Late yesterday, the U. S. House of Representatives approved landmark regulatory reform legislation that would overhaul U.S. financial services regulation with new controls on large and interconnected financial firms, tougher capital and operating standards for banks, and a new regime for the regulation of derivatives. The conference report for H.R. 4173, the Dodd-Frank Wall Street Reform and Consumer Protection Act, was approved along mostly party lines by a vote of 237-192. Three Republicans voted for the bill and 19 Democrats voted against it.
The measure is now heading to the Senate for a final vote. While leaders had originally intended to bring this measure to the floor for a vote prior to the July 4 recess, the death of Sen. Robert C. Byrd (D-WV), coupled with an already full schedule, makes this feat virtually impossible. The Senate is expected to vote during the week of July 12, 2010.
The final conference report, as passed by the House contained a number of provisions of importance to AFP members. In addition to addressing the regulation of over-the-counter derivatives, credit rating agencies and interchange fees, the measure also included language on other area that will undoubtedly impact our nation’s capital markets.
The bill, as passed by the House yesterday, included provisions that establish a Financial Stability Oversight Council, led by the Treasury Secretary, that would monitor and apply stringent rules to large and complex firms that pose threats to the wider financial system; give regulators new powers to seize and dismantle failing financial companies; toughen scrutiny over financial instruments known as over-the-counter derivatives; and create a new consumer regulator to police mortgages, credit cards, and other financial products from abusive terms, hidden fees and deceptive practices among other things. The conference report also included "the Volcker Rule" which requires regulators to implement regulations for banks, their affiliates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds. Nonbank financial institutions supervised by the Fed also have restrictions on proprietary trading and hedge fund and private equity investments. The new Financial Stability Oversight Council will study and make recommendations on implementation to aid regulators.
Other areas addressed in the bill include:
Bringing Transparency and Accountability to the Derivatives Market
The measure that passed yesterday would require the vast majority of all derivatives trading be executed on a public exchange as opposed to between banks and their customers as many contracts are currently structured. The bill also dictates that non-financial company end-users, along with their pension plans and captive finance affiliates, generally are exempted from new regulations on derivatives and will be able to continue to use over-the-counter derivatives to manage risk, without posting margin or clearing the transactions. Finally, the legislation:
- Closes Regulatory Gaps - Provides the SEC and CFTC with authority to regulate over-the-counter derivatives so that irresponsible practices and excessive risk-taking can no longer escape regulatory oversight.
- Central Clearing and Exchange Trading - Requires central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared.
- Market Transparency - Requires data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding to risks.
- Financial safeguards - Adds safeguards to system by ensuring dealers and major swap participants have adequate financial resources to meet responsibilities. Provides regulators the authority to impose capital and margin requirements on swap dealers and major swap participants, not end users.
- Higher standard of conduct - Establishes a code of conduct for all registered swap dealers and major swap participants when advising a swap entity. When acting as counterparties to a pension fund, endowment fund, or state or local government, dealers are to have a reasonable basis to believe that the fund or governmental entity has an independent representative advising them.
New Requirements and Oversight of Credit Rating Agencies
The measure creates an Office of Credit Ratings at the SEC with expertise and its own compliance staff. This new office will have the ability to fine agencies at violate the rules. Under the legislation, the SEC is required to examine Nationally Recognized Statistical Ratings Organizations (NRSROs) at least once a year and make key findings public. The legislation also addresses:
- Disclosure - Requires NRSROs to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.
- Independent Information - Requires agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible.
- Conflicts of Interest - Prohibits compliance officers from working on ratings, methodologies, or sales; installs a new requirement for NRSROs to conduct a one-year look-back review when an NRSRO employee goes to work for an obligor or underwriter of a security or money market instrument subject to a rating by that NRSRO; and mandates that a report to the SEC when certain employees of the NRSRO go to work for an entity that the NRSRO has rated in the previous twelve months.
- Liability - Investors can bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. NRSROs will now be subject to "expert liability" with the nullification of Rule 436(g) which provides an exemption for credit ratings provided by NRSROs from being considered a part of the registration statement.
- Right to Deregister - Gives the SEC the authority to deregister an agency for providing bad ratings over time.
- Education - Requires ratings analysts to pass qualifying exams and have continuing education.
- Eliminates Many Statutory and Regulatory Requirements to Use NRSRO Ratings - Reduces over-reliance on ratings and encourages investors to conduct their own analysis.
- Independent Boards - Requires at least half the members of NRSRO boards to be independent, with no financial stake in credit ratings.
- Ends Shopping for Ratings - The SEC shall create a new mechanism to prevent issuers of asset backed-securities from picking the agency they think will give the highest rating, after conducting a study and after submission of the report to Congress.
Addresses Interchange Fees
The measure passed yesterday also contained language that would regulate interchange fees. In mid-June, House and Senate leaders announced a compromise on the language that would be included in the final conference report. In part, this legislation:
- Protects Small Businesses from Unreasonable Fees - Requires Federal Reserve to issue rules to ensure that fees charged to merchants by credit card companies debit card transactions are reasonable and proportional to the cost of processing those transactions.
- Fraud prevention costs – Allows the Fed to regulate interchange fee rates, and consider fraud prevention costs incurred by the bank. In order to qualify for this adjustment, the bank would have to comply with standards established by the Fed that would demonstrate that the bank is taking effective steps to reduce fraud, and the bank would also have to show that the adjustment it seeks is limited to those reasonably necessary fraud prevention costs. Banks will be incentivized to efficiently and effectively prevent fraud while competing to provide the best protection for the lowest cost.
- Discounting between card networks – The Fed will be directed to issue rules preventing card networks from requiring that their debit cards be used on only one debit card network (thereby ensuring that merchants will have the choice of at least two networks upon which to run debit transactions). This provision allows merchants to choose the debit network with the lowest cost – the opposite of the current system where merchants are forced to use a specific network with fixed prices. However, this provision dropped language that made it applicable to credit card transactions, a very significant change.
- Non-discrimination between cards issued by different banks - The language contains a rule of construction affirmatively stating that nothing shall be construed to authorize any person to discriminate between debit cards or between credit cards on the basis of the issuer who issued the card.