Dodd-Frank Wall Street Reform and Consumer Protection Act Signed

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1 JULY 23, 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act Signed By: Raymond J. Gustini, Lloyd H. Spencer, William E. Kelly, Keith L. Krasney, Paulette J. Morgan, Barry M. Rothchild, and Tiana Butcher Because of this law, the American people will never again be asked to foot the bill for Wall Street s mistakes. -President Barack Obama, July 21, 2010 Congress has more work to do to ensure the bill is implemented successfully, but today we have created a new, sound foundation for the 21 st century economy. -Senate Banking Committee Chair Christopher J. Dodd, July 21, 2010 President Barack Obama has signed legislation adopted by the House of Representatives and the U.S. Senate known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd- Frank Act or the Act ). The Act contains broad changes in the regulation of U.S. financial institutions and markets providing historic changes in how each are regulated. For the first time a specifically designated regulatory entity will be overseeing how large institutions affect risks to the nation s economic health and the stability of its markets and be able to undertake targeted actions against institutions posing systemic risks. The final legislation was the product of a three-week conference between House and Senate representatives and was passed in the House on June 30, 2010, and in the Senate on July 15, At over 2,300 pages, the legislation will be followed by extensive new regulations by some estimates nearly 500 new regulations that will have to be adopted, most within one year of enactment and many within a six- or nine-month period. By any measure the legislation s impact will be far-reaching and likely represents the most significant change in banking and financial markets regulation since the Great Depression. The legislation covers a number of key areas: 1

2 Creation of a new interagency council, the Financial System Oversight Council that is charged with identifying and monitoring the systemic risk to the U.S. economy posed by systemically significant, large financial companies, including bank holding companies and non-bank financial companies An end to too big to fail and a special orderly liquidation procedure outside the bankruptcy courts for large, systemically significant institutions Securities and Exchange Commission rulemaking that will consider whether to impose investment adviser fiduciary standards on broker dealers Establishment of a new consumer protection governing body within the FRB, the Bureau of Consumer Financial Protection to regulate consumer financial products and services Increased federal deposit insurance to $250,000 for banks and credit unions A new method for calculation of deposit insurance premiums based on total assets, less tangible capital instead of insured deposits Repeal of prohibition on payment of interest on demand deposits Relief from Sarbanes-Oxley 404(b) for smaller public companies under $75 million in market capitalization Increased capital standards, including a phase-out of trust preferred securities as capital for larger bank holding companies Preservation of the thrift charter, while still eliminating the Office of Thrift Supervision by merging it into the Office of the Comptroller of the Currency Interchange debit card fees of large banks subject to price setting by the Federal Reserve Board based on a reasonable and proportional standard Increased regulation and transparency for credit rating agencies through establishment of a new regulatory office within the SEC Securitization New securitization requirements, including a required 5% holdback for securitizers. Securitizations of qualified mortgages would be excepted Derivatives Reform Profound changes to the manner in which derivative products and derivatives market participants are regulated, including a pushout provision that prohibits some derivatives activity within banks One-time audit of the Federal Reserve Board activities during the 2008 financial crisis Adoption of the Volcker Rule to limit proprietary trading or hedge fund sponsorship by banks Risk committees required for bank holding companies with $10 billion or more in assets Title I Financial Stability 2

3 Title I represents the most significant changes to regulation of financial services and markets in decades. The objective of Title I to have a more concentrated focus on the systemic risk in the U.S. financial system was met by the creation of the Financial System Oversight Council ( FSOC ). The FSOC would be chaired by the Treasury Secretary and have ten voting members, including the Treasury, the Federal Deposit Insurance Corporation ( FDIC ), the Securities and Exchange Commission ( SEC ), the Commodities Futures Trading Commission ( CFTC ), the Comptroller of the Currency ( OCC ), the Federal Reserve Board ( FRB ), the Federal Housing Finance Agency ( FHFA ), the National Credit Union Administration ( NCUA ), the head of the newly-created Bureau of Consumer Financial Protection, and an independent presidential appointee with insurance expertise. Title I, Section 112 of the Dodd-Frank Act succinctly describes the FSOC s authority: (A) To identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or non-bank financial companies, or that could arise outside the financial services marketplace; (B) To promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the government will shield them from losses in the event of failure; and (C) To respond to emerging threats to the stability of the United States financial system. Within this framework, the FSOC would determine by a two-thirds vote (including the required vote of its chair, the Secretary of the Treasury) when a non-bank financial company needs to be placed under the supervision of the FRB and subject to prudential standards because of either (i) material financial distress at the non-bank financial company, or (ii) if the nature, size, scope, scale concentration, interconnectedness, or mix of its activities could pose a serious threat to the financial stability of the United States. Non-Bank Financial Company Definition The Act defines any non-bank financial company as any company that is predominantly engaged in financial activities. A non-bank financial company is predominantly engaged in financial activities if 85% of gross revenues or 85% of consolidated assets are financial in nature. The term financial is defined by reference to Section 4(k) of the Bank Holding Company Act of Excluded from the definition are various regulated entities such as a bank holding company, a national securities exchange, a Farm Credit System institution, and a security-based swap execution facility. Once the FSOC acts to place a non-bank financial company under its jurisdiction, it would be subject to comprehensive examination and supervisory jurisdiction of the FRB. The FSOC would then recommend to the FRB the establishment of enhanced prudential standards applicable to non-bank financial companies supervised by the FRB. The enhanced standards would be more stringent than those for covered entities that do not present risk to the financial stability of the United States. The heightened prudential standards could include risk-based capital requirements, leverage limits, liquidity requirements, concentration limits, short-term debt limits and heightened public disclosure. 3

4 Foreign Non-Bank Financial Companies Title I references both U.S. and foreign non-bank financial companies. A foreign non-bank financial company could be subject to FSOC action if it is incorporated in a foreign country and is predominantly engaged in financial activities, including activities conducted through a branch in the United States. The Act gives some deference to the extent and nature of the foreign non-bank financial company s assets and activities in the U.S. and the extent of its home country prudential regulation. Hotel California Provision The Hotel California provision would prohibit large ($50 billion in assets), interconnected bank holding companies that received TARP assistance from dropping bank charters to avoid the heightened scrutiny and possible increased prudential regulation by the FRB. In the case of large bank holding companies, FRB supervision would be automatic. Large bank holding companies would be subject to significantly enhanced regulation if the FRB determines that they pose a grave threat to the financial stability of the United States. Under this provision (Section 121) the FRB, upon a two-thirds vote of the FSOC, could also limit the ability of the large bank holding company to merge, offer financial products or services, or require termination of one or more activities. Collins Amendment Title I in Section 171 also contains the controversial Collins Amendment, introduced by Senator Susan Collins (R-ME). Initially intended to equate holding company capital for large and small bank holding companies, the amendment also references the prompt corrective action ( PCA ) definitions of Tier 1 capital at the bank level as a minimum holding company capital requirement. However, since Tier 1 capital for banks does not include trust preferred securities, the amendment would have prohibited the inclusion of trust preferreds at the holding company level as Tier 1 capital and require significant balance sheet deleveraging by holding companies unless remedied. As modified, Section 171 excludes small companies (under $500 million in asset bank holding companies) from any provisions of the section. The modification also grandfathers trust preferred stock issued before May 19, 2010, for all bank and thrift holding companies with less than $15 billion in consolidated assets. Holding companies with $15 billion or more are eligible for a five-year phase-in compliance with the provision, and beginning on January 1, 2013, are required to phase out trust preferred securities over a three-year period. Risk Committees Under Section 165(h) of the Dodd-Frank Act, all large ($10 billion or more in assets) publicly traded bank holding companies or a covered non-bank financial company must establish a risk committee of independent directors. At least one member of the committee must be a risk management expert. Regulations on risk committees are required within one year of enactment. The FRB has authority to require risk committees for bank holding companies with less than $10 billion in assets as necessary or appropriate to promote sound risk management practices. Office of Financial Research 4

5 The Act also creates in Subtitle B the Office of Financial Research ( OFR ) to assess and support the FSOC by collecting data from banks and other agencies, performing research, and designing and developing tools to measure risk. The OFR is essentially divided into two units: (i) a Data Center to prepare, collect and publish information, and (ii) a Research and Analysis Center to develop analytical capabilities to support FSOC. The OFR will be housed in the Department of Treasury. Title II Orderly Liquidation Authority Title II would create a new orderly liquidation procedure and provide authority for resolving the liquidation of systemically significant non-bank financial companies and bank holding companies outside of normal bankruptcy proceedings. The orderly liquidation program would be administered by the FDIC. Under Title II a systemically significant financial company could be removed from the normal bankruptcy process and placed in Title II s Orderly Liquidation Authority program if it poses a significant risk to the financial stability of the United States. Under these circumstances the orderly liquidation must be conducted in a manner that mitigates risk and minimizes moral hazard and that ensures that (i) creditors and shareholders bear the losses of the company, (ii) management responsible for the losses will not be retained, and (iii) so that all parties with responsibility for the losses bear company losses consistent with their responsibility. The triggering mechanism for commencing an orderly liquidation of a financial company as described in Section 203 of the Act occurs when the FDIC and the FRB unilaterally or upon the initial recommendation of the Treasury Secretary, vote by two-thirds of their boards to place a financial company in the Orderly Liquidation Program. Upon this recommendation the Treasury Secretary, in consultation with the President, must make a determination that orderly liquidation is an appropriate response after consideration of numerous factors including the effects of a failure on financial stability in the United States and the effects on counterparties and shareholders and creditors of the orderly liquidation actions as appropriate. Only financial companies (including bank holding companies) that derive 85% of revenue or have 85% of assets in financial activities are eligible for designation of a financial company for orderly liquidation to bypass normal bankruptcy and participate in the orderly liquidation process. Under Title II various proposals to prefund a $50 billion orderly liquidation fund to be utilized by the FDIC were abandoned in the face of strenuous opposition of Senate Republicans and an after the fact regime was substituted for the prefunded approach that relies instead upon a series of funding mechanisms to assist the FDIC with resolution costs. The funding mechanism includes FDIC obligations issued to the Treasury and repaid from liquidated assets of the failed entity. To further supplement its ability to repay the Treasury, the FDIC is authorized to assess any creditor who received payments under Orderly Liquidation that would have exceeded those payments the creditor would have received in bankruptcy. Finally, if all of these repayment sources are insufficient to reimburse the FDIC, the FDIC must impose risk-based assessments on large (over $50 billion in assets) bank holding companies and non-bank financial companies referred to the FRB by the FSOC. Under Title II, Section 214, any company placed in orderly liquidation must be liquidated. No restructuring option is available. 5

6 Title II also contains language designed to ensure that taxpayers do not bear the loss from orderly liquidation of financial companies and taxpayers are prohibited from bearing any loss in the orderly liquidation of a financial company. Title III Transfer of Powers to the Comptroller of the Currency, the Corporation, and the Board of Governors As originally proposed, nearly 5,000 state member banks would have been transferred from the FRB to the FDIC as the principal federal bank regulatory agency. However, as adopted by the conferees the FRB retained its jurisdiction over FRB state-member banks. The OTS was abolished by the Act and all of its rulemaking and supervisory authority over federal associations will be transferred to the OCC. Any pending OTS rule changes would become proposed regulations of the OCC. The transition of the OTS to the OCC takes place within a year of enactment. Bank holding companies would continue to be supervised by the FRB. Following the elimination of the OTS, thrift holding companies will be under the jurisdiction and rulemaking authority of the FRB. State nonmember banks and state chartered thrifts (but not their holding companies) will be supervised by the FDIC. Federal thrift charters could continue to be awarded by the OCC. Change in Calculation for Deposit Insurance Premiums The way in which federal deposit insurance premiums are calculated was changed in the Dodd-Frank Act in a manner that appears to favor smaller retail oriented banks with relatively larger ratios of deposits to total assets over larger banks that have traditionally relied on a combination of deposits and wholesale funding sources. As modified, instead of assessing on the basis of total insured deposits, FDIC deposit insurance premiums will be based on a bank s total assets net of tangible equity. This change should have the effect of increasing deposit insurance premiums for banks with relatively low ratios of domestic deposits to total assets generally the model followed by the largest banks. Lower insurance costs for deposits could favor retail deposit funding strategies over wholesale funding and increase competition among all banks for retail deposits. Section 335 of the Act provides that deposit insurance and share insurance coverage is permanently increased for banks and credit unions to $250,000. For banks only there is also a retroactive window period that increases deposit insurance to $250,000 for the period from January 1, 2008, through October 3, This provision is designed to protect uninsured deposits of the failed Indy Mac bank. Title IV Regulation of Advisers to Hedge Funds and Others Although Title IV is styled as a law regulating advisers to hedge funds, its scope is much broader. It amends Section 203(b) of the Investment Advisers Act of 1940 (the Advisers Act ) to accomplish several objectives. First, it eliminates the fewer than 15 clients exemption from the registration requirements of the Advisers Act, which has been relied upon by managers of, and advisers to, private pools of capital (including not only hedge funds but also venture capital funds, buy-out and other private equity funds, and funds-of-funds) as well as by family offices and smaller boutique investment advisers. It also requires advisers to all private funds (other than venture capital funds and other funds with less than $150 million in assets under management) to register under the 6

7 Advisers Act. Finally, it shifts jurisdiction over all investment advisers with less than $100 million in assets under management from the SEC to state securities administrators. Private Funds and Foreign Private Advisers The Dodd-Frank Act adds to the Advisers Act several new terms, including private fund and foreign private adviser. A private fund is any entity that would be an investment company but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940; a fund relying on Section 3(c)(1) may not have more than 100 investors while a 3(c)(7) fund is not limited in the number of its investors but all of its investors must be qualified purchasers (i.e., institutional investors and high net worth individuals). The Act will require advisers to all private funds (except for advisers to venture capital funds and private funds with less than $150 million in assets under management), who have heretofore relied on the fewer than 15 clients exemption provided by Section 203(b) of the Advisers Act, to register as investment advisers under the Advisers Act. The Act does not define venture capital fund but mandates that the SEC adopt a definition of the term within one year after the Act becomes law. The Dodd-Frank Act also exempts from the registration requirements of the Advisers Act foreign private advisers. These are defined as investment advisers with no place of business in the United States, with fewer than 15 clients who are resident in the United States, and with no more than $25 million in U.S.-source assets under management. Also, such advisers may not hold themselves out generally to the public in the United States as investment advisers and may not advise registered investment companies or business development companies. Venture Capital Funds The Dodd-Frank Act exempts from the registration and reporting requirements of the Advisers Act advisers that solely advise one or more venture capital funds. Responsibility for determining what constitutes a venture capital fund will reside with the SEC. But because the Senate version of the Act had exempted both venture capital fund advisers and private equity fund advisers, and the final legislation removed the exemption for advisers to private equity funds, the SEC definition of a venture capital fund (and, consequently, the scope of the exemption) is likely to be narrowly drawn and to exclude advisers to buy-out and private equity funds. Although advisers to venture capital funds will be exempt from the registration and reporting requirements of the Advisers Act, they will be required to maintain such records and to make such periodic reports as the SEC may determine to be necessary or appropriate for the protection of investors. Smaller and Mid-Sized Private Funds; Family Offices The Dodd-Frank Act also exempts from the registration and reporting requirements of the Advisers Act advisers that solely advise one or more private funds that have, in the aggregate, less than $150 million in assets under management. As with advisers to venture capital funds, advisers to private funds with less than $150 million in assets under management will be required to maintain such 7

8 records and make such periodic reports as the SEC may determine to be necessary or appropriate for the protection of investors. The Act further provides that, with respect to advisers to mid-sized private funds (a term the Act does not define), the SEC shall take into account the size, governance, and investment strategy of such funds to determine whether they pose systemic risk, and directs that the SEC s registration and examination procedures with respect to advisers to mid-sized funds shall reflect the level of systemic risk posed by such funds. The Act requires the SEC to adopt regulations providing for an exemption from the registration requirements of the Advisers Act, consistent with the SEC s current exemptive policy, for family offices. State Jurisdiction Over Smaller Registered Investment Advisers The Dodd-Frank Act amends the Advisers Act to change the threshold at which exclusive jurisdiction over registered investment advisers (including advisers who have registered voluntarily) shifts from state securities regulators to the SEC. Under prior law, registered advisers with less than $25 million in assets under management were subject to the exclusive jurisdiction of the state securities regulators in the jurisdictions in which they conduct business, and such advisers were prohibited from registering with the SEC. The Act raises this threshold to $100 million in assets under management, thereby subjecting advisers with less than $100 million under management to the exclusive jurisdiction of the state securities regulators. The Act does, however, permit an investment adviser with less than $100 million in assets under management to register with the SEC rather than with state securities regulators if the adviser would be required to register in 15 or more states. Accredited Investors The Act immediately excludes from the determination of an accredited investor s net worth the value of his or her primary residence. Title IV also requires the SEC to revise Regulation D, beginning four years after enactment of the Act, to make periodic adjustments to the net worth standard for an accredited investor. It also directs the GAO to conduct a study of the appropriate criteria for determining the financial thresholds and other criteria needed to qualify as an accredited investor and for eligibility to invest in private funds, and to report is conclusions to Congress within three years. Title V Insurance Under Title V, an Office of National Insurance is created within the Treasury to monitor all aspects of domestic insurance activity to identify gaps in regulation or issues that could contribute to systemic risk across all insurance lines except for health insurance. The Office would also coordinate federal policy on international insurance matters and could preempt state insurance laws that conflict with international insurance agreements and result in less favorable treatment of a non-united States domiciled insurer than a state domiciled insurer. Title VI Improvements to Regulation of Bank and Savings Association Holding Companies and Depository Institutions 8

9 Title VI of the Dodd-Frank Act enhances the regulation of depository institutions and their holding companies and includes the controversial Volcker Rule. It also deals with the longstanding controversy over the industrial bank loophole and source of strength requirements and concentration limits. Moratorium on Non-Banks Title VI in Section 603 seeks to buy time on the non-bank controversy by placing a three-year moratorium on FDIC approval of any application (received after November 23, 2009) for deposit insurance or a change in control of a credit card bank, industrial bank, or trust bank that is directly or indirectly owned or controlled by a commercial firm. A commercial firm is defined to mean any entity that derives less than 15% of its consolidated annual gross revenue from activities that are financial in nature and, if applicable, from the ownership or control of one or more insured depository institution(s). The GAO is required to conduct a study and provide a report within 18 months of whether the exceptions in the Bank Holding Company Act for these institutions should be eliminated. A non-depository bank would not be covered by the moratorium in Section 603. Functionally Regulated Subsidiaries Examination and Reporting Title VI expands the ability of the FRB to examine, impose reporting requirements on, and to take enforcement action against functionally regulated subsidiaries of bank holding companies. Bank and Non-Bank Acquisitions The Dodd-Frank Act directs the appropriate federal banking agency to take into consideration the impact on concentration risks to the stability of the United States banking or financial system when approving or disapproving an application under the Bank Holding Company Act to acquire shares of a bank or under the Bank Merger Act to merge with or acquire the assets of a bank. This will also apply to the acquisition of a non-bank company. In addition, financial holding companies will be required to obtain the FRB s prior approval of an acquisition of a non-bank company with consolidated assets in excess of $10 billion. Bank holding companies will also be required to be well capitalized and well managed to acquire a bank located outside of the bank holding company s state as opposed to adequately capitalized and adequately managed under current law. Similarly, the Bank Merger Act was amended to require the resulting entity of an interstate bank merger to be well capitalized and well managed as opposed to adequately capitalized and adequately managed under current law. Bank holding companies that are financial holding companies will also have to be well capitalized and well managed to engage in expanded financial activities under the Bank Holding Company Act. Currently, this well-capitalized and well-managed requirement only applies to the bank holding company s depository institution subsidiaries. Savings and Loan Holding Companies FRB examination authority The Dodd-Frank Act amends the Home Owners Loan Act to provide the FRB with the same examination and report authority over savings and loan holding companies and their subsidiaries, including functionally regulated subsidiaries, as contained in the Bank Holding Company Act for bank holding companies. In addition, a company that controls a 9

10 savings association that functions solely in a trust or fiduciary capacity will not be included within the definition of a savings and loan holding company. Holding company activities Savings and loan holding companies will be permitted to engage in all activities that a financial holding company is permitted to engage in under the Bank Holding Company Act, subject to the same requirements and under the same terms and conditions applicable to financial holding companies. As a result, savings and loan holding companies and their savings association subsidiaries will be subject to the same well-capitalized and well-managed requirements discussed above to engage in the expanded financial activities permissible for financial holding companies. Mutual holding company dividends The Dodd-Frank Act amends the Home Owners Loan Act to require each subsidiary of a mutual holding company to provide the appropriate federal banking agency and the FRB with 30 days advance notice of a proposed declaration of dividends, and the mutual holding company to provide the FRB with 30 days advance notice if it intends to waive the right to receive dividends. The mutual holding company s notice must include a determination by the board of directors that the proposed dividend waiver is consistent with the fiduciary duty of the board of directors to the mutual members of the mutual holding company. The FRB may object to the proposed dividend waiver within 30 days of the notice. However, the bill provides a grandfather provision for mutual holding companies that, prior to December 1, 2009, reorganized into a mutual holding company, issued minority stock either from its mid-tier holding company or subsidiary stock savings association, and waived dividends it was entitled to receive. For these grandfathered mutual holding companies, the FRB cannot object to a proposed dividend waiver unless the waiver would be detrimental to the safe and sound operation of the savings association. In addition, the grandfathered mutual holding companies will not be required to consider the waived dividends when determining an exchange ratio in the event of a full stock, or second step, conversion. Intermediate holding companies The Dodd-Frank Act permits the FRB to require grandfathered unitary savings and loan holding companies to create intermediate savings and loan holding companies to establish or conduct all or a portion of its financial activities if the grandfathered unitary savings and loan holding company conducts activities other than financial activities. The FRB must require a grandfathered unitary savings and loan holding company to create an intermediate savings and loan holding company if it determines that the establishment of such intermediate holding company is necessary to appropriately supervise the financial activities of the company or to ensure that supervision by the FRB does not extend to the activities of the company that are not financial activities. Financial activities generally means the financial activities permissible for a financial holding company under the Bank Holding Company Act. A grandfathered unitary savings and loan holding company that controls an intermediate holding company will not be deemed to be a savings and loan holding company but will be required to serve as a source of strength to its subsidiary intermediate holding company. The FRB may adopt regulations establishing affiliate transaction limits between an intermediate holding company and the grandfathered unitary savings and loan holding company and its affiliates. Concentration Limits in Connection With Acquisitions by Financial Companies and Pursuant to the Bank Merger Act 10

11 Title VI in Section 622 places overall limitations on the growth of U.S. financial companies. It does so by prohibiting a financial company from engaging in a merger or consolidation with, acquiring all or substantially all of the assets of, or otherwise acquiring control of, another company if the total consolidated liabilities of the financial company upon consummation of the transaction would exceed 10% of the aggregated consolidated liabilities of all financial companies at the end of the calendar year preceding the transaction. Certain exceptions to the limit will apply to acquisitions of a bank in danger of default, FDIC-assisted acquisitions and acquisitions that would result in only a de minimis increase in the liabilities of the financial company. The banking agencies also may not, under Section 623, approve an interstate merger transaction under the Bank Merger Act if upon consummation of the transaction the resulting insured depository institution and all of its affiliate insured depository institutions would control more than 10% of the total amount of deposits of insured depository institutions in the United States. In addition, the FRB and OCC will not be permitted to approve a bank holding company s or savings and loan holding company s interstate acquisition of an insured depository institution if, after consummation, all of the insured depository institutions that are affiliated with the bank holding company or savings and loan holding company would control more than 10% of the total amount of deposits of insured depository institutions in the United States. Certain exceptions to the limit will apply to acquisitions of an insured depository institution in danger of default and FDIC-assisted acquisitions. Transactions With Affiliates and Insiders Title VI amends the restrictions on transactions with affiliates in Section 23A of the Federal Reserve Act by including credit exposure from derivatives transactions and securities borrowing and lending as covered transactions and requiring a continuing collateral requirement for these and other covered transactions, including a purchase of assets subject to a repurchase agreement. The Dodd-Frank Act also eliminates the exception from the 10% of capital stock and surplus amount limitation on covered transactions with financial subsidiaries. Section 614 of the Dodd-Frank Act revises the definition of extension of credit in connection with loans to insiders. Credit exposure from derivative transactions, repurchase agreements, reverse repurchase agreements, securities lending transactions, and securities borrowing transactions will constitute an extension of credit. In addition, Section 615 requires purchases and sales of assets from or to an executive officer, director, or principal shareholder to be on market terms and, if the transaction represents more than 10% of the capital stock and surplus of the insured depository institution, a majority of the non-interested board members must approve the transaction in advance. Lending Limits Section 610 of the Act provides that credit exposure on derivative transactions, repurchase agreements, reverse repurchase agreements, and securities lending and borrowing will be included as loans or extensions of credit for national banks and savings associations when calculating their lending limits. State banks may only engage in derivative transactions if the law with respect to lending limits of the state in which the bank is chartered takes into consideration credit exposure to derivative transactions. Countercyclical Capital Rules and Source of Strength Requirements 11

12 The Dodd-Frank Act instructs the appropriate federal banking agencies to make the capital requirements for bank and savings and loan holding companies and insured depository institutions countercyclical so that the amount of capital required to be maintained increases in times of economic expansion and decreases in times of economic contraction, consistent with safety and soundness. Bank holding companies, savings and loan holding companies, and, if the insured depository institution does not have a holding company, any company that directly or indirectly controls the depository institution, will be required by statute to serve as a source of financial strength for the subsidiary or controlled depositary institution. Further, an industrial company that controls an insured depository institution such as an industrial loan corporation could, for the first time, be subject to the source of strength requirements. In addition, such industrial companies may be required to submit a report, under oath, assessing its ability to serve as a source of strength. Securities Holding Companies Section 618 of the Act eliminates the investment bank holding company election provisions under the Securities Exchange Act of Currently, if the investment bank does not have a bank or thrift affiliate and is not a foreign bank, it may elect to be supervised by the SEC. The Dodd-Frank Act will permit certain companies that are required by a foreign regulator or provision of foreign law to be subject to comprehensive consolidated supervision to register with the FRB to become a supervised securities holding company. To qualify as a securities holding company, the foreign company must control one or more brokers or dealers registered with the SEC and may not otherwise be subject to consolidated supervision by the FRB or a foreign regulator, or control an insured depository institution. Such supervision would include capital adequacy and risk management standards, examination and recordkeeping requirements, and would subject such securities holding companies to the provisions of the Bank Holding Company Act (other than the restrictions on non-banking activities and investments) but would include prior approval requirements for acquisitions of more than five percent of the voting shares of a bank or bank holding company. The Volcker Rule Proprietary Trading and Investment in Hedge Funds and Private Equity Funds Prohibition General prohibition Title VI contains a provision reflecting the Volcker Rule initially proposed by former FRB Chair Paul Volcker. The Dodd-Frank Act amends the Bank Holding Company Act by adding a new Section 13 that provides for a general prohibition on banking entities from: engaging in proprietary trading; or acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring a hedge fund or private equity fund. A non-bank financial company subject to supervision by the FRB that engages in proprietary trading or invests or sponsors hedge funds or private equity funds will be subject to additional capital requirements and quantitative limits on its proprietary trading and investments in hedge funds and private equity funds. 12

13 Banking entity means any insured depository institution (other than an institution that functions solely in a trust or fiduciary capacity and meets certain conditions), any company that controls an insured depository institution, any company that is treated as a bank holding company under the International Banking Act, and any affiliate or subsidiary of such entity. Proprietary trading means engaging as a principal for the trading account of the banking entity or non-bank financial company subject to supervision by the FRB in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the banking agencies, SEC, and CFTC determines by rule. Hedge fund and private equity fund mean an issuer that would be an investment company but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act or such similar funds that the banking agencies, SEC, and CFTC may determine by rule. Implementation period The prohibitions of the Volcker Rule will be implemented over time. First, an initial study by FSOC is required to be completed within six months of enactment of the Dodd-Frank Act. Then the bank regulatory agencies, SEC, and CFTC will develop regulations within nine months after completion of the study. The provisions of new Section 13 will take effect on the earlier of: 12 months after the date of the issuance of the final rules by the bank regulatory agencies, SEC, and CFTC; or Two years after the date of enactment of the Dodd-Frank Act. After that, institutions covered by the initiative would have two years to divest relevant businesses or comply with the rule subject to up to three one-year extensions that may be granted by the FRB. The FRB may grant an additional extension up to five years for banking entities that have a contractual obligation that was in effect on May 1, 2010, regarding investments or ownership in, or to provide additional capital to, an illiquid fund. Capital requirements during implementation The bank regulatory agencies, SEC, and CFTC are required to issue rules and impose additional capital requirements on any equity, partnership, or other ownership interest in or sponsorship of a hedge fund or private equity fund by a banking entity. Permitted activities The prohibitions of the Volcker Rule, as contained in Section 13 of the Bank Holding Company Act, do not apply to the following activities: purchases or sales of U.S. government securities, GNMA, FNMA, and FHLMC instruments or state and municipal bonds; underwriting or market-making related activities; risk-mitigating hedging activities designed to reduce specific risks to the banking entity in connection with and related to its individual or aggregate positions, contracts or other holdings; trading activities conducted on behalf of the banking entity s customers; 13

14 investments in small business investment companies and other investments qualifying as rehabilitation expenses with respect to qualified rehabilitated buildings and certified historic structures; investments by a regulated insurance company for its general account or by an affiliate of such regulated insurance company provided certain conditions are met; organizing and offering a private equity or hedge fund if, among other things, the fund is organized and offered only in connection with the provision of bona fide trust, fiduciary, or investment advisory services and only to persons that are customers of such services of the banking entity ( Trust Services Exception ); trading activity by a foreign company not controlled by a U.S. banking entity, that occurs solely outside the United States investments in equity, partnership, or other ownership interests or sponsorship of a hedge fund or private equity fund by a foreign company not controlled by a U.S. banking entity provided no ownership interests are offered for sale or sold to a resident of the United States; and such other activities permitted by the banking agencies, SEC, and CFTC by rule subject to the safety and soundness of the banking entity and the financial stability of the United States. These activities will not be permitted if the transactions or activity would result in a material conflict between the banking entity and its clients, customers, or counterparties, a material exposure by the banking entity to high-risk assets or high-risk trading strategies (both terms to be defined in regulations), would pose a threat to the safety and soundness of the banking entity, or would pose a threat to the financial stability of the United States. Capital requirements and limitations on permitted activities The bank regulatory agencies, SEC, and CFTC are required to issue rules that impose additional capital requirements and quantitative limitations, including diversification requirements, regarding the permitted activities if such agencies determine such requirements are appropriate to protect the safety and soundness of the banking entities engaged in such activities. De minimis investments A banking entity may invest in a hedge fund or private equity fund for purposes of establishing the fund and providing initial equity investment to permit the fund to attract unaffiliated investors or make a de minimis investment. Not later than one year after the establishment of the fund (which may be extended for an additional two years), the banking entity s investment must not be more than three percent of the total ownership interests of the fund and must be immaterial to the banking entity, which will be defined by regulation provided that the aggregate of all interests of the banking entity in such funds may not exceed three percent of its Tier 1 capital. The banking entity must deduct the aggregate amount of these investments from its assets and tangible equity for purposes of compliance with any additional capital requirements that apply to the permitted activities. Affiliate transaction limitations A banking entity that serves as the investment manager, investment adviser, or sponsor to a hedge fund or private equity fund or that organizes and offers any such fund pursuant to the Trust Services Exception may not (and neither may its affiliates) enter 14

15 into a covered transaction as defined in Section 23A of the Federal Reserve Act with the hedge fund or private equity fund. There is a limited exception for prime brokerage transaction if certain conditions are met. In addition, transactions between a banking entity that serves as the investment manager, investment adviser, or sponsor to a hedge fund or private equity fund or that organizes and offers any such fund pursuant to the Trust Services Exception and such fund will be subject to Section 23B of the Federal Reserve Act. Non-bank financial companies The banking agencies, SEC, and CFTC are directed to adopt rules imposing additional capital requirements or other restrictions on non-bank financial companies subject to supervision of the FRB. Interest on Demand Deposit Accounts The Dodd-Frank Act at Section 627 repeals the prohibition on paying interest on demand deposits, which will permit depository institutions to offer interest on checking accounts to business customers. De Novo Branching The remaining restrictions on de novo branching by national banks will be lifted pursuant to provisions in Section 613 of the Act. Restrictions on Charter Conversions Title VI also prevents banks and savings associations subject to formal (e.g., cease and desist orders) or informal (e.g., memorandum of understanding) enforcement orders with respect to a significant supervisory matter from converting charters. The Act provides for an exception if the appropriate federal banking agency after the proposed conversion notifies the federal banking agency that issued the enforcement order of the proposed conversion including a plan to address the significant supervisory matter. The federal banking agency that issued the enforcement order must object within 30 days of receipt of the notice. Title VII Wall Street Transparency and Accountability Title VII was one of the most controversial and contested provisions of the Act during the deliberations in the Senate and later in conference. Significant changes have been made but in many areas the Act will require an entirely new approach to the creation of clearing and settlement of swaps and the capital and margin requirements related thereto. This discussion represents an overview and a more detailed alert on Title VII is planned for the future. For ease of reference the term swap will refer to both swaps and security-based swaps and the terms swap dealer and major swap participant shall refer to swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants. When we use the term Agency or Agencies we are referring to the SEC and the CFTC as regulatory authorities for security-based swaps and swaps. Both Agencies are maintained by Title VII as regulators for swaps ( CFTC ) and security-based swaps ( SEC ). In many instances participants in swaps or securitybased swaps markets will be regulated by both entities. Prohibition on Federal Assistance 15

16 General Rule Perhaps more than any other provision the prohibition against federal assistance to a bank operating a swaps dealer engendered enormous controversy since federal assistance was defined to include items fundamental to a banking business, including federal deposit insurance or guarantees for certain purposes (including FDIC assistance arrangements and loss sharing), access to the FRB discount window, and to other FRB credit facilities. Unless remedied it was projected to result in broad scale divestiture or push out of swaps entities by banks or the cessation of swaps activities (Section 716). Key exceptions Several exceptions were provided for swaps activities and also to permit the conduct of swap activity in a non-bank affiliate in a holding company structure. The affiliate exception permits an insured depository institution to have or establish a swaps entity affiliate provided the insured depository institution is part of a holding company structure. There are additional exceptions: The prohibition on federal assistance, for example, does not apply to an insured depository institution that limits its swap or security-based swap activities to: (a) hedging activities directly related to the insured depository institution s activities, and (b) acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under 12 U.S.C. 24 (other than acting as a swaps entity for credit default swaps) unless such swaps are cleared by a registered (or an exempt from registration) derivatives clearing organization or a clearing agency ( DCO ) (Section 716). In addition there are the following exceptions: The prohibition on federal assistance only applies to swaps entered into by an insured depository institution after the end of the transition period described in the Act. Generally this period provides a 24-month period to permit divestiture or other compliance measures to take effect (Section 716). A swaps entity (which shall include any registered swap dealer or major swap participant) shall not include any insured depository institution or a covered financial company described in Title II that is in a conservatorship, receivership, or a bridge bank operated by the Federal Deposit Insurance Corporation (Section 716). Effective date The prohibition on federal assistance shall be effective two years following the date on which the Act is effective (Section 716). Authority of Financial Stability Oversight Council The Financial Stability Oversight Council may determine that, when other provisions established by the Act are insufficient to effectively mitigate systemic risk and protect taxpayers, that swaps entities may no longer access federal assistance with respect to any swap, or other activity of the swaps entity (Section 716). Registration and Regulation of Swap Dealers and Major Swap Participants The Act provides that the Agencies will regulate swaps in their respective areas of responsibility. The Act requires that, to the extent possible, the Agencies coordinate with each other and the prudential regulators prior to commencing any rulemaking or issuing an order relating to swaps, for the purpose of assuring regulatory consistency and comparability (Section 712). 16