As widely reported, in mid-June 2009, the Obama Administration released a White Paper reshaping the U.S. financial regulatory system, with a plan to have reform in place before the end of 2009. This article discusses those proposals that may directly affect registered investment companies. The proposed reforms require the enactment of new legislation and rule changes; for each proposal, there now is concurrent legislation that has either been sent to Congress by the Administration, or introduced as a bill in one or both houses of Congress. At this time, it is unknown to what extent the Obama proposals may be enacted, and in what form. What follows is an overview of the key proposals addressed in the paper that may affect registered funds, as well as the related legislation currently being considered by Congress.
New Money Market Funds Regulation
In response to problems experienced by money market funds during 2008, the Administration is recommending that the SEC move to strengthen regulations surrounding money market funds. Specifically, the Administration has asked the SEC to:
- Require money market funds to maintain liquidity buffers;
- Reduce the maximum weighted average maturity of money market fund assets;
- Tighten applicable credit concentration limits;
- Improve credit risk analysis and management of money market funds; and
- Allow boards of money market funds to suspend redemptions in extraordinary circumstances to protect fund shareholders’ interests.
However, the White Paper also stated that the Administration did not believe the above measures should be expected to prevent a run on money market funds “of the scale experienced in September 2008.” Consequently, the Administration proposed that the President’s Working Group on Financial Markets (the Working Group) prepare a report by September 15, 2009, that considers “fundamental changes to address systemic risk,” which could include moving away from stable net asset values and/or requiring money market funds to have access to reliable emergency liquidity facilities from private sources. The due date of the report was later postponed to December 1, 2009, to give the group time to consider public comments. In addition, the proposal recommends that the SEC and the Working Group work to mitigate any potential adverse effects of a stronger regulatory framework, such as investor flight or reductions in the term of money market liabilities issued by financial firms.
The SEC recently proposed rule changes that mirror the proposals recommended by the Obama Administration. For more on those proposals, see our previous Investment Management Alert, “SEC Proposes Amendments to Rules for Money Market Funds,” at http://www.drinkerbiddle.com/secrulesmmfunds/.
A “Reap What You Sow” Approach to Asset-Backed Securities
The White Paper seeks to address the recent problems with the asset-backed securities (ABS) market in which lenders and securitizers did not have sufficient incentives to consider the performance of the loans underlying the asset-backed securities. Accordingly, the White Paper recommends that federal banking agencies promulgate regulations requiring originators or sponsors of ABS to retain 5 percent of the credit risk of securitized credit exposures. In addition, the proposal calls for regulations that prohibit the originator from hedging or transferring that risk. It recommends that the agencies have the authority to provide exceptions or adjustments to the requirements, as needed, as well as to apply the requirements to securitization sponsors rather than loan originators.
The proposal also calls for the SEC to be given clear authority to require “robust ongoing reporting” by issuers of ABS. Specifically, the White Paper recommends that such reporting include providing investors and credit rating agencies with the information they need to assess the credit quality of the assets underlying the securitization at inception and throughout the life of the transaction, as well as to assess the other risks of ABS. In addition, the White Paper urges the industry to make the documentation for ABS transactions more transparent and understandable so that market participants can more easily assess the credit, market liquidity and other risks of ABS. The recommendations also suggest that the SEC and the Financial Industry Regulatory Authority (FINRA) expand the Trade Reporting and Compliance Engine (the standard electronic trade reporting database for corporate bonds) to include ABS.
Under legislation sent to Congress by the Administration in late July, banking regulators and the SEC would have the authority to issue regulations that require the securitizer of an ABS to retain 5 percent of the credit risk of the underlying assets. The legislation also expands the SEC’s authority to require loan-level disclosure for ABS in a standard format in order to increase transparency of ABS.
Credit Rating Agencies’ Disclosure
Another key component of the proposal is a recommendation that the SEC continue strengthening the regulation of credit rating agencies by requiring them to:
- Have policies and procedures that manage and disclose conflicts of interest;
- Differentiate the credit ratings assigned to structured credit products from those assigned to unstructured debt;
- Disclose credit rating performance measures for structured credit products in a way that allows comparisons across products and provides meaningful measures of the related uncertainty and potential volatility;
- Disclose what risks their credit ratings are designed to assess, as well as material risks not reflected in the ratings, including how the risks of structured products fundamentally differ from those of unstructured corporate debt; and
- Disclose sufficient information about their methodologies for rating structured finance products, including qualitative reviews of originators, so that users can reach their own conclusions about the methodologies.
At the same time, the proposals include recommendations for regulators to reduce their use of credit ratings in regulations and supervisory practices, when possible. The proposals also call for regulators to recognize the potential differences in performance between structured and unstructured credit products with the same credit rating. It also recommends that risk-based regulatory capital requirements reflect the risk of structured credit products, and minimize chances for firms to use securitization to reduce their regulatory capital requirements without a commensurate reduction in risk.
In late July, the Administration sent proposed legislation based on the above recommendations to Congress. This legislation is in addition to the proposed and adopted rule amendments released by the SEC in February 2009, which the Administration strongly supports. The proposed legislation would prohibit credit rating firms from consulting with any company that they also rate, as well as prohibit or require the management and disclosure of conflicts arising from the way a rating agency is paid, its business relationships, its affiliations or other conflicts. Each rating report would also disclose the fees paid by the issuer for a particular rating, as well as the total amount of fees paid by the issuer to the rating agency in the prior two years. Each rating agency would also be required to designate a compliance officer, and if a rating agency employee is hired by an issuer and that employee had worked on ratings for that issuer in the preceding year, that rating agency would be required to conduct a review of ratings to determine if any conflicts of interest existed, and adjust the ratings as necessary.
The legislation would also require disclosure of preliminary ratings to reduce “ratings shopping,” as well as to use different symbols to distinguish the risk of structured products. In addition, the legislation would also require qualitative and quantitative disclosure of the risks and performance variance inherent in any given security.
The legislation would also establish a dedicated office within the SEC to strengthen supervision of rating agencies, and would make registration mandatory for all credit rating agencies. The SEC would then require each agency to document its policies and procedures for determination of the ratings, and the SEC would examine the internal controls, due diligence and implementation of rating methodologies.
The Treasury would also work with the Working Group, and presumably, its successor, the Financial Services Oversight Council, to determine where references to ratings can be removed from regulations, as well as require a General Accountability Office study on reducing reliance on ratings in federal and state regulations.
OTC Derivatives Regulation
The White Paper also recommends government regulation in several ways of the over-thecounter (OTC) derivatives markets, including credit default swaps. First, it recommends that all OTC derivatives be cleared through regulated central counterparties. In addition, the White Paper recommends that OTC derivatives dealers and other firms whose market activities create large exposure to counterparties be subject to a “robust and appropriate regime of prudential supervision and regulation” that will include:
- Conservative capital requirements;
- Business conduct standards;
- Reporting requirements; and
- Conservative requirements relating to initial margins on counterparty credit exposures.
The White Paper further recommends that the OTC derivatives market be made more transparent by amending the Commodities Exchange Act and related laws to authorize the Commodity Futures Trading Commission (CFTC) and SEC: to impose recordkeeping and reporting requirements (including an audit trail) on all OTC derivatives, as well as to ensure that they have “clear, unimpeded authority” to police and prevent fraud, market manipulation and other market abuses.
The SEC recently proposed rule changes that address the regulation of OTC derivatives regulation, based on the Obama Administration’s recommendations. For more on those reforms, see the article on page 12 entitled, “Obama Administration Announces New Derivatives Trading Reform.”
Harmonizing the Role of the CFTC and SEC
Also included in the proposal are recommendations that the CFTC and SEC identify all existing conflicts in statutes and regulations and recommend changes in a report to be delivered to Congress by September 30, 2009, in an effort to harmonize the regulation of futures (under the CFTC’s purview) and securities (under the SEC’s). The White Paper noted that, in many instances, the overlapping yet different regulatory authorities of both agencies has resulted in protracted legal disputes about whether a specific product should be regulated as a future or a security. The report would either explain why the differences in regulation of economically equivalent instruments are essential to protecting investors and maintaining market integrity and price transparency, or make recommendations for changes to eliminate the differences. If the SEC and CFTC cannot agree on recommendations and explanations of differences, the White Paper recommends that the issue be referred to the Financial Services Oversight Council, which should be required to address the differences and report to Congress within six months of its formation.
The SEC and CFTC recently began meeting in order to reach agreement on their respective roles.
Federal Reserve Oversight of Payment, Clearing and Settlement Systems
The White Paper proposes that the Federal Reserve have the responsibility and authority to conduct oversight of systemically important payment, clearing and settlement systems, and activities of financial firms. Under the proposal, the Federal Reserve would have the authority to collect information from any payment, clearing or settlement system to assess whether the system is systemically important. Each system would be subject to “regular, consistent and rigorous on-site safety and soundness examinations.” If the system is already regulated by the CFTC or SEC, those agencies would remain the primary regulators of the system. That is, if the system is already subject to comprehensive regulation by either agency, they would lead those exams and reviews, though the Federal Reserve would have the right to participate, including to determine the scope and methodology of the exam or review. The CFTC or SEC would continue to have primary authority for enforcement. However, if the Federal Reserve and market regulator could not agree on the need for enforcement, the Federal Reserve would have emergency authority to take enforcement action, after consulting with the newly created Financial Services Oversight Council, which would attempt to mediate the differences.
The Obama Administration sent legislation to Congress at the end of July regarding this proposal. The legislation would create a Financial Services Oversight Council, which would replace the President’s Working Group on Financial Markets and would have a permanent, full-time staff at the Department of the Treasury. The Council would have eight members: 1) the Secretary of the Treasury, who would serve as the Chair; 2) the Chairman of the Board of Governors of the Federal Reserve System; 3) the Chairman of the CFTC; 4) the Director of the proposed Consumer Financial Protection Agency; 5) the Chairperson of the Federal Deposit Insurance Corporation; 6) the Director of the Federal Housing Finance Agency; 7) the Director of the proposed National Bank Supervisor; and 8) the Chairman of the SEC. The country’s largest financial firms that are found to pose a threat to the economy’s financial stability based on their size, leverage and interconnectedness, dubbed “Tier 1 financial holding companies,” would be subject to strong, consolidated supervision and regulation, and would face more conservative prudential standards than other bank holding companies.
In addition, the legislation would give the Federal Reserve strong statutory authority to oversee systemically important payment, clearing and settlement activities and systems. The Federal Reserve would be required to consult with the Council and to coordinate oversight with the CFTC and SEC, which will remain primary regulators of such systems.
Change in Prospectus Delivery Timing, Additional Investor Protections
The Administration also proposes authorizing the SEC to require that certain disclosures, including a summary prospectus, be provided to investors at or before the point of sale, rather than with the sale confirmation, as is generally the case now. Relatedly, the Administration suggests that the SEC should be given the monies to do more field testing, consumer outreach and testing of disclosures to individual investors. In addition, the Administration has also called for the SEC to establish a fiduciary duty for broker-dealers offering investment advice. It also recommends empowering the SEC to examine and ban forms of compensation that encourage intermediaries to put investors into products that are profitable to the intermediaries, but not in the investors’ best interest. The proposal also suggests new legislation that would provide “simple and clear disclosure” to investors about the scope of their relationships with investment professionals, as well as prohibit certain conflicts of interest and sales practices.
In addition, the Administration is recommending legislation that would give the SEC the authority to:
- Conduct a study on the use of mandatory arbitration clauses in investor contracts, as well as the authority to potentially prohibit mandatory arbitration clauses in broker-dealer and investment advisory accounts with retail customers;
- Establish a fund to pay whistleblowers for information that leads to enforcement actions with significant financial rewards; and
- Expand available sanctions.
Legislation regarding the above recommendations was sent to Congress by the Obama Administration in mid-July. Specifically, the legislation would give the SEC authority to establish a fiduciary duty for any broker, dealer or investment adviser who gives investment advice about securities. The SEC would also have the authority to examine and ban forms of compensation that encourage financial intermediaries to steer investors into certain products that are profitable to the intermediary. The legislation also would give the SEC authority to prohibit mandatory arbitration clauses in broker-dealer, municipal securities dealer, and investment advisory agreements.
In addition, the legislation would give the SEC the authority to regulate the quality and timing of disclosures and prospectuses, including that it could require a summary prospectus and disclosure of fund expenses prior to the completion of fund sales. While the SEC adopted final rules adopting the use of a summary prospectus in January 2009, there is currently no proposed rule that requires a summary prospectus or other disclosure to be delivered prior to the completion of fund sales. The legislation would also encourage additional consumer testing by the SEC.
The legislation would also harmonize liability standards among securities laws, and rectify inconsistencies. Currently, an individual barred from being an investment adviser because of misconduct can still apply to become a broker-dealer. The legislation would give the SEC authority to remove regulated persons from all aspects of the securities industry. Lastly, the legislation would make permanent the recently established Investor Advisory Committee.