Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The Treasury Department has proposed to exempt foreign exchange swaps and forwards from certain provisions of the Dodd-Frank Act that regulate derivative transactions.   Section 721 of the Dodd-Frank Act amends section 1a of the Commodity Exchange Act, or CEA, which defines the term “swap” under the CEA and includes foreign exchange swaps and foreign exchange forwards in the definition. Section 1a(47)(E) of the CEA authorizes the Secretary of the Treasury to make a written determination that foreign exchange swaps, or foreign exchange forwards, or both:

• should not be regulated as swaps under the CEA; and

• are not structured to evade the Dodd-Frank Act in violation of any rule promulgated by the CFTC pursuant to section 721(c) of the Dodd-Frank Act.

According to the Treasury Department, the FX swaps and forwards market is markedly different from other derivatives markets. Existing procedures in the FX swaps and forwards market mitigate risk and help ensure stability. Central clearing requirements will strengthen the rest of the derivatives market, but could actually jeopardize practices in the FX swaps and forwards market that help limit risk and ensure that it functions effectively. This market plays such an important role in helping businesses manage their everyday funding and investment needs throughout the world that disruptions to its operations could have serious negative economic consequences.

The Treasury Department warns that FX swaps and forwards will remain subject to Dodd-Frank’s rigorous new trade reporting requirements and business conduct standards. Additionally, the Dodd-Frank Act makes it illegal to use these instruments to evade other derivatives reforms. Importantly, the proposed determination does not extend to other FX derivatives, such as FX options, currency swaps, and non-deliverable forwards.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

Complementing its recently proposed rules establishing margin requirements for swap dealers (SDs) and major swap participants (MSPs), the CFTC proposed rules regarding capital requirements for these “covered swap entities” at yesterday’s open meeting. Although the Commission has not released the text of the rule yet, its announcements, fact sheet, and Q&A regarding the rules provide a basic outline of the new capital requirements.

The Capital Requirements

The capital requirements for an SD or MSP depend on whether the entity is a futures commission merchant (FCM) and, if not, whether it is a subsidiary of a U.S. bank holding company:

SDs and MSPs that are also FCMs

These SDs and MSPs would be required to meet existing FCM requirements to hold minimum levels of adjusted net capital, and also would be required to calculate the required minimum level as the greatest of the following:
• a fixed dollar amount, which under the proposed rules would be $20 million;
• the amount required for FCMs that also act as retail forex exchange dealers;
• 8 percent of the risk margin required for customer and non-customer exchange-traded futures positions and over-the-counter (OTC) swap positions that are cleared by a clearing organization;
• the amount of adjusted net capital required by a registered futures association of which the FCM is a member; and
• for an FCM that also is registered as a securities broker or dealer, the amount of net capital required by SEC rules.

SDs and MSPs that are not FCMs and are nonbank subsidiaries of U.S. bank holding companies

These SDs and MSPs would be required to meet the same capital requirements that U.S. banking regulations apply to the bank holding company. Generally, such banking regulations require a minimum ratio of qualifying total capital to risk-weighted assets of 8 percent, of which at least half, i.e., 4 percent, should be in the form of Tier 1 capital. The proposed rules also specify a minimum fixed dollar amount of at least $20 million of Tier 1 capital.

SDs and MSPs that are neither FCMs nor a bank holding company subsidiary as described above

These SDs and MSPs would be required to maintain tangible net equity equal to $20 million, plus additional amounts for market risk and over-the-counter derivatives credit risk. A firm’s tangible net equity generally would be based on net equity as determined under U.S. GAAP, minus intangibles such as goodwill.

Capital Calculations, Reporting, and Recordkeeping

SDs and MSPs will be required to use approved models for their capital calculations, but can apply for Commission approval of their own internal models. FCMs will be required to continue meeting current requirements for unaudited monthly financial reports and annual audited financial statements. SDs and MSPs that are not subject to supervision by a prudential regulator (e.g., the Federal Reserve Board) will be subject to similar financial condition reporting requirements under the proposed rules.

We noted recently, and skeptically,  bank regulators’ broken record like drone about how Dodd-Frank is good for community banks.  Community bankers seem to have taken notice as well, and are not buying the regulators’ story.

In a letter to Sheila Bair, Chairman of the FDIC, the American Bankers Association noted the following:

  • Dodd-Frank dramatically constricts the sources of capital for many community banks even while regulators and examiners are demanding more capital.
  • Significant and possibly burdensome new reporting requirements that may be imposed by the Consumer Financial Protection Bureau and the Office of Financial Research.
  • Dodd-Frank imposes dramatically more burdensome requirements on mortgage lending, which can only be avoided for loans called “Qualified Residential Mortgages.” This will be especially harmful for community banks, because loans outside the safe harbor will require additional capital that is especially difficult and costly for smaller institutions to raise.
  • Many of what may appear to be benefits of Dodd-Frank are likely to be fleeting. The change in assessment base for deposit insurance premiums is likely to provide only temporary advantage at best for many community banks.

Some of these points and more were set forth in this testimony by the American Bankers Association before a Congressional committee.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

Deputy Secretary of the Treasury Neal Wolin gave another plug for the benefits of Dodd-Frank for community banks on the Treasury Department blog.  It’s as if all the regulators keep saying the same things over and over they hope the bankers will eventually believe that Dodd-Frank is all up side and no down side.  See previous statements by Mr. Bernanke and Ms. Bair here.

Mr. Wolin noted the following:

  • The Dodd-Frank Act raises deposit insurance protection to $250,000, providing greater protection for one of community banks’ core sources of funding. 
  • Dodd-Frank ensures that the cost of deposit insurance is born by the institutions that engage in the riskiest activities and that, consequently, benefit the most from its protection.  Dodd-Frank does this by requiring insurance premiums to be based on total liabilities, which are a more accurate reflection of risk than deposits alone.  As a result, the premium burden will shift away from smaller institutions to larger, riskier banks.
  • Dodd-Frank provides that large financial institutions will be subject to heightened prudential standards, including requirements to hold more capital and maintain larger liquidity buffers. Community banks, which do not pose the same type of risks to the system as large firms, will not be subject to these obligations.
  • Dodd-Frank levels the playing field between small banks and nonbank financial service providers, such as payday lenders and independent mortgage brokers. Dodd-Frank corrects this deficiency by giving federal regulators the ability to regularly examine nonbank financial services providers and to prohibit unfair and deceptive practices in which they may engage.
  • Dodd-Frank works to protect small banks from excessive supervisory burdens. The regulator responsible for  monitoring the safety and soundness of community banks will also bear responsibility for enforcing rules promulgated by the new Consumer Financial Protection Bureau. This will allow small banks to avoid multiple exams.
  • The Dodd-Frank Act reduces the unfair funding advantages enjoyed by the largest institutions prior to the crisis by setting out a process for those institutions to be wound down, broken apart, and liquidated when facing imminent failure. 

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC has proposed rules that would remove references to credit ratings in several rules under the Exchange Act.  These proposals represent the next step in a series of actions taken under the Dodd-Frank Wall Street Reform and Consumer Protection Act to remove references to credit ratings within agency rules and, where appropriate, replace them with alternative criteria.  Under Dodd-Frank, federal agencies must review how their existing regulations rely on credit ratings as an assessment of creditworthiness. At the conclusion of this review, each agency is required to report to Congress on how the agency modified these references to replace them with alternative standards that the agency determined to be appropriate.

The proposal addresses the following topics:

  • Removing References to Credit Ratings in the SEC’s Net Capital Rule for Broker-Dealers
  • Removing References to Credit Ratings in the Definition of “Major Market Foreign Currency”
  • Removing References to Credit Ratings When Determining Net Capital Charges for Credit Risk
  • Removing References to Credit Ratings in Rule 15c3-3
  • Removing References to Credit Ratings in Rules 101 and 102 of Regulation M
  • Removing References to Credit Ratings in Rule 10b-10

The SEC is also is requesting comment on potential standards of creditworthiness for purposes of Exchange Act Sections 3(a)(41) and 3(a)(53), which define the terms “mortgage related security” and “small business related security,” respectively, as the SEC considers how to implement Section 939(e) of the Dodd-Frank Act.

In a statement at the meeting in which the rules were adopted, Commissioner Luis A. Aguilar said “In order to generate comments on today’s proposal, I will support the proposal, but I have serious concerns. As one example, I am troubled about the proposed amendments to Rule 15c3-1, the net capital rule, because it does not appear that we have been able to identify an appropriate substitute for credit ratings.”  He continued quoting a commentator on a previous proposed rule that “[T]here is an inherent conflict of interest involved in allowing broker-dealers to evaluate the credit risk of the securities they hold, and thereby determine how much capital they must hold against those securities. Such a system creates an incentive for broker-dealers to overestimate the creditworthiness of those securities so as to minimize the amount of required capital and thereby to minimize the broker-dealer’s costs.”

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC released a study that was under Section 989G(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The Dodd Frank Act required the SEC to conduct a study to determine how the SEC could reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act of 2002 for companies whose market capitalization is between $75 and $250 million, while maintaining investor protections for such companies.  Section 989G(b) also provides that the study must consider whether any methods of reducing the compliance burden or a complete exemption for such companies from Section 404(b) compliance would encourage companies to list on exchanges in the United States in their initial public offerings.

The study addressed the auditor attestation requirement with respect to an issuer’s internal control over financial reporting, or ICFR, pursuant to Section 404(b) as required by Section 989G(b) of the Dodd-Frank Act.  It did not address management’s responsibility for reporting on the effectiveness of ICFR pursuant to Section 404(a) of the Sarbanes-Oxley Act.

The SEC Staff believes that the existing investor protections for accelerated filers to comply with the auditor attestation provisions of Section 404(b) should be maintained (i.e., no new exemptions). There is strong evidence that the auditor‘s role in auditing the effectiveness of ICFR improves the reliability of internal control disclosures and financial reporting overall and is useful to investors. The Staff did not find any specific evidence that such potential savings would justify the loss of investor protections and benefits to issuers subject to the study, given the auditor’s obligations to perform procedures to evaluate internal controls even when the auditor is not performing an integrated audit.  

The Staff also concluded that  while the research regarding the reasons for listing decisions is inconclusive, the evidence does not suggest that granting an exemption to issuers that would expect to have $75-$250 million in public float following an IPO would, by itself, encourage companies in the United States or abroad to list their IPOs in the United States.  The Staff acknowledged that the reasons a company may choose to undertake an IPO are varied and complex. The reasons are often specific to the company, with each company making the decision as to whether and where to go public based on its own situation and the market factors present at the time. The costs associated with conducting an IPO and becoming a public company no doubt factor into the decisions and may be particularly challenging for smaller companies.   However, the Dodd-Frank Act already exempted approximately 60% of reporting issuers from Section 404(b), and the Staff does not recommend further extending this exemption.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

Last year at Occidental Petroleum, shareholders voted against Occidental’s voluntary say-on-pay vote.  This year, according to recently filed additional soliciting material, ISS has supported Occidental’s say-on-pay proposal.

However, this year ISS has recommended shareholders vote against the five directors on the company’s nominating committee and Ray Irani, Occidental’s Chairman of the Board and CEO.  ISS bases this recommendation on its assertion that, “The appointment of the Executive Chair for a three-year term is not in the best interests of shareholders.”   It is no surprise that Occidental strongly disagrees with this ISS recommendation and believes that ISS’ analysis is deeply flawed.

Some of Occidental’s main points are:

  • Its business is successful.
  • As a result of last year’s failed say-on-pay vote, they met with shareholders and learned that the shareholders were extremely supportive of the company’s leadership, just not the level of compensation.
  • Last year’s say-on-pay vote dealt only with compensation and not with Mr. Irani’s leadership abilities.
  • ISS’ view on the merits of an Executive Chairman is theoretical and Occidental’s Board has to operate in the real world.

 Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The Federal Reserve Board has requested public comment on a proposed rule under Regulation Z that would require creditors to determine a consumer’s ability to repay a mortgage before making the loan and would establish minimum mortgage underwriting standards.

The revisions to the regulation, which implements the Truth in Lending Act, or TILA, are being made pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The proposal would apply to all consumer mortgages (except home equity lines of credit, timeshare plans, reverse mortgages, or temporary loans).

Consistent with the Dodd-Frank Act, the proposal would provide four options for complying with the ability-to-repay requirement:

  • First, a creditor can meet the general ability-to-repay standard by considering and verifying specified underwriting factors, such as the consumer’s income or assets.
  • Second, a creditor can make a “qualified mortgage,” which provides the creditor with special protection from liability provided the loan does not have certain features, such as negative amortization; the fees are within specified limits; and the creditor underwrites the mortgage payment using the maximum interest rate in the first five years. The Board is soliciting comment on two alternative approaches for defining a “qualified mortgage.”
  • Third, a creditor operating predominantly in rural or underserved areas can make a balloon-payment qualified mortgage. This option is meant to preserve access to credit for consumers located in rural or underserved areas where banks originate balloon loans to hedge against interest rate risk for loans held in portfolio.
  • Finally, a creditor can refinance a “non-standard mortgage” with risky features into a more stable “standard mortgage” with a lower monthly payment. This option is meant to preserve access to streamlined refinancings.

The proposal would also implement the Dodd-Frank Act’s limits on prepayment penalties.

The Board is soliciting comment on the proposed rule until July 22, 2011. General rulemaking authority for TILA is scheduled to transfer to the Consumer Financial Protection Bureau on July 21, 2011. Accordingly, this rulemaking will not be finalized by the Board.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

 

The standard advice for the non-binding shareholder referendum on say-on-pay is to put an executive summary on compensation in your proxy statement’s CD&A and emphasize the pay for performance link.  That of course works, but shareholders have to dig through the proxy statement and find it.  That is not always likely to happen, especially with a retail base.

 

Exxon Mobil seems to have found a solution by filing additional materials that look like they will be mailed to shareholders with the proxy statement.  The materials emphasize the independence of the compensation committee, the pay-for-performance link and risks management relative to compensation practices.  It looks like additional printing costs may be incurred but perhaps those costs are worth it to avoid confusion and educate shareholders.

 

Goldman Sachs has taken a similar but different approach.  Goldman’s additional materials look like a PowerPoint show to walk key shareholders through corporate governance and compensation materials.  Getting out in front of the issues with definitive materials and a contact list cannot hurt.

 

Both examples show how “complicated” proxy season’s strategies can become.  We suspect we will see other original approaches as well.

 

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

Deputy Secretary Neal Wolin delivered remarks on the implementation of Wall Street reform legislation at the Pew Charitable Trusts. In his remarks, Wolin discussed the importance of moving forward quickly, carefully and responsibly to implement the critical protections in the Dodd-Frank Wall Street Reform and Consumer Protection Act. 
Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.