Key Questions Financial Institutions Should Ask About the Dodd-Frank Act

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1 Key Questions Financial Institutions Should Ask About the Dodd-Frank Act OCTOBER 1, 2010 OVERVIEW On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ). The most comprehensive restructuring of financial services industry regulation since the 1930s, the Dodd-Frank Act significantly affects all types of financial institutions and financial activities. Depository institutions, broker-dealers, asset managers, insurers, and their activities are subject to new and heightened regulatory oversight and standards. Summaries and commentaries focusing on the 2,300-page legislation abound, varying in both detail and accessibility, and often increasing rather than diminishing the confusion surrounding the potential consequences. Financial institutions are still struggling to understand the precise provisions, rulemakings, and studies that might affect their businesses. Given this environment, Promontory Financial Group has drafted a list of key questions that financial institutions should be asking regarding the Dodd-Frank Act. Financial institutions should use these questions as a tool to engage their executives, employees, board members, shareholders, and advisers in deliberating how the Dodd-Frank Act might affect not only their organizational structure, activities, and finances, but also their risk management, governance, and compliance programs. Promontory does not intend for these questions and brief commentary to be a detailed response to every issue raised by the Dodd-Frank Act, but to serve as a guide to point financial institutions in the right direction in understanding and weighing the legislation s impact. Promontory has divided these questions into eight sections, focusing on the type of financial institution and/or activity being regulated under the Dodd-Frank Act: 1. Systemically significant financial institutions and activities (page 2) 2. Enhanced bank and bank holding company regulation (page 6) 3. The new regulatory structure for thrifts and thrift holding companies (page 11) 4. Enhanced insurer regulation (page 12) 5. Increased derivatives regulation (page 14) 6. New asset management and broker-dealer regulation(page 16) 7. Credit ratings and securitization reforms (page 19) 8. Corporate governance and executive compensation reforms (page 21) For more information about the issues discussed in this report, please contact Susan Krause Bell (skrausebell@promontory.com), Jonathan Gould (jgould@promontory.com), or Kristen Jaconi (kjaconi@promontory.com). Executive summaries of Titles I-XIV of the Dodd-Frank Act are available at Dodd-Frank Executive Summaries 2010 PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 1

2 SYSTEMICALLY SIGNIFICANT FINANCIAL INSTITUTIONS AND ACTIVITIES Systemically Significant Designation What companies will be designated as systemically significant? The Financial Stability Oversight Council (the Council ) must determine which bank holding companies and nonbank financial companies pose risks to U.S. financial stability, and subject those companies to the supervision and regulation of the Board of Governors of the Federal Reserve System (the Federal Reserve ). Bank holding companies over $50 billion in assets are considered to be large, interconnected bank holding companies and automatically designated as systemically significant. The Federal Insurance Office (the FIO ) is authorized to recommend to the Council that an insurer be designated as a systemically significant nonbank financial company. The Council can begin designating systemically significant institutions at any time. Moreover, the Council is not required to write rules or seek comment on how to make the designation. Financial institutions, particularly large, nonbank firms, should monitor the Council s statements and actions to discern its approach in applying the statute. Will a designated bank holding company be subject to additional prudential requirements? Yes. Bank holding companies designated as systemically significant will face heightened prudential standards including capital, leverage, and liquidity, as well as credit exposure reporting, concentration limits, stress testing, and resolution plans ( living wills ). In implementing this provision, the Federal Reserve must determine the details of the capital and liquidity standards while considering the evolving international standards being discussed by the Basel Committee on Banking Supervision. In addition, as noted below, the FSOC is to study and report on a possible contingent capital requirement. The Federal Reserve will also have expanded supervisory authority over many of the operations of designated bank holding companies. The Fed lite approach of the Gramm-Leach-Bliley Act is gone and the Federal Reserve can examine any subsidiaries. Moreover, the Federal Reserve is required to apply bank-like supervision to subsidiaries that engage in bank-permissible activities (except for functionally regulated subsidiaries such as broker-dealers or investment advisers). Finally, designated bank holding companies can expect the Federal Reserve to apply higher standards to enterprise-wide risk management. Will a designated nonbank financial company be subject to additional prudential requirements? Yes. Nonbank financial companies designated as systemically significant will come under Federal Reserve supervision, which is likely to be a significantly different, and more intrusive, style of supervision than these companies now face. These nonbank 2010 PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 2

3 financial companies will also be subject to heightened requirements covering the same areas as those facing designated bank holding companies, including: capital and leverage, a prompt-corrective-action-type framework, liquidity, resolution plans ( living wills ), reporting, concentration limits, and risk committees. They may also be subject to contingent capital requirements. What is meant by a possible contingent capital requirement? Conceptually, contingent capital is debt issued by financial institutions that would convert to equity under certain circumstances prescribed by supervisors. The Council must study and report by July 2012 on the feasibility, benefits, costs, and structure of contingent capital requirements for nonbank financial companies supervised by the Federal Reserve and large, interconnected bank holding companies, including an evaluation of the characteristics and amounts of contingent capital that should be required, an analysis of potential prudential standards that should be used to determine whether a company s contingent capital would be converted to equity in times of financial stress, and recommendations for implementing regulations. Will a financial firm with a foreign parent be subject to additional prudential requirements? Yes. If a financial firm that is designated as systemically significant has a foreign parent, Federal Reserve supervision will be focused on U.S.-related activities. The Dodd-Frank Act specifically empowers the Federal Reserve to require establishment of an intermediate holding company for U.S. financial activities. U.S. intermediate holding companies of foreign banks that are bank holding companies or savings and loan holding companies may be subject to enhanced capital requirements. The U.S. Comptroller General (the head of the Government Accounting Office, or GAO ), in consultation with the Secretary of the Treasury, the Federal Reserve, the Comptroller of the Currency (the OCC ), and the Federal Deposit Insurance Corporation (the FDIC ), must study and report to Congress by January 2012 on the capital requirements applicable to U.S. intermediate holding companies of foreign banks that are bank holding companies or savings and loan holding companies, including the extent to which foreign banks are subject on a consolidated basis to home country capital standards comparable to U.S. capital standards. U.S. intermediate holding companies of foreign banks that had previously relied on Federal Reserve Supervision and Regulation Letter SR 01 1: Application of the Board's Capital Adequacy Guidelines to Bank Holding Companies owned by Foreign Banking Organizations (Jan. 5, 2001) will have five years in which to comply with the Federal Reserve s capital requirements. Could a systemically significant financial company be forced by regulators to make structural changes? Yes, under certain circumstances. The Federal Reserve may determine that a systemically significant financial company poses a grave threat to U.S. financial stability PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 3

4 Upon such a determination, the Federal Reserve (with the Council s approval) must limit the company s ability to merge with, acquire, consolidate with, or otherwise become affiliated with another company; restrict the company s ability to offer a financial product or products; require the company to terminate one or more activities; impose conditions on the manner in which the company conducts one or more activities; or, if these limitations are inadequate, require the company to sell or otherwise transfer assets or off-balance-sheet items to unaffiliated entities. Could the Dodd-Frank Act affect financial activities deemed to be high risk, now or in the future? Yes. The Council may provide for more stringent regulation of a financial activity by recommending to the primary financial regulatory agencies that they apply new or heightened prudential standards and safeguards for a financial activity or practice conducted by bank holding companies or nonbank financial companies under their jurisdiction, if the Council determines that the activity or practice could create or increase the risk of significant liquidity, credit, or other problems spreading among bank holding companies, and nonbank financial companies, U.S. financial markets, or lowincome, minority, or underserved communities. It bears watching how the Council will implement this authority. Currently, bank supervisors have the authority to develop standards that address emerging risks, but the machinery often cranks slowly due to the need to coordinate across agencies and the tendency to supervise rather than regulate risks in the early stages. The Council may act more quickly, particularly in the wake of the financial crisis where warnings regarding the risks of subprime mortgages went unheeded. Should companies expect reporting and information requests from the Financial Stability Oversight Council and/or the Office of Financial Research? Yes, although the specifics are unclear. The Council, acting through the Office of Financial Research (the OFR ), has the authority to require the submission of periodic and other reports from any nonbank financial company or bank holding company for the purpose of assessing the extent to which either a financial activity or financial market in which the nonbank financial company or bank holding company participates, or the nonbank company or bank holding company itself, poses a threat U.S. financial stability. Although the Dodd-Frank Act requires the Council to use existing reports where possible, it is likely that in order to collect comparable, comprehensive information on risks, it will design its own reporting system. Additionally, the OFR has subpoena power and can conduct broad inquiries PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 4

5 Financial Market Utilities and Payment, Clearing, and Settlement Activities Could other companies and activities be designated systemically important? Yes. The Dodd-Frank Act authorizes the Council to designate certain financial market utilities as, or likely to become, systemically important. The Council is also authorized to designate certain payment, clearing, or settlement activities as, or likely to become, systemically important, even if the firm conducting the activity is not so designated. Unlike the designation of other financial firms, the Council is obligated to publish a potential designation of a financial market utility for notice and comment. Will a designated financial market utility or a financial institution conducting designated payment, clearing, and settlement activities be subject to additional requirements? Yes. The Federal Reserve is required to prescribe risk management standards governing designated financial market utilities operations and designated payment, clearing, and settlement activities, unless these utilities or activities fall under the jurisdiction of the Commodity Futures Trading Commission (the CFTC ) or the Securities and Exchange Commission (the SEC ). Then, the CFTC and the SEC are permitted to prescribe such standards for these entities and activities. A designated financial market utility s primary supervisory agency must examine it once a year, and may examine its integral service providers. The primary supervisor also has authority to take enforcement actions against the financial market utility, and the Federal Reserve may recommend such an enforcement action. The appropriate supervisor may also examine (and take enforcement action against) a financial institution for a designated payment, clearing, or settlement activity, to determine the risk posed to the institution and the financial system by the activity, and the institution s management of the risk. The Federal Reserve (which may or may not be the primary supervisor) may also examine the activity and take enforcement actions. Finally, the Council can require any financial market utility or financial institution conducting a payment, clearing, or settlement activity to submit information to assess whether the utility or activity is systemically important. Financial Stability Studies Could there be any future limitations on bank size and other requirements for large financial institutions? Yes. The Council must study and report to Congress no later than January 2011, and not later than every five years thereafter, on the economic impact of possible financial services regulatory limitations intended to reduce systemic risk, including: An estimation of the benefits and costs of explicit or implicit limits on the maximum size of banks, bank holding companies, and other large financial institutions; 2010 PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 5

6 Limits on large financial institutions organizational complexity and diversification; Requirements for operational separation between large financial institutions business units; Limits on risk transfer between large financial institutions business units; requirements to carry contingent capital or similar mechanisms; Limits on financial institutions commingling of commercial and financial activities; and Segregation requirements between large financial institutions traditional financial activities and trading or other high-risk operations; and other limitations on large financial institutions structure or activities that may be useful to limit systemic risk. Large financial institutions and mid-size financial institutions looking to grow substantially by acquisitions should monitor this study and the impact of any recommendations on their growth and acquisition strategies. ENHANCED BANK AND BANK HOLDING COMPANY REGULATION Capital Requirements Are there any possible changes to the calculation of tier 1 capital? Yes. Hybrid instruments will continue to be the focus of regulatory attention. The Collins Amendment included in the Dodd-Frank Act will apply the leverage and riskbased capital requirements applicable to insured depository institutions to bank holding companies with $500 million or more in consolidated assets and generally exclude trust preferred instruments from tier 1 capital. The GAO, in consultation with the Federal Reserve, the OCC, and the FDIC, must study and report to Congress by January 2012 on the use of hybrid capital instruments as a component of banks and bank holding companies tier 1 capital, including a review of the consequences of disqualifying trust preferred instruments and whether the disqualification could lead to existing banking organizations failure or undercapitalization, and recommendations for specific legislative or regulatory action regarding the treatment of hybrid capital instruments. Oversight of Subsidiaries Bank-Permissible Activities Does the Dodd-Frank Act impact a bank s conduct of permissible activities outside of the bank (e.g., a leasing company)? Yes. These activities will now be subject to Federal Reserve examination, in the same manner, subject to the same standards, and with the same frequency as would be required if such activities were conducted in the lead depository institution of the holding company. This could be a significant change not only in terms of examination presence, but in terms of expectations regarding risk management of the activity. Bank holding companies with subsidiaries conducting bank-permissible activities should 2010 PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 6

7 assume that their supervisor will apply the same risk-management standards to the subsidiary as it would if the activities were conducted within the bank. Acquisition Restrictions Could the Dodd-Frank Act affect a bank s expansion plans? Yes. Growth by acquisition may be impeded by new quantitative and qualitative requirements, but growth by branching is simplified. For example, the Dodd-Frank Act prohibits a financial company from growing by acquisition beyond 10% of the aggregate consolidated liabilities of all financial companies in the United States and raises the standard of review for interstate bank acquisitions and Bank Merger Act applications from adequately capitalized and adequately managed to well capitalized and well managed at the bank holding company level or resulting bank level, as applicable. Enhanced Restrictions on Transactions with Affiliates Does the Dodd-Frank Act limit banks engagement in any derivatives transactions or securities lending and borrowing transactions with affiliates? Yes. These activities are now subject to quantitative limitations and collateral requirements, among other things. The definition of covered transactions is expanded to include credit exposures arising from derivatives transactions and securities lending and borrowing transactions. This means such activities will count toward aggregate limits on covered transactions and must be at least fully secured depending upon the nature of the collateral. Special Purpose Charters Activities Will the Dodd-Frank Act affect special purpose banking charters? Yes. Special purpose charters including industrial banks, credit card banks, and trust banks will now be subject to statutory restrictions on transfer of ownership if owned by commercial firms. In addition, their future is the subject of a mandated GAO study and report to Congress on the potential elimination of the Bank Holding Company Act exemption afforded these charters. Could problems at non-depository institution subsidiaries affect a financial holding company s ability to engage in financial activities? Yes. The Dodd-Frank Act requires a financial holding company ( FHC ) to remain well capitalized and well managed to maintain its FHC status. Previously, only depository institution subsidiaries of the FHC were required to meet these standards. Accordingly, 2010 PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 7

8 problems within the FHC but outside the depository institutions could jeopardize the FHC s ability to engage in expanded financial activities. Volcker Rule Does the Dodd-Frank Act affect the ability of certain financial institutions to engage in private equity, hedge fund, or proprietary trading activities? Yes. The Volcker Rule (as section 619 of the Dodd-Frank Act is commonly known) generally prohibits proprietary trading and sponsorship of or investment in hedge funds or private equity funds (unless under both 3% of total ownership in the fund and 3% of tier 1 capital) by insured depository institutions and their holding companies and affiliates. However, the Dodd-Frank Act provides numerous exceptions to the Volcker Rule. For instance, the proprietary trading restriction relates to near-term investments, not longer-term investments, and does not cover trading in U.S. government, agency, and government-sponsored enterprise securities, state or municipal obligations, or bona fide risk-mitigating or hedging activities. In addition, regulators must consider and weigh these and any further exceptions: The Dodd-Frank Act requires the Council to study and make recommendations with respect to implementation of the Volcker Rule within six months of the enactment of the Dodd- Frank Act. Within nine months of the Council s study, the federal banking agencies, the SEC, and the CFTC are to issue coordinated rulemakings, which could limit or create further exceptions. Financial institutions should monitor the Council s study and the federal regulators rulemakings. Enhanced Consumer Protections Does the Dodd-Frank Act restrict interchange fees (for card networks) for electronic debit transactions? Yes, for large banks with total assets over $10 billion. The Dodd-Frank Act requires that debit interchange fees be reasonable and proportional to the costs incurred by the debit card issuer in processing transactions. The Dodd-Frank Act specifically requires the Federal Reserve to issue a regulation by March 2011 defining permissible debit interchange fees that a debit card issuer may charge or receive. In connection with its determination of what constitutes a reasonable fee, the Federal Reserve may make adjustments for fraud prevention costs incurred by the debit card issuer. Banks should monitor these regulations and the possibility of additional fee limits and the expansion of tying fees to costs. Does the Dodd-Frank Act establish whistleblower provisions relating to consumer banking activity? Yes. The Dodd-Frank Act creates a new whistleblower cause of action for employees performing tasks relating to the offering or provision of consumer financial products or services. This provision prohibits retaliation against employees who provide 2010 PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 8

9 information to their employers or to the government regarding a violation of the Dodd- Frank Act or any other provision of law subject to the jurisdiction of the Consumer Financial Protection Bureau (the CFPB ). Companies should ensure that they establish policies and procedures for employees to internally report any alleged violation of the Dodd-Frank Act and any other provision of law under the CFPB s jurisdiction and for companies to respond to these reports, including, where appropriate, escalating issues to the audit committee or other board committee. Does the Dodd-Frank Act affect the Office of the Comptroller of the Currency s preemption powers and the growing authority of state attorneys general? Yes, in two respects. Under the Dodd-Frank Act, consumer financial protection laws applicable to national banks and federal thrifts are preemptible only under specified circumstances, including if the OCC determines that the state consumer law in question prevents or significantly interferes with a national bank s or federal thrift s exercise of its powers. Thus, while preemption is preserved, its use is somewhat circumscribed. At the same time, the Dodd-Frank Act empowers state attorneys general to enforce CFPBprescribed regulations against all covered persons, including national banks and federal thrifts. What federal consumer financial laws will be overseen by the Consumer Financial Protection Bureau? The CFPB assumes responsibility for interpreting and implementing the federal consumer financial and fair lending laws, including, among others, the Truth in Lending Act, the Equal Credit Opportunity Act, and the Real Estate Settlement Procedures Act. The CFPB will not take over responsibility for rulemaking or enforcement of the Community Reinvestment Act, which will remain under the jurisdiction of the existing bank regulators. Will the Consumer Financial Protection Bureau affect examinations conducted by the prudential regulators? Yes. The Dodd-Frank Act provides that, with respect to banks that exceed $10 billion in assets, the CFPB will have exclusive authority to require reports and conduct examinations on a periodic basis for purposes of assessing compliance with federal consumer financial laws. The Dodd-Frank Act further stipulates that the CFPB will coordinate with the prudential regulators and the state bank regulatory authorities and utilize existing reports where available PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 9

10 Mortgage Lending Restrictions Does the Dodd-Frank Act restrict steering incentives and prepayment penalties for qualified and non-qualified mortgages? Yes, in several respects. The Dodd-Frank Act prohibits a mortgage originator from receiving compensation, directly or indirectly, based on mortgage terms other than the principal amount, and; steering a consumer away from a mortgage for which he/she is eligible, that meets the definition of qualified mortgage 1, to a mortgage that does not meet this definition. The Dodd-Frank Act further provides that a residential mortgage that is not a qualified mortgage may not contain terms under which a consumer must pay a prepayment penalty for paying all or part of the principal after consummation of the loan. Moreover, for a qualified mortgage, prepayment penalties may not be imposed in excess of (i) 3% of the outstanding balance during the first year; (ii) 2% during the second year; (iii) 1% during the third year, following which no prepayment penalty may be imposed. In addition, a creditor may not offer a consumer a residential mortgage permitting prepayment penalties without also offering a mortgage with no prepayment penalties. Does the Dodd-Frank Act affect the appraisal process? Yes. A mortgage lender, a mortgage broker, and any other person connected with a residential real estate transaction involving an appraisal who has a reasonable basis to believe that an appraiser has failed to comply with the Uniform Standards of Professional Appraisal Practice, is violating applicable laws, or is otherwise engaged in unethical or unprofessional conduct must report the matter to the applicable state appraisal board. Companies should establish policies and procedures relating to the reporting of fraudulent, unethical, or unprofessional behavior of appraisers to state appraisal boards. Micro-Lending Does the Dodd-Frank Act support micro-lending? Yes. The Dodd-Frank Act recognizes the importance of access to small-dollar consumer credit and creates a program funded by the Department of the Treasury for small-dollar loans (less than $2,500) as an alternative to payday loans. The Department of the Treasury is authorized to establish a multi-year program of grants, cooperative agreements and similar contracts/undertakings to promote initiatives that enable low and moderate income individuals access to financial products (e.g., deposit accounts, savings accounts, closed-end loans). Entities considered eligible for the incentives offered under this program include federally-insured depository institutions and 1 A qualified mortgage is a high-quality residential mortgage. The Dodd-Frank Act amends the Truth in Lending Act to provide a definition of a qualified mortgage, which includes a number of features, such as not allowing for negative amortization or deferral of principal payments PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 10

11 partnerships or joint entities of one or more of the eligible entities. Banks should monitor this program and any other actions banking regulators take to encourage microlending. NEW REGULATORY STRUCTURE FOR THRIFTS AND THRIFT HOLDING COMPANIES Supervision Does the Dodd-Frank Act affect thrift supervision? Yes. The Dodd-Frank Act eliminates the Office of Thrift Supervision (the OTS ). It transfers OTS functions relating to federal thrifts to the OCC and OTS functions relating to state thrifts to the FDIC (excepting rulemaking authority, which is transferred to the OCC). The Dodd-Frank Act transfers OTS functions relating to savings and loan holding companies to the Federal Reserve. What should thrifts know about the supervisory differences among the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision? Banking and thrift guidance is interagency in nature, so the policies are generally the same. However, supervisory practices are idiosyncratic. For example, credit classification standards are generally believed to have been interpreted and applied less stringently by the OTS than by other agencies. Also, thrift holding companies will be subject to the Federal Reserve s consolidated capital requirements. In the past, the OTS only focused on certain egregious capital issues at the holding company level, such as a holding company s heavy reliance on double leverage. Qualified Thrift Lender Test Does the Dodd-Frank Act affect thrifts that fail to meet the qualified thrift lender test? Yes. Failure to meet the qualified thrift lender test (QTL test) will result in immediate restrictions on activities, branching, and dividends. Thrifts failing the QTL test will no longer have the option of becoming a commercial bank to avoid these restrictions as they did prior to the Dodd-Frank Act s enactment. Unitary Thrift Holding Companies Are any financial institutions grandfathered under the Dodd-Frank Act? Yes. Unitary thrift holding companies are still exempt from the activities limitations generally imposed on savings and loan holding companies, but may be required to create intermediate holding companies in which to house most financial activities PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 11

12 ENHANCED INSURER REGULATION Federal Insurance Office What are the responsibilities of the new Federal Insurance Office? The FIO is responsible for monitoring all aspects of the insurance industry, including identifying all issues or gaps in insurance regulation potentially contributing to a systemic crisis in the insurance industry or U.S. financial system. It must also conduct a study on how to modernize and improve the U.S. system of insurance regulation and provide legislative, regulatory, or administrative recommendations. Insurers should monitor the FIO s work with respect to this study and respond to any requests for input. To the extent that recommendations require legislative changes, potential implementation would likely take years. Are insurers subject to information requests from the Federal Insurance Office? Yes. The FIO is authorized in carrying out its duties to receive and collect data and information from insurers and has subpoena power. Insurance Sales Could the Dodd-Frank Act affect the sale and distribution of variable annuity and variable life insurance products? Yes. The Dodd-Frank Act authorizes the SEC to promulgate rules: (i) providing that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice to a retail customer about securities, such as variable annuity and variable life insurance products, will be to act in the best interest of the customer; and (ii) designating documents or information to be provided by brokers or dealers to retail investors prior to investment product or service sales. Insurers should understand how any potential changes would affect their training, compliance, advertising programs, and distribution networks. International Insurance Activities Does the Dodd-Frank Act affect an insurer engaged in international insurance activities? Yes. The Dodd-Frank Act affects international insurance activities in two respects. First, the Dodd-Frank Act authorizes the FIO to coordinate federal efforts and develop federal policy on prudential aspects of international insurance matters; and the Secretary of the Treasury and U.S. Trade Representative to jointly negotiate on the United States behalf bilateral or multilateral insurance agreements with foreign authorities relating to prudential measures. Second, the FIO Director will be able to preempt state insurance 2010 PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 12

13 measures if those measures (i) are inconsistent with bilateral or multilateral insurance agreements between the United States and foreign authorities and (ii) result in less favorable treatment of a foreign insurer than a U.S. insurer domiciled, licensed, or admitted in that state. Nonadmitted Insurance Reinsurance Does the Dodd-Frank Act streamline regulation of the nonadmitted property and casualty insurance market? Yes. The Dodd-Frank Act requires that nonadmitted insurance sales be subject only to the statutory and regulatory requirements of the insured s home state; facilitates access of large commercial purchasers to nonadmitted insurance carriers; streamlines the licensing process for surplus line brokers; and prohibits any state other than the insured s home state from requiring surplus line brokers to be licensed to sell nonadmitted insurance to an insured. In addition, the GAO must study the impact of the Dodd-Frank Act s nonadmitted insurance market reforms on the size and market share of the nonadmitted insurance market for providing coverage typically provided by the admitted insurance market. Insurers participating in the property and casualty insurance market should monitor this study. Does the Dodd-Frank Act streamline regulation of the reinsurance market? Yes. The Dodd-Frank Act (i) prohibits a state from denying credit for reinsurance if the home state of the insurer purchasing reinsurance is accredited by the National Association of Insurance Commissioners (the NAIC ) or has solvency requirements substantially similar to the NAIC s requirements; (ii) preempts all state laws, regulations, provisions, or other actions, except with respect to taxes and assessments on insurers and insurance income, that are not those of the home state of the insurer purchasing reinsurance; and (iii) requires that a reinsurer s home state be solely responsible for regulating the reinsurer s financial solvency if the state is accredited by the NAIC or has solvency requirements substantially similar to the NAIC s requirements. In addition, the FIO must conduct reports on (i) the breadth and scope of the U.S. and global reinsurance market; and (ii) the impact of the Dodd-Frank Act s provisions relating to nonadmitted and reinsurance reform on the ability of state regulators to access reinsurance information for insurers. Reinsurers should monitor these reports and be prepared to respond to any FIO request for comment or information PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 13

14 INCREASED DERIVATIVES REGULATION Swaps Push Out Does the Dodd-Frank Act affect depository institutions that engage in swaps activity? Yes. The Dodd-Frank Act generally prohibits federal assistance (e.g., Federal Reserve discount window access, deposit insurance) to swap entities (i.e., swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants), effectively preventing banks from acting as swap entities. However, the Dodd-Frank Act also contains exemptions to this general prohibition which permit insured depository institutions (i) to engage in limited swaps activity related to hedging and other risk-mitigating activities or (ii) to engage in derivatives transactions involving interest rates and loans or other reference assets permissible for investment by national banks (such as foreign exchange, coins, gold, and silver). The Dodd-Frank Act permits insured depository institutions to push out any prohibited swaps activities to independently capitalized affiliates. Swap Dealer and Major Swap Participant Regulation Does the Dodd-Frank Act affect the swaps activity of dealers, and intermediaries? Yes. The Dodd-Frank Act establishes different definitions, requirements, and exemptions for entities depending upon the capacity in which these entities engage in swaps activity. A swap dealer is any person who: (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. A security-based swap dealer is defined in the same manner, but with respect to security-based swaps. A major swap participant is defined as any person who is not a swap dealer, and: (i) maintains a substantial position in swaps; (ii) whose outstanding swaps create substantial counterparty exposure; or (iii) is a financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by an appropriate federal banking agency, and maintains a substantial position in outstanding swaps. A major security-based swap participant is defined in the same manner, but with respect to security-based swaps. Swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants will be subject to CFTC and/or SEC registration requirements, business conduct standards, including designating a chief compliance officer, and capital and margin requirements PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 14

15 Duties Toward Special Entities Are there additional requirements to which swap dealers and major swap participants will be subject when engaging in swaps activity with special entities, such as governmental entities, pension plans, and employee benefit plans? Yes. Swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants will be subject to heightened business conduct standards with respect to special entities (e.g., pension plans, governmental entities, employee benefit plans, endowments), which include acting in the special entity s best interest and having a reasonable basis to believe that the counterparty special entity has an independent representative that has sufficient knowledge to evaluate the swaps transaction and risks. These heightened standards fall short of the fiduciary standard which would have been imposed by earlier draft versions of the legislation. Swaps Clearing and Derivatives Clearing Organizations and Clearing Agencies Does the Dodd-Frank Act affect the clearing of swaps? Yes. The Dodd-Frank Act requires that most standardized transactions (although that term is not used) between financial counterparties be cleared by a central counterparty. The Dodd-Frank Act also requires derivatives clearing organizations and clearing agencies to submit to the CFTC or the SEC all swaps and security-based swaps that they plan to accept for clearing. The Dodd-Frank Act further requires derivative clearing organizations and clearing agencies to register with the CFTC or the SEC, respectively, and to comply with several requirements in order to clear swaps and security-based swaps, including establishing margin requirements for cleared transactions. End-User Exemption Are any entities exempt from the swaps clearing requirements? Yes. The Dodd-Frank Act provides an exemption from the swaps clearing requirements for any swap counterparty that (i) is not a financial entity, such as a swap dealer or major swap participant; (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the CFTC how it generally meets its financial obligations associated with entering into non-cleared swaps. A similar exemption is provided for security-based swaps clearing PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 15

16 Swap Execution Facilities What is a swap execution facility and does the Dodd-Frank Act impose requirements upon these entities? A swap execution facility ( SEF ) is defined as a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, including any trading facility that facilitates the execution of swaps between persons and is not a designated contract market. A security-based SEF is defined in the same manner, but with respect to security-based swaps. SEFs are subject to registration requirements, trade processing standards, and trade monitoring requirements. A security-based SEF is subject to similar requirements and standards. Regulators will determine through rulemaking the universe of entities that will be required to register as SEFs and this currently is an area of intense interest and focus by the derivatives industry. Among the issues of particular interest is whether voice-brokered facilities or single dealer or broker-operated systems will qualify as SEFs or security-based SEFs. NEW ASSET MANAGER AND BROKER-DEALER REGULATION Investment Adviser Regulation How does the Dodd-Frank Act affect the regulation of advisers to private funds? Advisers to private funds, such as hedge funds and private equity funds, with at least $150 million in assets under management are now required to register under the Investment Advisers Act and are subject to reporting, examination, and other compliance requirements. In addition, these private fund advisers are subject to additional private fund recordkeeping, reporting, and examination requirements, including disclosures relating to the use of leverage and counterparty and credit risk exposure. The Dodd-Frank Act explicitly exempts from registration advisers to private funds with less than $150 million in U.S. assets under management, venture capital funds, foreign private funds, family offices, and small business investment companies as well as private fund advisers registered with the CFTC. The Dodd-Frank Act requires the SEC to issue rules on private fund adviser reporting requirements, smaller private fund adviser reporting and recordkeeping requirements, and the definition of venture capital fund, and permits the SEC to issue rules subjecting advisers to venture capital funds to reporting and recordkeeping requirements. Private fund advisers should monitor and be prepared to comment upon these rulemakings. In addition, the GAO must study and report by July 2011 on the feasibility of forming a self-regulatory organization for private funds. Private fund advisers should monitor this study and provide input and data, as appropriate PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 16

17 How does the Dodd-Frank Act affect the federal registration of investment advisers with under $100 million in assets? The Dodd-Frank Act exempts from federal registration under the Investment Advisers Act a state-registered and state-examined investment adviser with assets under management between $30 million and $100 million. However, if this exemption would require the investment adviser to register with 15 or more states, the adviser may choose to register under the Investment Advisers Act. Investment Adviser and Broker-Dealer Standards of Care Could the Dodd-Frank Act affect the sale and distribution of securities products? Yes. The Dodd-Frank Act requires the SEC to study the effectiveness of existing standards of care for brokers, dealers, investment advisers, and their associated persons for providing personalized securities investment advice and recommendations to retail customers. In July 2010, the SEC published a request for public comment to inform this study. 2 The Dodd-Frank Act also authorizes the SEC to promulgate rules to provide that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to a retail customer (and such other customers as the SEC may by rule provide), will be to act in the best interest of the customer. Broker-dealers and investment advisers should understand how any potential changes would affect their operations (including for broker-dealers their underwriting, trading, and market making activities), training, compliance, and advertising programs and distribution networks. Mutual Fund Advertising and Investment Product Disclosures Could the Dodd-Frank Act bring about changes in mutual fund advertising and investment product disclosures? Possibly. The GAO must study and report by January 2012 on mutual fund advertising, including recommendations to improve investor protections in mutual fund advertising and additional information necessary to ensure that investors can make informed financial decisions when purchasing mutual funds. The Dodd-Frank Act authorizes, but does not require, the SEC to promulgate rules designating documents or information to be provided by brokers or dealers to retail investors prior to investment product or service sales. Broker-dealers and asset managers should understand how any potential changes to mutual fund advertising and investment product sales disclosures would affect their training, compliance, advertising programs, and distribution networks. 2 SEC, Request for Comment: Study Regarding Obligations of Brokers, Dealers, and Investment Advisers, 75 Fed. Reg. 44,996 (July 30, 2010) PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 17

18 Conflicts of Interest Does the Dodd-Frank Act address conflicts of interest between broker-dealer underwriting units and equity and/or fixed income research departments? Yes. The GAO must report by January 2012 on potential conflicts of interest that exist between the staffs of the investment banking and equity and fixed income securities analyst functions within the same firm; and make recommendations designed to protect investors in light of such conflicts. Broker-dealers should monitor this report and understand the impact of any recommendations, including the report s focus not only on equity research, but also fixed income research. Short Sale Reforms Does the Dodd-Frank Act affect short sale regulation? Yes, in several respects. The Dodd-Frank Act requires every registered broker or dealer to provide notice to its customers that they may elect to not have their securities used for securities lending, and, if the broker or dealer does lend the customer s securities, the compensation the broker or dealer may receive. In addition, the Dodd-Frank Act requires the SEC to prescribe rules for institutional investment managers with $100 million in assets requiring the public disclosure of certain short sale information. Mandated SEC studies may recommend further short sale reforms. The SEC s Division of Risk, Strategy, and Financial Innovation must study (i) short-selling on exchanges and in the over-the-counter market; and (ii) the feasibility, benefits, and costs of (a) requiring real-time public reporting or real-time reporting to the SEC and the Financial Industry Regulatory Authority of public company short positions; and (b) conducting a voluntary pilot program in which public companies will agree to have all trades of shares marked "short," "market maker short," "buy," "buy-to-cover," or "long," and reported in real time through the Consolidated Tape. Asset managers should monitor these studies to understand whether the SEC will recommend further short sale reforms. Whistleblower Programs Does the Dodd-Frank Act establish whistleblower programs at the Securities and Exchange Commission and the Commodity Futures Trading Commission? Yes. The Dodd-Frank Act creates whistleblower programs at the SEC and the CFTC, providing new protections and awards for individuals reporting securities law violations to the SEC and commodity law violations to the CFTC. Companies should ensure the establishment, review, and/or updating of policies and procedures for employees to internally report any alleged violation of the securities or commodity laws and for companies to respond to these reports, including, where appropriate, escalating issues to the audit committee or other board committee PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 18

19 Office of Investor Advocate and Investor Advisory Committee Does the Dodd-Frank Act establish any other structural mechanisms at the Securities and Exchange Commission to enhance investor protections? Yes. In addition to the SEC s whistleblower program as noted above, the Dodd-Frank Act establishes (i) an Office of Investor Advocate, to, among other things, assist retail investors in resolving significant problems with the SEC or self-regulatory organizations; and (ii) the Investor Advisory Committee to advise the SEC on its regulatory priorities, and issues relating to, among other things, the regulation of securities products, trading strategies, and fee structures, and the effectiveness of disclosure. Broker-dealers and asset managers should monitor the activities of the Office of Investor Advocate and the Investor Advisory Committee as the SEC might change its own practices in response to these entities findings and recommendations. CREDIT RATINGS AND SECURITIZATION REFORMS Elimination of Credit Rating References in Federal Statutes and Regulations Does the Dodd-Frank Act aim to reduce market and regulatory reliance on credit ratings? Yes. The Dodd-Frank Act aims to lessen market and regulatory reliance on credit rating agencies by requiring each federal agency to review its regulations requiring an assessment of the credit-worthiness of a security or money market instrument or referencing credit ratings and modify these regulations to replace any credit rating reference with a standard of credit-worthiness that each agency determines to be appropriate. On August 10, 2010, the federal banking regulators released an advance notice of proposed rulemaking soliciting comment on the development of alternatives to using credit ratings in their capital. 3 Additionally, on August 13, 2010, the OCC released an advance notice of proposed rulemaking soliciting comment on alternatives to the use of credit ratings in its regulations governing bank-permissible investment securities and certain other activities. 4 Companies should respond to this request for information, as appropriate, and should use or consider using other measures besides credit rating agencies ratings to determine credit-worthiness. 3 OCC, Federal Reserve, FDIC, OTS, Advance Notice of Proposed Rulemaking Regarding Alternatives to the Use of Credit Ratings in the Risk-Based Capital Guidelines of the Federal Banking Agencies (Aug. 10, 2010), at 4 OCC, Advance Notice of Proposed Rulemaking: Alternatives to the Use of External Credit Ratings in the Regulations of the OCC, 75 Fed. Reg. 49,423 (Aug. 13, 2010) PROMONTORY FINANCIAL GROUP, LLC. ALL RIGHTS RESERVED. 19