Obama Submits Draft Financial Reform Bills; No House Floor Action Before September

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Over the past month, the Obama administration has been sending to Capitol Hill its proposed legislation to fundamentally reform financial markets, including separate measures to strengthen the Securities and Exchange Commission's investor protection mission, require hedge fund registration, improve credit rating agency oversight, and create a Consumer Financial Protection Agency (CFRA).

The administration has also submitted legislation on limits on executive compensation (please see related article in this issue), and further bills to implement the administration's sweeping financial regulatory reform plan, outlined June 17 (5 APPR 570, 6/26/09), are expected.

House Financial Services Chairman Barney Frank (D-Mass.) said July 21 he plans for his committee to begin considering the legislative recommendations by the end of the month. However, he also said that the House leadership has indicated to him that a crammed legislative calendar probably will prevent any financial regulatory reform legislation from reaching the House floor before September.

Separately, the SEC has been developing legislative proposals in the areas targeted by the administration, and the SEC submitted at least some aspects of that package to Rep. Paul Kanjorski (D-Pa.), who is crafting a law to modify securities laws (please see related article in this issue).

Draft Investor Protection Legislation

Michael Barr, assistant treasury secretary for financial institutions, in a July 10 telephone conference told reporters that the administration's legislative package on investor protection ensures that “consumers and investors have the protections they need” to restore confidence in U.S. markets.

Among other measures, draft legislation delivered July 10 would give the SEC authority to:

• require a fiduciary standard for broker-dealers and investment advisers who issue investment advice;
• restrict or limit mandatory arbitration;
• expand whistleblower protections;
• harmonize liability standards, including those relating to aiding and abetting; and
• regulate the quality and timing of mutual fund disclosures such that the commission could require certain disclosures before the purchase of a fund.

As part of the provisions pertaining to a consistent standard for broker-dealers and investment advisers, Barr said that the SEC would be given “broad” authority to ban forms of compensation that would encourage financial intermediaries to steer investors into products that are not in their best interests. As to whistleblower protections, the Treasury official noted that the SEC would be given authority to establish a fund using monetary penalties collected during enforcement activities that are not otherwise distributed to investors.

In addition, the proposed legislation would make permanent the SEC's recently-created Investor Advisory Committee, and clarify the SEC's authority to conduct consumer testing. The group is holding its first public meeting July 27.

Hedge Fund Registration

The administration July 15 submitted legislative proposals to require advisers to hedge fund and other private pools of capital to register with the SEC.

Currently, private fund advisers are not required to register with any regulator. The administration's proposed legislation would, for the first time, require all investment advisers with more than $30 million of assets under management to register with the SEC. The draft legislation, which would amend the Investment Advisers Act of 1940, also would require the SEC to conduct periodic examinations of the funds to monitor compliance and potential market risks.

Under the proposed legislation—the Private Fund Investment Advisers Registration Act of 2009—once registered with the SEC, the investment advisers would be subject to:

• regulatory reporting requirements;
• disclosure requirements;
• strong conflict of interest and antifraud bars;
• SEC examination, enforcement, and recordkeeping requirements; and
• the requirement to establish a comprehensive compliance program.

In addition, the Treasury Department said in a July 15 release that all investment funds advised by SEC-registered advisers would be subject to recordkeeping, disclosure, and reporting requirements.

Under the proposed legislation, advisers to funds would be required to report, on a confidential basis, the funds' assets under management, borrowings, off-balance-sheet exposures, counterparty credit risk exposures, trading and investment positions, and other “important information,” Treasury said. The SEC would be required to share the disclosures with the Federal Reserve and the Financial Services Oversight Council—a new entity proposed by the administration to serve in an advisory capacity to help fill regulatory gaps, coordinate policy, resolve disputes, and identify emerging risks.

Credit Rating Agency Oversight

Under the credit rating agency oversight legislative proposals the Treasury Department sent to Capitol Hill July 21, all rating firms would have to register with the SEC, meaning they would be subject to SEC examinations and inspections. The SEC would have to require that rating agencies document the policies and procedures that determine their ratings. Furthermore, the SEC would examine the internal controls, due diligence, and implementation of rating methodologies across firms to ensure compliance with those policies and consistency with public disclosures.

According to Treasury's Barr, the SEC could accomplish “a number” of the draft legislation's goals within its current statutory authority. Indeed, the draft proposed measures that the SEC is currently considering under its rulemaking authority, or that the agency has previously considered. For instance, in 2008, the SEC proposed requiring that rating agencies use a distinct ratings symbology for structured finance products such as asset-backed securities. The proposal was never finalized; commentators questioned whether the agency had the authority to mandate such a practice.

Historically, the SEC has had limited authority over credit rating agencies. Although that changed somewhat with the enactment of the 2006 Credit Rating Agency Reform Act, many have contended that the SEC nonetheless lacks sufficient power in this area. Promising more power, Treasury's proposal would require a dedicated office within the SEC for overseeing credit rating agencies.


The administration has not yet submitted legislation on its plans on increased derivatives regulation.

However, Treasury Secretary Timothy Geithner July 10 in House hearings outlined the administration's plan to oversee derivatives trading, charting a path that would require all standardized contracts to be traded on an exchange and centrally cleared, while customized contracts, partly as a disincentive to their use, would be held to higher capital and margin requirements.

Testifying before a joint session of the House Financial Services and Agriculture committees, Geithner said oversight of the products would be split between the SEC and the Commodity Futures Trading Commission.

The two agencies, which largely have endorsed the same oversight scheme in previous testimony before Congress, have “made a lot of progress” to agreeing on a jurisdiction plan, though “they're not there yet,” Geithner said. The secretary added, “we're working closely with both agencies to explore options to try to bring them together” on the matter.

Geithner said the administration would propose a “broad definition” of what constitutes a standard derivative “that will be capable of evolving with the markets and will be difficult to evade.” The goal, he said, is to “encourage substantially greater use of standardized OTC derivatives and thereby to facilitate substantial migration of OTC derivatives onto central clearinghouses and exchanges.” The higher capital and margin requirements for custom contracts would be a means to that end, he amplified.

“Given their higher levels of risk, capital requirements for derivative contracts that are not centrally cleared must be set substantially above those for contracts that are centrally cleared,” Geithner explained. He added that the plan would require that regulators “carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges.”

Besides requiring all standard derivatives to trade on an exchange or regulated electronic trade execution system and to be centrally cleared, the administration plan would:

• require all over-the-counter derivative dealers and all other major OTC derivative market participants to be subject to substantial supervision and regulation, including strong business conduct standards;
• give regulators access to the transactions and open positions of individual market participants; and
• provide the SEC and CFTC with clear authority for civil enforcement and the regulation of fraud, market manipulation, and other abuses.

Other aspects of the plan include restricting the use of derivatives to sophisticated parties, and working internationally to ensure that foreign counterparts match the United States' strict oversight regime.

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