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While its fate remains uncertain, financial reform is finally moving back into the limelight after being overshadowed by health care reform. Reenergized by recent headlines scrutinizing actions by Wall Street, the debate over the proposed Restoring American Financial Stability Act of 2010 (the “Dodd bill”) appears likely to begin in the full Senate this week.

The Dodd bill was approved in March by the Senate Banking, Housing and Urban Affairs Committee, along party lines. To secure some Senate Republican support and avoid a possible filibuster, several material bipartisan compromises are expected that may ensure passage of the bill. Senate Democrats led by Senator Dodd hope for a Senate vote on finalized legislation before Memorial Day, May 31.

As currently drafted, the Dodd bill reshuffles regulatory authority over financial institutions, creates new regulatory bodies, including the Financial Stability Oversight Council and the Bureau of Consumer Financial Protection, imposes enhanced prudential standards on financial companies and regulations on financial products, and addresses the issue of institutions considered “Too Big to Fail.” Many sections of the bill affect non-bank institutions, including proposals on executive compensation, corporate governance and private securities offerings.

Highlights of the Dodd Bill

Consumer Protection

• Establishment of the Bureau of Consumer Financial Protection. Although housed within the Federal Reserve, the Bureau of Consumer Financial Protection would have autonomous authority to issue and enforce rules governing all entities that offer consumer financial services and products. A number of entities are exempted from the Bureau’s authority, including retailers of nonfinancial goods or services, realtors, accountants, tax preparers, attorneys and persons regulated by the SEC, CFTC, or state insurance or state securities regulators. The Bureau will also have broad supervisory powers to detect risks to consumers and assess compliance with federal consumer financial laws.
• Credit Rating Agencies Reform. The Dodd bill creates a new Office of Credit Rating Agencies within the SEC with authority to improve independence and increase accountability of credit rating agencies. In addition, investors could bring a private right of action against rating agencies for knowingly or recklessly failing to conduct a reasonable investigation.

Systemic Risk Regulation

• Creation of the Financial Stability Oversight Council. Consisting of the nine heads of federal financial regulators and chaired by the Treasury Secretary, the goal of the Council is to identify and monitor risks to the U.S. economy posed by large financial companies and complex financial products. The Council will recommend to the Federal Reserve heightened prudential standards for risk-based capital, liquidity and leverage for large bank holding companies. The Council may place nonbank financial companies under the supervision of the Federal Reserve, subjecting such companies to its prudential standards. Upon a two-thirds vote by Council members, the Federal Reserve may break apart a supervised financial company if the Federal Reserve believes that other actions are inadequate to mitigate a threat to the financial system.

Orderly Liquidation

• Unwinding Faltering “Too Big to Fail” Financial Companies. Upon recommendation by the Federal Reserve and the FDIC and after approval by the Treasury Secretary and a panel of three bankruptcy judges, the FDIC can be appointed as receiver for a financial company in “default or danger of default.” For a broker or dealer, the FDIC would be required to appoint SIPC as liquidation trustee. The Dodd bill also creates the much-debated $50 billion orderly liquidation fund available to the FDIC to administer a liquidation. This fund will be created in advance by assessments on large bank and nonbank financial companies with total assets of over $50 billion. The Obama Administration has called for the orderly liquidation fund to be removed from the legislation.

Executive Compensation and Corporate Governance

• Say-on-Pay. The Dodd bill mandates that issuers hold annual non-binding shareholder votes to approve or disapprove the compensation to be paid to executives.
• Clawbacks of Executive Compensation. The Securities Exchange Act would be amended to require clawbacks of incentive-based compensation from any current or former executive officer when an issuer restates its financial statements. The new requirement covers any compensation in excess of the amount that would have been paid using the restated accounting during a three year period preceding the restatement. This change would broaden existing law, which applies only to current chief executive officers and chief financial officers and is limited to a look-back period of one year.
• Independence of the Compensation Committee. The Dodd bill would require the members of the compensation committee to fulfill standards of independence set by the issuer’s stock exchange and would permit compensation committees, without the need for approval from the full board, to hire compensation consultants and legal counsel if such advisors are independent.
• Increased Proxy Disclosure. The Dodd bill would require proxy statement disclosure on a number of matters, including (i) any employee or director hedging against equity securities granted by the company as compensation, (ii) reasons why an issuer has chosen to combine or separate the positions of chairman of the board and chief executive officer, (iii) the relationship between executive compensation and the financial performance of an issuer and (iv) the ratio of median annual total compensation of employees to the compensation of the chief executive officer.
• Majority Election of Directors. The Dodd bill would mandate a majority vote for the election of directors in uncontested elections. If the election is contested, or there are more nominees than positions on the board, then a plurality will be required. If a director of an issuer fails to attain a majority of votes cast in an uncontested election, the director would be required to resign from the board. The board would be required to accept the director’s resignation or upon a unanimous vote otherwise, disclose why it did not accept the director’s resignation.
• Shareholder Proxy Access. The Dodd bill provides the SEC with specific authority to adopt rules permitting shareholders to nominate directors in the issuer’s own proxy solicitation materials.
• Further Elimination of Broker Discretionary Voting. Broker discretionary voting would be prohibited on executive compensation or “any other significant matter.” (Broker discretionary voting in director elections has already been eliminated by the SEC.)
• Special Compensation Rules for Financial Institutions. There are also compensation provisions in the Dodd bill that will affect only bank holding companies, including prohibitions of excessive compensation and compensation plans that could lead to material financial loss to the bank holding company.

Private Placement Offerings

• Waiting Periods and Uncertainty for Regulation D Offerings. Companies can currently complete private offerings of covered securities pursuant to Regulation D quickly and with certainty because of preemption of state blue sky laws. The Dodd bill invites the SEC to designate a class of securities as “non-covered securities” by virtue of their sale in an offering of limited size or scope. Non-covered securities would be subject to state securities regulation. The Dodd bill also requires the SEC to review all filings of Regulation D offerings within 120 days. Failure by the SEC to review a filing will result in the applicable security losing its status as a covered security, unless the SEC determines that there has been a good faith and reasonable attempt by the issuer to comply with all applicable terms, conditions and requirements of the filing and that any non-compliance is insignificant to the offering as a whole.
• Heightened Accredited Investor Standard. The Dodd bill would increase the eligibility threshold for accredited investor status for the effects of inflation, and require additional adjustments at least every five years. Although the details of these adjustments are left for determination by the SEC, early estimates show that the initial required adjustment alone may more than double the existing financial requirements. This may significantly reduce an important pool of capital available to small and start-up companies.

Regulation of Banks

• Draws new lines between federal regulators of banks, thrifts and bank holding companies. The FDIC will oversee all state-chartered banks and any state thrift or bank holding company with assets below $50 billion. The Office of the Comptroller of the Currency will regulate all federally-chartered banks and any federal thrift or bank holding company with assets below $50 billion. The Federal Reserve will have authority over any thrift or bank holding company with assets over $50 billion.
• Implements the Volcker Rule. Bank holding companies and their subsidiaries would be prohibited from engaging in proprietary trading as well as investing in or sponsoring hedge funds.

Regulation of Derivatives

• New Proposal Pending. Currently a placeholder, new proposals on the regulation of derivatives are expected from ongoing negotiations.
• “Skin in the Game.” The Dodd bill requires securitizers and originators of asset backed securities to retain at least 5% of the credit risk.

Regulation of Investment Advisors

• SEC Registration for Hedge Funds. The Dodd bill eliminates the exemption in section 203(b)(3) of the Investment Advisers Act of 1940 for advisers to “private funds” with fewer than fifteen clients. The asset threshold for federal registration of investment advisors would be increased to $100 million. Although the Dodd bill contains exemptions for advisors to venture capital and private equity funds, the definitions of these funds are left for determination by the SEC. The SEC is also directed to define “family office” in a manner consistent with current no action positions.

For more information regarding the proposed legislation, please contact your regular Baker Hostetler contact person.

Authorship Credit: Phillip M. Callesen and Matthew Oliver

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