Publications

---

Senator Christopher Dodd (D-CT), chairman of the Senate Committee on Banking, Housing and Urban Affairs, has introduced his long-awaited proposal, referred to as the “Restoring American Financial Stability Act of 2009,” whereby the regulatory architecture governing the operation of the US financial system (including the banking, hedge fund and insurance sectors), would be dramatically recast and radically restructured. To consider the bill in its entirety, please click here. To review a summary of this legislation, prepared by the staff of the Senate Banking, Housing and Urban Affairs Committee, click here.

At more than 1,100 pages, the bill, introduced on November 10, 2009, sets forth an ambitious new universe of regulatory agencies under one overarching new agency, with revised jurisdictional authorities designed, in the words of Senator Dodd, to make, “…sweeping and bold changes…We’re in the 21st century. We’re basically looking at a regulatory structure that was designed in the early part of the 20th century.”

Senator Dodd’s Strategy

Senator Dodd’s proposal comes after the Obama Administration issued its series of “white papers” this summer, which contained many of the same recommendations, and following House action, which is still ongoing, on those same White House recommendations. But no one is more aware than Senator Dodd that his proposed legislation will need to be revised in the course of the legislative process. In the remaining 13 months of this Congress, the scope and concepts set forth in this proposal will evolve to reflect numerous efforts at compromise and conciliation with a plethora of competing House and Senate voices. Yet the senator has chosen to start the bargaining process from the broadest possible position, noting, “I could have tried to draft something that was already a compromise of ideas in a sense, but I think you make a huge mistake by doing that. You’re given very few moments in history to make this kind of a difference. We’re trying to do that and I think this is important.”

A New Banking Regulator

Of greatest import in the new legislation, and the source of the gravest controversy, is the proposal to remove all bank regulatory and supervisory powers from both the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), and to eliminate the independent existence of the Office of the Comptroller of the Currency and the Office of Thrift Supervision. In the place of these agencies, bank regulation would be the exclusive province of a newly created Financial Institutions Regulatory Administration (FIRA), which would have one division responsible for large, multinational institutions and a separate division for smaller community banks.

This proposal has already engendered significant opposition from these agencies, each of which would lose its existing jurisdiction, even its separate existence, under the Dodd approach. It has also encountered skepticism from Chairman Barney Frank (D-MA) and others in the House of Representatives whose cooperation and agreement would be crucial were the legislation in question to pass the Senate and have to be wedded with the House version in a conference between the two bodies. Industry groups appear to be adamantly opposed, as well, to this reformulation of regulatory oversight, with larger banks bemoaning the loss of administrative alternatives that currently exist under the present system of multiple banking agencies and community banks fearing that the FIRA will become the captive of the largest members of the financial sector, to their disadvantage.

A New Consumer Protection Agency

Much like the bill recently approved by the House Financial Services Committee and by the House Committee on Energy and Commerce, the Dodd initiative would establish a Consumer Financial Protection Agency (CFPA), with extraordinarily broad regulatory and supervisory powers, combined with unprecedented litigation authority, to police the issuance of financial products and services by banks, thrifts and other financial firms to consumers. The Dodd proposal includes many of the controversial elements found in the House formulation, including the elimination of federal preemption and the concomitant preservation and expansion of state consumer protection laws to the extent these establish higher compliance standards for “covered persons.”

A New Systemic Regulator

Contrary to the approach favored by the House Financial Services Committee, Senator Dodd’s bill curtails the responsibility of the Federal Reserve as a guardian and manager of systemic risk. Instead, the Dodd proposal establishes an Agency for Financial Stability, in which the chairman of the Federal Reserve is but one of a number of members. The agency would be led by a chairperson appointed by the President (and subject to Senate confirmation) and would include the participation of the Secretary of the Treasury, the chairs of the newly established FIRA and of the CFPA, and the chairs of the Securities and Exchange Commission, the FDIC and the Commodity Futures Trading Commission. This new agency would be responsible for setting enhanced supervision of specified financial institutions that, by virtue of their size and prominence, pose unique risks to the financial system, as well as to other non-specified firms.

The potential consequences of such regulation by this new agency could be very broad-reaching and severe: not only will there be new prudential standards applicable to such firms, including contingent capital requirements (that is, contingent capital instruments that convert into equity if certain risk standards are not met by the firm in question), but new disclosure and reporting obligations would be mandated for these institutions. These systemically important firms will also need to establish “living will” arrangements: resolution plans that will be reviewed by the agency and other banking regulators, to be implemented in the event of a bankruptcy or liquidation of the entity under consideration. Additional constraints on acquisition activity and affiliate lending arrangements would also be imposed, and the firms in question may face the requirement of disposing of designated assets or business lines should they be deemed too large in their operations and posing too great a resultant risk to the overall financial sector.

A New Insurance Regulator

The proposed legislation also creates an Office of National Insurance, departing from decades of practice and precedent that delegated the regulation of insurance entities in the US to the singular judgment of the states. Although focusing primarily on the collection of data and information pertaining to the insurance industry, the avoidance of systemic risk by insurance industry participants and the coordination of international regulatory standards in this area, the Dodd legislation nevertheless opens the possibility that new, federal standards will be applicable to the insurance firms in question, in addition to existing state requirements.

This proposal also raises questions relating to health care insurance, should both this initiative and the pending health care reform package be enacted into law. As a practical and political matter, federal supervision of the “business of insurance,” once established, will not likely stop with casualty and life insurance alone.

New Regulation of Hedge Funds and Other Securities Laws Developments

In keeping with elements of the approach of the Obama Administration, Senator Dodd’s proposed legislation eliminates an exemption from SEC registration and regulation presently provided under the securities laws to hedge fund managers that only deal with accredited investors, but allows certain limited exemptions for venture capital fund advisers and private equity fund advisers. New requirements are set forth in this bill on the collection of systemic risk data on the part of these newly regulated industry participants, the custody of client assets and the calculation of the definition of accredited investor. For many such advisers, the results of this proposal, if enacted into law, would be to increase significantly the nature and extent of federal regulation over their operations and capital-raising activities.

The bill also provides new regulatory oversight on securities-related swap agreements and on over-the-counter derivatives as well as increasing the regulation of credit rating agencies and providing for shareholder votes on executive compensation and golden parachute arrangements. Clawbacks of compensation would be triggered in cases of non-compliance with applicable financial standards by the firm being scrutinized. Broker/dealers would be held to the higher standards of fiduciary conduct that are applicable to investment advisers, mandatory pre-dispute arbitration would be restricted, and aider-and-abettor liability would be extended to all those who recklessly, rather than only knowingly, engage in conduct facilitating violations of applicable securities laws. The bill would also impose a new obligation on the part of asset-backed securities originators, requiring them to retain 10 percent of the credit risk of total assets conveyed through such securitizations.

Next Steps

As previously noted, Senator Dodd’s legislative formulation will doubtlessly be amended and reformulated in the weeks and months to come, to respond to critics of the approach taken in creating new banking agencies and by the massive and unprecedented restructuring or wholesale elimination of certain existing banking agencies covered by the broad sweep of the bill’s coverage. What the ultimate outcome of this process will be, as well as the timing involved for consideration, mark-up and possible enactment, is very difficult to estimate at this stage. However, it is safe to project that massive financial services regulatory change is coming within the year. We will continue to monitor these developments and alert our clients and interested parties about significant developments in this process and about the potential impact on the industry of each significant step toward a final bill.

For more information about the effect of these proposed reforms on your business, please contact:

Tom Boyd

Drew G. L. Chapman

Rusty Conner

Richard Coll

Andrew Eskin

James Kaplan

Megan Kraai

David Krohn

Michael Reed