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

The SEC has begun to issue comments on Dodd-Frank disclosures included in SEC filings.  While perhaps the comments to date are not great in number, they demonstrate the SEC is capable of asking difficult questions about the impact of Dodd-Frank on an issuer’s operations.  We recommend that issuers consider the impact of Dodd-Frank when preparing their Form 10-Ks and other disclosure documents.  The more significant comments we noted are set forth below.

FXCM Inc.:  The SEC comment stated in part “Based on your description of your CFD business in the prospectus, it appears that the CFDs would fall within the definition of swap under the current language of Section 206A of Gramm-Leach-Bliley and would fall within the definition of a swap under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Please explain in a detailed legal analysis how your proposed plan of business would operate under both the federal securities law and the Commodity Exchange Act.” 

The issuer’s response, in part, stated “To the extent that CFDs were deemed to be swaps, futures, forwards or other instruments over which the CFTC has jurisdiction or will, as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, have jurisdiction in the future, the CFDs offered and sold by the Company’s non-U.S. subsidiaries would be fully outside of such jurisdiction since they are offered exclusively outside the U.S. and exclusively to non-U.S. persons. . . [citations omitted]  Further, Congress provided in Dodd-Frank that the CFTC’s jurisdiction over swaps would not generally reach swap transactions outside the U.S. Specifically, Dodd-Frank provides that the provisions of the Commodity Exchange Act relating to swaps shall not apply to transactions outside the U.S. unless they “ have a direct and significant connection with activities in, or effect on, commerce” in the U.S. or contravene rules promulgated by the CFTC to prevent the evasion of provisions of the Commodity Exchange Act related to swaps. Section 722(d) of Dodd-Frank (to be codified in Section 2(i) of the Commodity Exchange Act).”

Randgold Resources Limited:  The SEC comment stated “We note your operations in the Democratic Republic of the Congo (DRC) produce gold which is defined as a conflict mineral in the recent Dodd-Frank Wall Street Reform and Consumer Protection Act. With a view toward possible disclosure, tell us whether or not your mining operations acquire or purchase gold and/or other conflict minerals from local mining companies and/or artisanal miners.”  The issuer responded “The Company respectfully advises the Staff that the Company’s Kibali Project in the Democratic Republic of the Congo is a development project which is currently at the feasibility stage, and consequently is not yet an operating mine and does not produce any gold. Furthermore, the Company does not purchase gold or other conflict minerals from any local mining companies and/or artisanal miners.”

First Horizon National Corporation:  This issuer responded to a comment requesting the issuer provide a “more robust discussion of your trust preferred loans.”  In part the issuer’s response stated “Since the vast majority of trust preferred issuers to which FHN has extended credit have less than $15 billion in total assets, the passage of the Dodd-Frank Act is not expected to significantly affect future payoff rates for these loans.”

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

A federal interagency working group, led by the CFTC and including representatives from the Department of Agriculture, Treasury, SEC, EPA, FERC, FTC, and DOE (EIA), has released a report on oversight of existing and prospective carbon markets, as required under section 750 of the Dodd-Frank Act. The group was charged with providing “recommendations . . . to ensure an efficient, secure, and transparent carbon market, including the oversight of spot markets and derivative markets.” Accordingly, the report recommends that the following objectives guide the oversight of existing and prospective carbon markets:

Objective 1. Facilitate and protect price discovery in the carbon markets.
Carbon market design and oversight should strive to ensure that carbon markets – including those for allowances, offsets and derivatives – reflect both supply and demand conditions, considering the present marginal cost of achieving emission reductions and market participants’ expectations of future marginal costs of reductions.

Objective 2. Ensure appropriate levels of carbon market transparency.

Regulatory oversight must ensure that proper levels of transparency exist in carbon markets. Both pre-trade and post-trade market transparency measures should exist in order to provide timely and accurate information to carbon market participants. Transparency can generally increase the efficiency of markets by providing for more informed decision making by market participants. To encourage market participation, transparency provisions should preserve the confidentiality of traders and their positions consistent with commodities and securities laws and provide appropriate exceptions for large or “block” trades. Regulatory oversight provisions also should ensure appropriate provision of fundamental market data relating to aggregate emissions of regulated entities and the supply of allowances and offset credits in the markets.

Objective 3. Allow for appropriate, broad market participation.

Regulatory oversight should ensure that rules regarding market participation allow entities with emission compliance obligations to efficiently meet their obligations and allow offset credit providers to bring those credits to market. More broadly, the rules and trading systems should be designed to encourage market liquidity, facilitate price discovery and allow those directly and indirectly impacted by the regulation of carbon emissions to efficiently hedge associated risks. Open market participation promotes the development of market liquidity and price discovery, which are essential to the efficient functioning of primary, secondary and derivative markets and could facilitate the ability of entities to hedge commercial risks associated with regulation of carbon emissions.

Objective 4. Prevent manipulation, fraud and other market abuses.

Carbon markets should be free of manipulation, fraud and other market abuses. Measures should be in place to prevent price distortions, market fraud and other manipulative activities and to provide for sufficient transparency for regulators to monitor activity in the market.

The group made the following additional recommendations regarding oversight of the derivatives market and the primary (sale of allowances and offsets) and secondary (resale) markets:

Derivatives Market–Rely on the existing regulatory oversight program, as enhanced by the Dodd-Frank Act, for both existing and prospective carbon allowance and offset derivatives markets. The current legal framework for oversight of derivative markets, as enhanced by provisions in the Dodd-Frank Act that will become effective in July 2011, will provide for robust and effective oversight of carbon derivatives markets and closely linked derivative markets, such as those based on energy commodities.

Primary and Secondary Markets–Ensure that appropriate oversight mechanisms are in place for primary and secondary allowance and offset markets, reflecting the above objectives and the interdependence of primary, secondary and derivative carbon markets and any unique characteristics or circumstances of such markets.

The SEC has released a staff study on enhancing investment adviser examinations required by Section 914 of the Dodd-Frank Act.  The Office of Compliance Inspections and Examinations, or OCIE, currently examines registered investment advisers.

The SEC staff’s conclusions are set forth in Part V of the study.  The staff notes the number and frequency of examinations of registered investment advisers have declined over the past six years.  This can be explained, in part, by substantial growth in the number of registered investment advisers and a decrease in the number of OCIE staff.  The staff expects that the frequency of examinations of registered investment advisers could increase following the effective date of Title IV of the Dodd-Frank Act as a result of a substantial decrease in the number of registered investment advisers, many of whom will transition from federal to state registration.  The amount of any potential increase in examinations, however, may be offset by the need to divert examination resources to fulfill new examination obligations that the SEC was given by the Dodd-Frank Act.

Although the number of registered investment advisers is expected to decrease substantially upon the enactment of Title IV of the Dodd-Frank Act, the staff expects the number of registered investment advisers and the assets managed by them to grow in subsequent years.  The rate of growth, however, is uncertain.  While the SEC’s resources and the number of OCIE staff may increase in the next several years, the number of OCIE staff is unlikely to keep pace with the growth of registered investment advisers.  Based on these uncertainties, the SEC faces significant capacity challenges in examining registered investment advisers.

Thus, the staff believes that the SEC likely will not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency.  The staff states the SEC’s examination program requires a source of funding that is adequate to permit the SEC to meet the new challenges it faces and sufficiently stable to prevent adviser examination resources from periodically being outstripped by growth in the number of registered investment advisers.

The staff recommends that Congress consider the following three approaches to strengthen the SEC’s investment adviser examination program:

  • Authorize the SEC to impose user fees on SEC-registered investment advisers to fund their examinations by OCIE;
  • Authorize one or more self regulatory organizations, or SROs, to examine, subject to SEC oversight, all SEC-registered investment advisers; or
  • Authorize FINRA to examine dual registrants for compliance with the Advisers Act.

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The Federal Reserve announced the establishment of offices to promote diversity and inclusion at the Federal Reserve Board and at all 12 of the Federal Reserve Banks.

The offices will build on the Federal Reserve System’s long-standing efforts to promote equal employment opportunity and diversity, and will continue to work to foster diversity in procurement, with a focus on minority-owned and women-owned businesses. The Dodd-Frank Wall Street Reform and Consumer Protection Act required that diversity and inclusion offices be established at certain federal agencies, including the Federal Reserve Board, and at the Federal Reserve Banks. In addition to promoting diversity at the Board and throughout the System, the Board’s Office of Diversity and Inclusion will play an integral role in the development of standards to assess the diversity practices at entities regulated by the Federal Reserve as required by the Dodd-Frank Act.

The Office of the Comptroller of the Currency has announced similar steps.

The SEC however has not complied with the mandate of the Dodd-Frank Act citing budgetary uncertainties.

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The Dodd-Frank Act mandated that the Financial Stability Oversight Council, or FSOC, ensure that all financial companies whose failure could pose a threat to the financial stability of the United States – not just banks – will be subject to strong oversight.

Using the considerations set forth in the Dodd-Frank Act, as well as taking into account public comments on a previously issued Advance Notice of Proposed Rulemaking, the FSOC has approved a proposed rule outlining the criteria that will inform the FSOC’s designation of such firms and the procedures the FSOC will use in the designation process.

Under the FSOC’s proposed rule, if designated, the largest, most interconnected and highly-leveraged companies would face stricter prudential regulation, including higher capital requirements and more robust consolidated supervision.

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The Board of Directors of the Federal Deposit Insurance Corporation, or FDIC, approved an interim final rule clarifying how the agency will treat certain creditor claims under the new orderly liquidation authority established under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Title II of the Dodd-Frank Act provides a mechanism for appointing the FDIC as receiver for a financial company if the failure of the company and its liquidation under the Bankruptcy Code or other insolvency procedures would pose a significant risk to the financial stability of the United States.

The final rule follows a notice of proposed rulemaking and 30-day comment period during which the FDIC received 27 comment letters and held two meetings with various industry representatives and trade associations. The comments generally expressed support for the FDIC’s efforts to promulgate rules for implementing the orderly liquidation authority of Title II. A majority of comments related to matters beyond the scope of the NPR, indicating the need for additional rulemaking in the future.

The interim final rule approved today differs from the notice of proposed rulemaking, or NPR, by clarifying the standard for valuation for collateral on secured claims and by clarifying the treatment of contingent claims. One aspect of the NPR elicited a number of comment letters: The availability of additional payments to creditors under the authority of the Dodd-Frank Act.

The interim final rule does not change this proposal from the NPR. Many commentators noted the importance of limiting any “additional payments” as a means of reducing moral hazard and instilling market discipline. Others were concerned with the prohibition of any additional payments to holders of long-term debt, which is defined as debt with an original term of more than 360 days, based on the misapprehension that shorter-term creditors are likely to receive such payments. Under the standards of the Dodd-Frank Act and the interim final rule, that concern is unwarranted according to the FDIC. Short-term debt holders are highly unlikely to meet the criteria set forth in the statute for permitting payment of additional amounts according to the FDIC. In virtually all cases, according to the FDIC, holders of shorter-term debt will receive the same pro rata share of their claim that is being provided to the long-term debt holders. Accordingly, a potential credit provider to a company subject to the Dodd-Frank resolution process should have no expectation of treatment that differs depending upon whether it lends for a period of over 360 days or for a shorter term.

The provisions allowing rare “additional payments” parallel the FDIC’s longstanding authority under the Federal Deposit Insurance Act and must be narrowly construed consistent with the Congressional intent. Consistent with the FDIC’s practice in bank resolutions, such additional payments are rare and payments to shareholders, subordinated debt holders, and long-term debt holders would not meet the statutory tests contained in the Dodd-Frank Act according to the FDIC.   Under the interim final rule, no creditor can receive any additional payment unless the FDIC Board of Directors has determined, by recorded vote, that the payments meet the statutory standards. In addition, such payments are subject to recoupment if ultimate recoveries are insufficient to repay any temporary government liquidity support provided as part of the orderly wind-down. This recoupment must occur before imposition of a general industry assessment to cover any shortfalls.  In no event may taxpayer money be used to cover losses associated with the failure of a large financial firm according to the FDIC.

The interim final rule also addresses discrete issues within the following broad areas:

  • The authority to continue operations by paying for services provided by employees and others (by clarifying the payment for services rendered under personal services contracts);
  • The treatment of creditors (by clarifying the measure of damages for contingent claims); and
  • The application of proceeds from the liquidation of subsidiaries (by reiterating the current treatment under corporate and insolvency

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

Section 622 of the Dodd-Frank Act establishes a financial sector concentration limit that would prohibit a financial company from merging or consolidating with, or acquiring, another company if the resulting company’s consolidated liabilities would exceed 10 percent of the aggregate consolidated liabilities of all financial companies.  This concentration limit is intended, along with a number of other provisions in the Dodd-Frank Act, to promote financial stability and address the perception that large financial institutions are “too big to fail.”

 As required by the Dodd-Frank Act, the Financial Stability Oversight Council, or FSOC,  completed a study of the extent to which the concentration limit would affect:  financial stability, moral hazard in the financial system, the efficiency and competitiveness of U.S. financial firms and financial markets, and the cost and availability of credit and other financial services to households and businesses in the United States.   The study also contains the FSOC’s recommendations regarding modifications to the concentration limit to mitigate practical difficulties likely to arise in its administration and enforcement, without undermining its effectiveness in limiting excessive concentration among financial companies.

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As mandated by the Dodd-Frank Act, the Financial Stability Oversight Council, or FSOC, conducted a study on how best to implement Section 619 of the Dodd-Frank Act (commonly known as the “Volcker Rule”).  The FSOC’s study puts forward recommendations designed to effectively and comprehensively implement the Volcker Rule in a manner that constrains risk-taking by, and promotes the safety and soundness of, banking entities.

The FSOC study recommends the following:

  • Require banking entities to sell or wind down all impermissible proprietary trading desks.
  • Require banking entities to implement a robust compliance regime, including public attestation by the CEO of the regime‘s effectiveness.
  • Require banking entities to perform quantitative analysis to detect potentially impermissible proprietary trading without provisions for safe harbors.
  • Perform supervisory review of trading activity to distinguish permitted activities from impermissible proprietary trading.
  • Require banking entities to implement a mechanism that identifies to Agencies which trades are customer-initiated.
  • Require divestiture of impermissible proprietary trading positions and impose penalties when warranted.
  • Prohibit banking entities from investing in or sponsoring any hedge fund or private equity fund, except to bona fide trust, fiduciary or investment advisory customers.
  • Prohibit banking entities from engaging in transactions that would allow them to ―bail out a hedge fund or private equity fund.
  • Identify ―similar funds that should be brought within the scope of the Volcker Rule prohibitions in order to prevent evasion of the intent of the rule.
  • Require banking entities to publicly disclose permitted exposure to hedge funds and private equity funds.

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

The Dodd-Frank Wall Street Reform and Consumer Protection Act  requires the Chairman of the Financial Stability Oversight Council, or FSOC, to issue a study on the Dodd-Frank Act’s risk retention requirements within 180 days of enactment.  This risk retention study was delivered to Congress on January 18, 2011 and examines the ways that risk retention, also known as “skin in the game,” can, according to its authors, help reform the securitization market, protect the public and the economy against irresponsible lending practices, and facilitate economic growth by allowing for safe and stable credit formation for consumers, businesses, and homeowners.

The governmental regulators which conducted the study noted the following (which views are not uniformly shared by the author of this article):

  • The study notes that asset-backed securitization provides important economic benefits by improving the availability and affordability of credit to a diverse group of consumers, businesses, and homeowners. 
  • However, as the recent financial crisis demonstrated, without reform, risks in the securitization process can detract from these benefits.  Leading up to the recent crisis, originators and securitizers made loans, bundled them together, and then sold them off to a broad array of outside investors, often without retaining a meaningful share of the risk. Because originators had little interest in whether the borrowers would be able to repay the loans, underwriting standards deteriorated and excessively risky mortgages flooded the market.  This helped fuel the financial crisis.
  • To address this serious flaw in the pre-crisis securitization market, the Dodd-Frank Act generally requires that securitizers or originators have “skin in the game” by retaining at least 5 percent of the credit risk of an asset sold to investors through the securitization process, which should allow market participants to price credit risk more accurately and allocate capital more efficiently. 
  • By putting in place such safeguards, the Dodd-Frank Act can help ensure that securitization is a stable and reliable source of credit for consumers, businesses, and homeowners in the United States.

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Section 916 of the Dodd-Frank Wall Street Reform and Consumer Protection Act  amended Section 19(b) of the Securities Exchange Act of 1934, or Exchange Act, which governs the handling of proposed rule changes submitted by self-regulatory organizations, or SROs.  Among other things, the Dodd-Frank Act’s amendments to Section 19 of the Exchange Act require the SEC to promulgate rules setting forth the procedural requirements of proceedings to determine whether a proposed rule change should be disapproved.  In satisfaction of this requirement, the SEC is adopting new Rules of Practice to formalize the process it will use when conducting proceedings to determine whether an SRO’s proposed rule change should be disapproved under Section 19(b)(2) of the Exchange Act. The new rules are intended to add transparency to the SEC’s conduct of those proceedings and address the process the SEC will follow to institute proceedings and provide notice of the grounds for disapproval under consideration as well as provide interested parties with an opportunity to submit written materials to the SEC.  In addition, the SEC is making conforming changes to Rule 19b-4 under the Exchange Act in recognition of the new Rules of Practice.  Further, pursuant to Section 107 of the Sarbanes-Oxley Act of 2002, the provisions of paragraphs (1) through (3) of Section 19(b) of the Exchange Act govern the proposed rules of the Public Company Accounting Oversight Board, or PCAOB.

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