American Bar Association Business Law Section Business Bankruptcy Committee Michael St. Patrick Baxter, Chair August 9, 2010 LEGISLATIVE UPDATE: DODD-FRANK ACT Judith Greenstone Miller Jaffe, Raitt, Heuer & Weiss, P.C. Chair, Legislation Subcommittee Aisha Williams Gilbert LLP Vice Chair, Legislation Subcommittee Salvatore A. Barbatano Tamar Dolcourt Foley & Lardner, LLP Contributing Editors Brooke Schumm Daneker, McIntire, Schumm et al. Contributing Editor The Dodd-Frank Wall Street Reform and Consumer Protection Act is landmark legislation affecting everything from the day-to-day operations of the largest financial institutions to the typical residential loan closing in a small practitioner s office. 1 The legislation is recognized to have international implications and will undoubtedly necessitate comprehensive agency rulemaking to enable its implementation. 2 A survey of the names of the fifteen titles in the Act usefully summarizes the scope and direction of this over 2000-page piece of legislation. Title I of the Dodd-Frank Act establishes a Financial Stability Oversight Council ( FSOC ) chaired by the Secretary of the Treasury. The voting membership of the FSOC will consist of the chairpersons of every major federal financial regulatory agency (e.g., the Federal Reserve Board, the FDIC, the SEC and the CFTC) as well as an independent director with 1 For this summary, enrolled bill, H.R. 4173 was used. It may be found at the Government Printing Office website. At www.house.gov, the bill appears in the Library of Congress THOMAS website under Bill Summary in the Index by Bill Number after the left column heading of H.R. 4165. 2 The Wall Street Journal recently cited a Davis Polk memorandum referring to over 200 rulemakings necessarily flowing from the Act. The Uncertainty Principle, Editorial, Wall. St. J., Jul. 14, 2010, at A18. 1
insurance industry expertise appointed by the President of the United States. The non-voting members include the Directors of the newly-established Office of Financial Research and Federal Insurance Office, respectively, and state regulators with expertise in banking, insurance and securities. The FSOC s mandate is to identify and provide for the prudential regulation of U.S. nonbank financial companies and foreign non-bank financial companies whose material financial distress, size, scale, interconnectedness or complex financial activities could jeopardize the financial stability of the United States. The Act equips the FSOC with comprehensive authority and investigatory devices with which to implement its mandate. Title II establishes the orderly liquidation authority required to compel compliance and enforce the protections of the Act and Title I. The process is initiated by the Secretary of the Treasury with a petition made to the U.S. District Court for the District of Columbia seeking the appointment of the FDIC as the Receiver for financial companies. Within 24 hours, upon written notice to the affected company, in a confidential proceeding, the court determines whether the affected company is in default or in danger of default, as defined in section 203(c)(4). If such a determination is made, the FDIC is appointed the Receiver and proceeds with the liquidation of the company. There are no reorganization opportunities in such a proceeding. Insurance companies are exempt from Title II of the Act and instead will to be liquidated under State law in state courts. However, the federal government is empowered to proceed under state law in the state court to utilize the FDIC as Receiver if a state fails to take action within 60 days of a determination by Treasury that an insurance company is in default or danger of default as defined in the Act. Brokers and dealers are also excepted from Title II of the Act. The Securities Investor Protection Corporation (SIPC) is to liquidate dealers and brokers as trustee. If a bankruptcy proceeding had been commenced, it is to be dismissed upon appointment of the FDIC as Receiver or as trustee for the debtor. The FDIC removes the officers and directors of the subject company and liquidates the company pursuant to the objectives and payment priorities of the Act, as opposed to the priorities contained in the Bankruptcy Code. 3 Title II of the Act completely displaces the Bankruptcy Code once a company is determined to be liquidated thereunder. Title III unifies the federal regulatory over financial institutions. The Office of Thrift Supervision is abolished and most of its regularity authority over federally chartered savings associations is reposed in the Comptroller of the Currency ( OCC ). The OCC retains its supervisory authority over national banks. A newly designated Deputy Comptroller of the OCC will oversee the examination and supervision of federally chartered savings associations. Title IV, consistent with the FSOC s mandate to identify and preempt systemic risk, extends regulatory authority to hedge funds, private investment funds, and advisers to such 3 Title II contains extensive provisions regarding the manner in which a company will be liquidated by the FDIC, as Receiver, the claims process and how the costs of the liquidation will be handled. 2
funds. The statute subjects such entities to minimum capital requirements, periodic financial stress tests, escalating remediation requirements and other prudential regulatory techniques. These techniques will also be utilized in the enforcement of the so-called Volcker Rule which restricts the ability of banks to invest in hedge funds and other nonbank financial companies. Title V, creating the Office of National Insurance under the Department of the Treasury, establishes the regulation of all lines of insurance in certain aspects, except health insurance, long-term care insurance (unless linked to an annuity) and crop insurance. By also authorizing the regulation of reinsurance, the practice of using financial instruments and obligations that effectively collateralized credit swaps and many synthetic transactions will be regulated by the federal government. State statutes that conflict in certain ways with the federal requirements and certain treaties may be pre-empted. Title VI amends the Bank Holding Company Act and imposes other regulatory restrictions addressing the fund sponsorship and investment activities of banks, bank holding companies and certain other nonbank financial companies. Section 619 of the Act codifies the Volcker Rule and defines the criteria relating to banks investment in or lending to hedge funds and other investment funds for which such banks act as organizers and offerors, investment managers, advisers or sponsors. The Act also enables the Federal Reserve Bank to impose capitalization and quantitative requirements on nonbank financial companies which engage in proprietary trading or invest in or sponsor private equity or hedge funds. Title VII is the Wall Street Transparency and Accountability Act of 2010. The principal objectives of Title VII are (i) management of systemic risk in the over-the-counter ( OTC ) derivatives market; and (ii) increased transparency in the OTC derivatives market. To implement the statutory objectives, the CFTC and the SEC are given new and comprehensive regulatory authority over participants in swap and securities-based swap transactions and the extensive, complex transactions in which they engage. The CFTC and SEC will oversee clearing and exchange trading in many derivatives transactions. They will also regulate margin and capital requirements and the dissemination of public information related to derivatives transactions. Title VIII is entitled Payment, Clearing and Settlement Provisions. The statute designates to the primary regulating agency the authority to regulate payment, clearing and settlement to meet the following objectives: (1) promote robust risk management; (2) promote safety and soundness; (3) reduce systemic risks; and (4) support the stability of the broader financial system. These objectives are to be achieved by adjusting the following: (1) risk management policies and procedures; (2) margin and collateral requirements; (3) participant or counterparty default policies and procedures; (4) the ability to complete timely clearing and settlement of financial transactions; (5) capital and financial resource requirements for designated financial market utilities; and (6) other areas that the Board determines are necessary to achieve the objectives and principles in subsection (b). The term financial market utility 3
dealing with, in part, interbank clearing and transactional associations is created, and the power to regulate them is enhanced. Title IX turns to investor protections. It establishes the Investor Advisory Committee ( IAC ) within the SEC. It has a broad charter to consult on issues relating to the regulation of securities products, trading strategies, and fee structures, the effectiveness of disclosure and initiatives for investor protection. Members of the IAC are to be a diverse group, including an Investor Advocate established under Section 915, a representative of interests of senior citizens and up to 20 others with industry knowledge. Subsection 913(f) provides for rulemaking authority to set the fiduciary standard for brokers or dealers with respect to personalized investment advice. The Commission can also intervene in changes made by a self-regulating entity in its internal procedures if the public interest so requires. There are provisions for an investor literacy study, a mutual fund disclosure study, conflicts of interest in and among banks and investment houses, investor access to broker dealer records, financial planner disclosures and titles, and the power to more closely regulate disclosures to retail investors. An Ombudsman post has been established in order to facilitate matters arising before the Investor Advocate Committee. Section 932 and Subtitle C of Title IX substantially change the regulatory format for rating agencies. Generally, the agency must increase internal controls and must demonstrate a competence over a class or type of security. The stated objective is that an agency have adequate financial and managerial resources to consistently produce credit ratings with integrity. Specific criterion for actions against rating agencies are also created. Statements made by rating agencies are now subject to the same standards as statements made by public accounting firms and securities analysts. Title X creates the new Bureau of Consumer Financial Protection (BCFP). Subtitle A establishes the new bureau. The BCFP is an independent agency housed within the Federal Reserve with the authority to oversee virtually all financial products offered or sold to consumers. Though the BCFP is housed within the Federal Reserve, it is largely independent and the Fed cannot interfere with its orders, rules or enforcement actions. The BCFP also has its own dedicated funding stream to be paid from the earnings of the Fed. Subtitle B grants the BCFP broad powers to regulate financial products offered to consumers to ensure that markets for financial products are transparent and competitive. The BCFP has the power to examine the compliance of large banks and credit unions, defined as those with over $10 billion in assets, with consumer protection laws. The BCFP also has the ability to review the actions of and require reports from financial institutions with under $10 billion in assets for the purpose of carrying out consumer protection laws. This subtitle also grants the BCFP the authority to limit mandatory arbitration provisions in consumer financial transactions. Finally, this subtitle contains the automobile dealer provisions, which exempt dealers from all of the oversight actions of the BCFP. 4
Subtitle C addresses several specific powers of the BCFP, including: the prohibition of unfair and deceptive practices and to require disclosures. The Act grants rights to consumers to access financial information, provides for responses to consumer inquiries by the BCFP and requirements for the covered institutions to provide the necessary information to respond to such requests, including any contact it has had with the consumer and any information related to the consumer s inquiry. This subtitle also establishes an ombudsman for private student loans. Subtitle D addresses the preservation of state law and defines the preemption standards which will apply to areas covered by the Act. This subtitle explicitly allows state laws or regulations which provide more consumer protection than the Act to remain in place, and does not preempt such statutes or regulations. This subtitle also allows State Attorneys General to bring suit to enforce provisions of the Act in their own states. The Attorneys General are, however, limited in their ability to bring suit against national banks or federal savings associations. The Attorneys General must also notify the BCFP of any actions brought by them and the BCFP may intervene if it chooses to do so. This subtitle specifically provides that it does not affect the States ability to regulate insurance companies within their borders. Subtitle E outlines the enforcement powers of the BCFP. The BCFP is allowed to investigate any matter within its regulatory power. It has the power to subpoena parties, demand documents or tangible things, require written answers to its questions and require oral testimony. The BCFP may also hold hearings and adjudicate disputes for matters within its regulatory authority. It may also choose to litigate these matters in federal court. Criminal matters will be referred to the Attorney General of the United States. This subtitle also contains protections for employees of covered institutions who cooperate with the BCFP, provide information or testify in front of it. Complaints by employees who believe they were disciplined for cooperating with the BCFP will be investigated and adjudicated by the Secretary of Labor. Subtitle F covers the transfer of functions and personnel to the BCFP. The BCFP will consolidate the consumer protection functions of several federal agencies with respect to financial products, including: the Comptroller of Currency, Federal Deposit Insurance Corporation (FDIC), Federal Trade Commission (FTC), National Credit Union Administration (NCUA), and the Department of Housing and Urban Development. This transfer is to take place within 60 days of the passage of the Act. Title XI deals with Federal Reserve System Provisions. The title begins with an antibail-out objective requiring the Fed to develop a program in order to insure its loans are properly collateralized and not made to insolvent borrowers. Once a company receives assistance or is assisted in several ways, the company cannot obtain the benefit of broad-based eligibility provisions. The Secretary of the Treasury must approve any anti-bail-out program. Any financial assistance given must be disclosed to the Senate Banking Committee and House Financial Services Committee within 7 days with all material terms disclosed, the cost to 5
taxpayers, and monthly updates, although, on request, certain portions of the assistance can be restricted to the ranking members of those Committees. In a bankruptcy, priority for federal assistance is given 11 U.S.C. 507(a)(2) priority. The Comptroller of the Currency is authorized to conduct audits of credit facilities and covered transactions subject to limits on disclosure of reports concerning audits which limits delay of the release to the public of information. If the recipient s name becomes public because of Fed system action, then the material is generally not to be confidential. With limited exceptions, after a credit facility expires, information must be later disclosed over a one to two year time frame. The Fed is generally charged with increasing its transparency by providing a broad range of information on its website in a link to be called Audit. The limits on timing of disclosure are similar to those in the prior paragraph. Section 1104 has the criterion for a liquidity event which can trigger the emergency loan authority under section 1105. A liquidity event is (A) an exceptional and broad reduction in the general ability of financial market participants (i) to sell financial assets without an unusual and significant discount; or (ii) to borrow using financial assets as collateral without an unusual and significant increase in margin; or (B) an unusual and significant reduction in the ability of financial market participants to obtain unsecured credit. If there is a written finding of a liquidity event, and it is one in which failure to take action would have serious adverse effects on financial stability or economic conditions in the United States; and iii) actions authorized under section 1105 are needed to avoid or mitigate potential adverse effects on the United States financial system or economic conditions, then a special guarantee authority can arise. Two thirds of the Boards of the Fed and the FDIC must agree that there is a liquidity event and that these conditions exist. Once a liquidity event determination is made, then the FDIC shall create a widely available program to guarantee obligations of solvent insured depository institutions or solvent depository institution holding companies (including any affiliates thereof) during times of severe economic distress, except that a guarantee of obligations under this section may not include the provision of equity in any form. The FDIC is to charge participants fees to cover the costs, and is authorized to charge special assessments if there is a shortfall. Title XII is entitled Improving Access to Mainstream Financial Institutions. This section of the Act aims at low and moderate income individuals, and aspires to increase their access to traditional deposit and checking accounts. The provisions focus on small dollar loan availability, defined as $2,500 and under. There are to be matching grants to support reserves and partnerships to increase access to small dollar amount lending. Loans and grants are to be directed to entities which also have programs for improving financial literacy. 6
Title XIII is entitled the Pay It Back Act. This title reduces the TARP program from $700 billion along with some prior reductions to $475 billion. The title further calls for a variety of savings, particularly proceeds from the sales of Fannie Mae, Freddie Mac, or Federal Home Loan Bank securities or American Reinvestment and Recovery Act turnbacks to be applied to the deficit. Any such funds are prohibited from being used as an offset for other spending increases or revenue reductions. Title XIV is entitled the Mortgage Reform and Anti-Predatory Lending Act. Because the BCFP is charged with the administration and purview of consumer protection laws, Title XIV begins by articulating that certain parts, Subtitles A, B, C and E and sections 1471, 1472, 1475, and 1476 are enumerated consumer laws as defined in section 1002 of the Act. Subtitle A begins by establishing Residential Mortgage Lending Standards through an amendment to TILA. First, mortgage originators (basically, anyone who takes a fee for placing a mortgage) are broadly defined, although a narrow exception for foreclosure counselors is set out. Originators must now be registered. Steering fees are prohibited, unless the mortgage is a no points mortgage and the consumer does not pay the originator. Broad discretionary regulatory authority is given to regulate abusive, unfair, deceptive, predatory, necessary or proper practices to enforce the spirit of the statute and make mortgage credit affordable. Subtitle B lays out the minimum standards for mortgages. It amends the Truth in Lending Act (TILA) to provide for each of the changes discussed below. It will require mortgage providers to make a reasonable and good faith determination, based on documentation, that the borrower will be able to pay back the loan and all of the appropriate taxes and fees. It also provides that if the mortgage provider knows or has reason to know that there are multiple mortgages on the property, it must make a reasonable and good faith determination that the borrower will be able to pay all of the mortgages. There are also specific requirements about what amounts must be used in a determination of a borrower s ability to pay for non-standard mortgages, such as interest-only or negative amortization mortgages. There is a presumption of the borrower s ability to pay for so-called qualified mortgages, i.e. traditional first-lien mortgages, with fixed rates, the same payment each month and generally no balloon payments. Some adjustable-rate and reverse mortgages also may be treated as qualified mortgages subject to the guidelines provided. This subtitle also provides new federal defenses to foreclosure actions. If a foreclose action is commenced, a borrower may assert claims based on the lender s failure to make a reasonable and good faith determination of his ability to repay the loan and may be entitled to recoupment or setoff based on that liability. The subtitle also increases the civil penalties for TILA violations related to the determination of a borrower s ability to pay the loans and increases the statute of limitations for such claims to three years from the date of the violation. The subtitle does restrict the liability of lenders for violations of the new sections regarding the determination of a borrower s ability to 7
pay in cases where the borrower has been convicted of actual fraud in connection with receiving the mortgage. Subtitle C regulates so-called high cost mortgages. High-cost mortgages are those which have an interest rate above 6.5% on the first mortgage, a rate above 8.5% on any subsequent mortgages, or those where the points and fees exceed over 5% of the transaction cost for transactions above $20,000. The Act also eliminates pre-payment penalties on high-cost mortgages and restricts balloon payments on these mortgages to no more than twice the prior average monthly payment. Subtitle D establishes the Office of Housing Counseling within the Department of Housing and Urban Development. This office will be responsible for all efforts related to home ownership and rental housing counseling, including preparing and disseminating information to consumers. Subtitle E addresses Mortgage Servicing. New limits on escrows are imposed on mortgage servicers (except for open end credit plans and reverse mortgages) by an amendment to TILA. The Real Estate Settlement Procedures Act ( RESPA ) is amended to preclude servicers from engaging in a number of practices, including failure to respond to the borrower inquiries on certain items, mandatory insurance except under certain conditions, excessive fees and other infractions of Board regulations. Title XV is entitled Miscellaneous. Its most important provision restricts the use of U.S. funds for foreign government bailouts. The federal government is prohibited from lending if the amount of the public debt of the country exceeds the gross domestic product of the country as of the most recent year for which such information is available; and (B) the borrower country is not eligible for assistance from the International Development Association. Other provisions relating to mine safety violation reporting and conflict mineral certifications will not be explored in this summary. Title XVI has two main provisions: a special assessment on large financial companies and a change in the tax treatment of certain financial contracts. In Section 1601, a special assessment of $19 billion is levied against certain entities outlined in the section, including financial companies with over $50 billion of assets, and hedge funds with over $10 billion of assets. This section further details how the assessments will be made. Section 1602 covers the creation and use of the special assessment fund which holds the proceeds of the assessment detailed in Section 1601. Section 1603 amends Section 1256 of the Internal Revenue Code to exclude certain financial instruments from the favorable tax treatment contained within that section. Contracts that are governed by Section 1256 are treated as sold at the end of the taxable year, and the gains (or losses) are divided between short-term capital gain or loss (40%) and long-term capital gain or loss (60%). Because certain of these contracts will now be regulated in 8
a way that would have allowed them to benefit from such favorable tax treatment, Congress amended the types of contracts which are governed by Section 1256. The newly-excluded contracts are: any securities futures contract or option on such a contract unless such contract or option is a dealer securities futures contract, any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. 9