange Act (CEA) and Securities Exchange Act of 1934 (1934 Act). As a general matter, the CFTC is responsible for implementing the provisions pertaining to swaps other than security-based swaps, and the SEC is responsible for implementing the provisions pertaining to security-based swaps. However, the two agencies will jointly regulate mixed swaps, which are a type of security-based swap with a commodity component.

b. The Federal Reserve Board (FRB), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Agency, called the “prudential regulators,” are given certain authority over banks, bank affiliates, or others subject to their oversight that act as swap dealers, security-based swap dealers, major swap participants, or major security-based swap participants. In particular, they are responsible for adopting capital requirements and margin requirements for uncleared swaps for any such entities, in lieu of the CFTC or SEC.

c. The “swap” definition covers options, traditional interest rate and other swaps, event contracts, instruments that become commonly known as swaps, and combinations or permutations of, or options on, the foregoing. The definition excludes, among other things, transactions involving nonfinancial commodities for deferred delivery if the parties intend to physically settle the transaction.

d. Foreign exchange forwards and swaps are covered by the swap definition, but the Secretary of the Treasury has the authority to exempt either or both from most regulation as swaps under the CEA, if it determines that such contracts are not structured to evade the legislation.

e. The definition of “security-based swap” covers swaps that are based on 1) a narrow-based index of securities, including any interest therein or on the value thereof; 2) a single security or loan, including any interest therein or on the value thereof; or 3) the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issue or the issuers of securities in a narrow-based security index, if the event directly affects the financial statements, condition, or obligations of the issuer. The definition covers options on Treasury securities, but not other swap structures on Treasury securities, which are excluded from the definition.

f. Persons acting as a swap dealer or major swap participant with respect to swaps must register in that capacity with the CFTC. Persons acting as a swap dealer or major swap participant with respect to security-based swaps must register as a security-based swap dealer or major security-based swap participant with the SEC.

g. A person is a swap dealer if it holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps for its own account in the ordinary course of business; or engages in activities causing the person to be commonly known as a dealer or market maker in swaps. A person may be a swap dealer for a single type, class, or category of swap or security-based swap and not for others.

h. A person is a major swap participant if it is not a dealer but 1) maintains a substantial position in outstanding swaps for any major swap category or security-based swap category, excluding positions held for hedging or mitigating commercial risk; 2) its outstanding swaps create substantial counterparty exposure that could have a serious adverse effect on the financial stability of the U.S. financial markets; or 3) it is a financial entity that is highly leveraged relative to the amount of capital it holds, is not subject to capital requirements established by a federal banking agency, and maintains a substantial position in outstanding swaps for any major category of swap or security-based swap. A person may be designated as a major swap participant for one or more categories of swap or security-based swap.

i. Swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants will have to comply with various requirements, ranging from business conduct practices, capital requirements, margin requirements, swap documentation practices, and requirements to designate a chief compliance officer.

j. The CFTC and SEC may require categories of swaps or security-based swaps to be subject to mandatory clearing. Once a category of swap or security-based swap is designated, it will be unlawful for a person to enter into a swap transaction of that type unless it is cleared through a registered or exempt clearing organization.

k. Once mandatory clearing is implemented for any category of swap or security-based swap, transactions in those instruments must be traded on a CFTC- or SEC-regulated exchange or swap execution facility, unless no such centralized market exists offering the instrument for trading.

l. Once mandatory clearing applies to a category of swap or security-based swap, transactions in that instrument may nonetheless be exempt from clearing and centralized trading requirements if 1) one of the parties to the transaction is not a financial entity; 2) it is using swaps or security-based swaps to hedge or mitigate commercial risk; and 3) it can demonstrate to the CFTC or SEC how it generally meets its financial obligations under its non-cleared swap or security-based swap transactions. Swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants, among others, are considered to be financial entities.

m. Transactions that are not cleared must be reported to a swap data repository registered with the CFTC or SEC, or to the CFTC or SEC if a swap data repository that will accept the transaction report is not available. Margin requirements also will apply to swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants with respect to their uncleared transactions. They also may be subject to requirements to hold funds posted by an end user counterparty to margin or secure the end user’s obligations on a segregated basis, without comingling with their own funds. The counterparties to uncleared transactions in swaps or security-based swaps must be eligible contract participants under the CEA definition.

n. Although the mandatory clearing provisions will not apply to transactions that are open when those provisions are implemented, the margin requirements described above will apply to those positions.

o. Both the CEA and the 1934 Act are amended to permit CFTC and SEC regulation of swap and security-based swap trading facilities and clearing organizations. Swap and security-based swap trading facilities that are not designated contract markets or registered national securities exchanges must limit participation in their markets to eligible contract participants. Designated contract markets and registered national securities exchanges are not subject to the same market participant limitation.

p. Clearing facilities for swaps or security-based swaps must accept swap transactions on a non-discriminatory basis whether executed on an OTC basis or on an affiliated or unaffiliated exchange or swap execution facility, and must permit swaps with the same terms and conditions to be offset against one another within the facility.

q. The CFTC and SEC are required to adopt rules to implement real-time public reporting of transaction data for swaps and security-based swaps, including OTC transactions. The reported data must include price and volume, but must not identify the parties to the trade. The amendments are silent on whether the CFTC or SEC should try to consolidate price and volume data from the various market facilities they regulate into consolidated streams of market data for swaps or for security-based swaps.

r. Unless otherwise specified in a specific statutory provision, the amendments take effect on the later to occur of 1) 360 days after enactment or 2) where rulemaking is required, no sooner than 60 days after publication of the final rules.

3. Limitations on Bank Trading in Derivatives

a. The Act prohibits a bank from engaging in certain swaps activities, forcing it either to cease engaging in the non-permitted activities or to move them to an affiliate before the ban takes effect. This is accomplished indirectly by banning federal assistance to a bank that engages in non-permitted swap activities, whether the assistance is with respect to its swaps activities or other activities.

b. Federal assistance means use of any advances from any Federal Reserve credit facility or discount window (that is not part of a program/facility with broad-based eligibility), FDIC insurance, or guarantees for the purpose of 1) making a loan to or purchasing equity or debt obligation of any the swap entity; 2) purchasing the assets of the entity; 3) guaranteeing any loan or debt issuance of swap entity; or 4) entering into any assistance arrangement (including tax breaks) or loss or profit sharing with the swap entity.

c. The restrictions do not apply for the first two years following enactment, which is allowed as a transition period during which a bank is expected to take steps to move the non-permitted swaps activities to an affiliate, or to wind down those activities. Banking regulators may, after consultation with the CFTC and SEC, extend the transition period up to one year. The restrictions do not apply to swaps executed during the transition period.

d. After the transaction period, a bank is permitted to directly engage in the following swap activities:

i. It may enter into swaps for hedging and risk mitigation directly related to its banking activities.

ii. It may enter into swaps involving rates or reference assets that are permissible bank investments under 12 U.S.C. § 24, paragraph Seventh. Those include:

1) U.S. Treasuries and certain other government debt securities
2) Foreign exchange
3) Bullion
4) Marketable debt securities, subject to the further condition in the case of credit default swaps that the swaps must be cleared

iii. It may enter into swaps with customers in connection with originating loans with those customers.

e. Affiliates of bank holding companies and savings and loan holding companies supervised by the Federal Reserve may engage in a broad range of swap activities.

i. The Act uses a confusing nomenclature by defining a “security-based swap” as any swap based on a security and defining a “swap” as any swap that is not a security-based swap other than a “mixed swap.”

ii. A bank affiliate may engage in swaps activities as a swap dealer, security-based swap dealer, major swap participant, or major security-based swap participant, including those not permitted in the bank, as long as the affiliate complies with certain provisions of the Federal Reserve Act and other requirements imposed by the CFTC or SEC, as appropriate, and the FRB.

f. For permitted bank swap activities and for swap activities of a bank affiliate, the bank and affiliate will be subject to compliance with standards set by their prudential regulator.

g. On an institution-by-institution basis, the Council may cut off the bank or bank affiliate’s access to federal assistance if it determines that other provisions of the Act are insufficient to mitigate systemic risk and to protect taxpayers.

4. Other Limitations on Bank Trading Activities

a. Subject to various exceptions, banks and their affiliates are prohibited from engaging in proprietary trading of securities, derivatives, futures, options on such securities, derivatives, or futures, or any other security or financial instruments (collectively, Financial Instruments), as determined by the federal banking agencies, SEC, and CFTC.

b. The exceptions to the general ban include the:

i. Purchase or sale of Financial Instruments in connection with market-making activities, to the extent they are designed not to exceed the reasonably expected near-term demands of customer or counterparties.

ii. Purchase or sale of Financial Instruments on behalf of customers.

iii. Purchase or sale of Financial Instruments as a part of risk-mitigating hedging activities.

c. A bank holding company or savings and loan holding company nonbank affiliate supervised by the FRB is not subject to a proprietary trading ban but is subject to capital requirements and quantitative limits with respect to its proprietary trading of Financial Instruments as determined by the federal banking agencies, SEC, and CFTC.

d. The Council must complete a study within six months of enactment of this section.

e. Within nine months of that study, the federal banking regulators, SEC, and CFTC must adopt rules implementing this section. The Council is responsible for coordinating rules issued under this section. The agencies are required to consult with one another to assure, to the extent possible, that their rules are comparable and provide for consistent application of provisions.

f. The provisions take effect on the earlier of 12 months after issuance of final rules by the various regulators under this section or two years after the date of enactment of the Act.

5. Regulation of Credit Rating Agencies

a. The Act requires nationally recognized statistical rating organizations (NRSROs) to establish and document internal controls concerning the methodologies and policies for determining credit ratings, and to submit an annual internal controls report to the SEC. This report must be attested to by the CEO of the NRSRO, must describe the management’s role in implementing the internal controls, and must evaluate the effectiveness of the control structure.

b. The Act gives the SEC the ability to sanction individuals associated with an NRSRO for failure to reasonably supervise an individual who violates the securities laws.

c. The SEC will have the authority to temporarily suspend or permanently revoke the registration of an NRSRO, with respect to a particular class of securities, if it finds that the NRSRO does not have the resources to consistently produce credit ratings with integrity.

d. The Act requires the SEC to adopt rules to prevent sales and marketing practices of NRSROs from influencing credit ratings. The SEC may suspend or revoke the registration of an organization for violating these rules.

e. NRSROs will be required to implement policies and procedures to limit potential conflicts of interest when an employee of the NRSRO has previously worked with an issuer, underwriter, or sponsor of a money market instrument.

f. The Act imposes limitations on the role of the designated compliance officer within each NRSRO. The designated compliance officer may not perform credit ratings, participate in the development of ratings, engage in marketing or sales functions, or assist in establishing compensation levels for employees not working directly for the compliance officer. The compensation for this position may not be linked to the financial performance of the NRSRO. The compliance officer must submit an annual report to the NRSRO, and file the report with the SEC, detailing the compliance of the NRSRO with securities laws and with its own internal procedure and policies, and detailing any changes in ethical and conflict of interest policies.

g. The Act establishes an Office of Credit Ratings (Office) within the SEC to oversee NRSROs. The Office will conduct annual examinations of each NRSRO, reviewing the organization’s adherence to internal policies and procedures; its management of conflicts of interest; its implementation of ethics policies; its internal governance; the activities of its compliance officer; the processing of complaints; and the its policies for governing post-employment activities of former staff. A summary of this report will be made public.

h. The SEC must adopt rules regarding the procedures and methodologies used to produce credit ratings to ensure that these methods are approved by the board of an NRSRO, are applied consistently, and adhere to the internal policies and procedures of the NRSRO. If changes are made to methodologies and procedures, the NRSRO must notify users of the credit rating, must disclose the reason for the changes, must specify the version of the method used for a particular credit rating, and must identify whether the change in methodology will affect current credit ratings. NRSROs also must notify users if significant errors in procedures or methodologies are identified.

i. At least half of the board of directors of each NRSRO, but not fewer than two members of the board, must be independent directors who are uninvolved in the credit rating process, and whose compensation is not linked to the business performance of the NRSRO. Independent directors may serve for a pre-fixed, non-renewable period of time, not exceeding five years. The board is required to oversee the procedures for determining ratings, the policies and procedures for addressing conflicts of interest, the effectiveness of the internal control system, and the compensation and promotion policies.

j. Statements made by credit rating agencies will be subject to the same enforcement and penalty provisions as statements made by public accounting firms and securities analysts, and will not be considered forward-looking statements for purposes of the safe harbor provision of Section 21E of the 1934 Act.

k. The Act repeals SEC Rule 439(g), which exempted credit ratings by NRSROs from the requirements applying to experts under Sections 7 and 11 of the Securities Act of 1933 (1933 Act) when the ratings were part of a registration statement.

l. If an action for money damages is brought against an NRSRO for purposes of pleading, it is sufficient that the complaint describe facts giving rise to a strong inference that the NRSRO failed to conduct a reasonable investigation of the rated security with respect to the factual elements on which it relied, or failed to obtain reasonable verification of these factual elements.

6. Changes to the 1934 Act and Other Federal Securities Laws

a. Section 15 of the 1934 Act is amended to allow the SEC to promulgate rules providing that broker-dealers giving personalized investment advice about securities to a “retail customer” — a customer who uses such advice primarily for personal, family, or household purposes — may be subject to the same fiduciary duty as investment advisors.

b. The Act authorizes the SEC to promulgate rules to prohibit or place restrictions on the use of agreements requiring customers or clients of any broker, dealer, municipal securities dealer, or investment adviser to arbitrate future disputes involving federal securities law and regulations, or the rules of an SRO.

c. The anti-manipulation provisions of Sections 9, 10(a), and 15(c)(1) of the 1934 Act are expanded to cover transactions in the over-the-counter market.

d. The 1933 Act and the Investment Company Act of 1940 (1940 Act) are amended to provide that every person that “knowingly or recklessly provides substantial assistance to another” in violation of those acts or rules promulgated thereunder shall be deemed in violation of the acts to the same extent as the person to whom the assistance was rendered. Section 209 of the 1940 Act is amended such that the SEC may seek monetary damages in civil actions from “any person that knowingly or recklessly has aided, abetted, counseled, commanded, induced or procured” a violation of the act or rules. The 1934 Act is amended such that the standard of care for aiding and abetting violations in actions brought by the SEC for injunction or for money civil penalties includes recklessness.

e. The 1933 Act is amended to give the SEC the authority to impose civil penalties in cease-and-desist actions brought under Section 8A of the 1933 Act. The penalties are enumerated into three tiers: 1) a maximum of $7,500 for a natural person and $75,000 for any other person; 2) a maximum of $75,000 for a natural person and $375,000 for any other person for acts/omissions involving fraud, deceit, manipulation, or reckless disregard of a regulatory requirement; and 3) a maximum of $150,000 for a natural person and $725,000 for any other person for acts/omissions involving fraud, deceit, manipulation, or reckless disregard of a regulatory requirement that resulted in substantial losses or significant risk of substantial losses to others, or substantial pecuniary gain to the person who committed the act/omission.

f. The Act amends the 1933 Act, the 1934 Act, and the 1940 Act to provide federal court jurisdiction in any action brought by the SEC or the U.S. Attorney arising out of the fraud sections of those acts, involving 1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the transaction occurs outside of the United States and involves only foreign investors or foreign advisers, or 2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.

7. Securities Investor Protection Act (SIPA) Reforms

a. SIPA is amended to increase insurance for lost cash from $100,000 to $250,000, subject to subsequent inflation adjustments.

b. SIPA is amended to prohibit an SIPC member from entering into insolvency, receivership, or bankruptcy proceedings, under federal or state law without prior approval by SIPC.

8. Securities Self-Regulatory Organizations (SRO) Rule Filing Changes

a. Section 19 of the 1934 Act is amended to provide streamlined filing procedures for SROs. The SEC must approve, disapprove, or institute proceedings to determine whether disapproval is appropriate within 45 days, but not earlier than 30 days. The SEC may unilaterally extend this period by up to 45 days if a longer period is deemed appropriate. If the SEC institutes a proceeding to determine whether disapproval is appropriate, the SEC must provide timely written notice and conclude a hearing within 180 days (with the possibility of a 60-day extension) of the SRO’s initial filing.

b. A proposed SRO rule will be automatically approved if 1) the SEC fails to approve, disapprove, or commence proceedings within 45 days (90 days if an extension is granted) or 2) the SEC institutes proceedings to determine whether disapproval is appropriate and it does not issue an order approving or disapproving the proposed rule change within 180 days (240 days if an extension is granted).

c. After filing a proposed rule change with the SEC, an SRO may publish a notice of filing along with the substantive content of the proposed rule change on a publicly accessible Web site. Thereafter, the SEC must send notice to the Federal Register for publication of the proposed rule change within 15 days of Web site publication. If the SEC fails to send notice of publication to the Federal Register within 15 days, then the date on which the Web site publication was made shall be deemed the day of publication.

9. Municipal Securities

a. The 1934 Act is amended to require municipal financial advisers, municipal swap advisers, and investment brokers to register with the SEC and comply with rules issued by the Municipal Securities Rulemaking Board (MSRB).

b. The 1934 Act is amended to impose a new fiduciary duty on municipal financial advisers to ensure that they adhere to the highest standard of care when advising municipal issuers.

c. The 1934 Act is amended to require that at all times the MSRB have a majority of independent members. The MSRB must consist of no fewer than eight “public” members, including at least one representative of institutional or retail investors, one issuer official, and one municipal securities expert. The remaining seven members would consist of at least one representative from a securities firm, one from a bank firm, and one from a non-dealer municipal adviser.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or the following:


George T. Simon
Chair, Securities, Commodities & Exchange Regulation Practice
Chicago, Illinois

Kathryn M. Trkla
Chicago, Illinois

Miki Vucic Tesija
Chicago, Illinois

Heidi H. Jeffery
Chicago, Illinois


Matthew D. Friedlander
Meredith A. Shippee