Tag: Dodd-Frank Wall Street Reform and Consumer Protection Act

Preliminary Results of Dodd-Frank Act Changes to Investment Adviser Registration Requirements

The Securities and Exchange Commission has released some statistics on the effect of Dodd-Frank on the registration of investment advisers (.pdf). March 30, 2012 was the compliance date for several provisions of the Dodd-Frank Act that amended the registration provisions of the Investment Advisers Act.

Registered private fund advisers advise 30,617 private funds with total assets of $8 trillion, which is 16% of total assets managed by all registered advisers. Approximately 31% of private fund total assets are attributable to advisers that registered since the effective date of the Dodd-Frank Act. Hedge funds (53%) and private equity funds (24%) comprised the majority of private fund assets managed by registered advisers. Real estate funds are in the other 23% along with liquidity funds and venture capital funds.

A total of 1,950 exempt reporting advisers filed Form ADVs with the SEC. 41% are foreign advisers. Exempt reporting advisers account for 6,702 private funds with total assets of $1.5 trillion. Of that mix, 17% are venture capital funds.

There are currently 12,623 advisers registered with the SEC with total assets under management of $48.8 trillion. The SEC expects expects that 2,400 mid-sized advisers will switch to state registration by June 28, 2012, resulting in approximately 10,000 advisers with $48.6 trillion in assets under management registered with the SEC.

Using these projections, the SEC anticipates that the cumulative impact of the Dodd-Frank Act registration changes will be a 25% decrease in the number of advisers registered with the Commission, but a 12% increase in the total assets under management of those registered advisers.

How Wall Street Killed Financial Reform

I’m sure you heard in the news that JP Morgan lost $2 billion in a trades using complex derivatives tied to corporate bond defaults. But didn’t we fix this two years ago when Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act? It seems like JP Morgan’s mistakes should be the first test of Dodd-Frank. The law fails. It’s just lucky that JP Morgan’s trade was stopped before it destroyed the bank.

By coincidence, Matt Taibbi wrote a piece in Rolling Stone about the failings of Dodd-Frank: How Wall Street Killed Financial Reform. I generally find Mr. Taibbi’s take on finance to be a bit over the top, with more hyperbole in a world that lacks the subtle shades of compromise. This article is no different. But he also gets lots of the right points. Dodd-Frank will not result in financial reform.

Taibbi makes five key points.

1. Strangle it in the Womb

Financial reform started off with some great ideas. But they were watered down as the law progressed through the legislative process. For example, Mr. Volker’s simple concept of banning proprietary trading got twisted and poked, allowing broad exemptions. The Consumer Financial Protection Bureau went from being an independent watchdog to an office under the budgetary constraints of the Federal Reserve System.

2. Litigation

The federal regulators will need to contend with courtroom challenges to their regulations, with industry arguing that they go beyond the scope of the legislation or failed to adequately run a cost-benefit analysis of the regulation.

3. If You Can’t Win, Stall

Many sections of the law are experiencing “unforeseen delays.” Taibbi blames Wall Street lobbyists. I blame the law itself. Dodd-Frank deferred much of the implementation to the regulators, meaning they would need to craft new complex regulations and definitions of key terms that are mere sketched out in the law itself. This overloaded the ability of the regulators to produce new regulations. They are tasked with a ten-fold increase in the rule-making agenda. That means the regulators need more staff and the time to get them up to speed. But Congress largely failed to provide the financial support.

4. Bully the Regulators

When Congress is frustrated with a regulator, they just cut funding. Rather than increase the SEC’s budget to allow for the resources to create and implement the new regulations, Republican congressmen tried to cut the Commission’s budget.

5. Pass a Gazillion Loopholes

Congress is moving bills forward to further undercut Dodd-Frank. We saw that with the Rapid passage of the Jumpstart Our Business Startups Act. (I would argue that it undercuts Sarbanes-Oxley, not Dodd-Frank.) As the balance of power in Congress shifts, parts of financial reform become less viable. I think the true test will come a year from now, after the Presidential election. A Romney win and some Republican congressional wins will likely lead to a rapid erosion of Dodd-Frank.

The one point that Taibbi only alludes to is that Congress does not understand the financial markets or the securities laws. I watched some of the Congressional testimony on the JOBS Act. Only a handful of the member of Congress had any idea what was really in the law. Dodd-Frank is even worse. It was a massive law. I would place a wager that no more than 10 members of Congress actually read the whole law before voting on it. Even fewer understood the implications.

 

Are You Systemically Important?

RMS Titanic

The first step in figuring out if a financial company is too big to fail, is to figure what it means to be “big”.  Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act authorizes the Financial Stability Oversight Council to determine that a nonbank financial company will be subject to supervision by the Board of Governors of the Federal Reserve System and prudential standards. It’s up to the FSOC to determine whether material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company, could pose a threat to the financial stability of the United States.

The FSOC has come up with a three stage process. First, based on quantitative criteria, the FSOC narrows the universe of nonbank financial companies by de facto defining “big”.

The Too Big to Fail thresholds are—

  • $50 billion in total consolidated assets;
  • $30 billion in gross notional credit default swaps outstanding for which a nonbank financial company is the reference entity;
  • $3.5 billion of derivative liabilities;
  • $20 billion in total debt outstanding;
  • 15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and
  • 10 percent short-term debt ratio of total debt outstanding with a maturity of less than 12 months to total consolidated assets (excluding separate accounts).

In the second stage of the process, the FSOC will conduct a comprehensive analysis, using the six-category analytic framework, of the potential for the nonbank financial companies identified in Stage 1 to pose a threat to U.S. financial stability. In general, this analysis will be based on a broad range of quantitative and qualitative information available to the  FSOC through existing public and regulatory sources, including industry- and company-specific metrics beyond those analyzed in Stage 1, and any information voluntarily submitted by the company.

Based on the analysis conducted during Stage 2, the FSOC intends to identify the nonbank financial companies that the Council believes merit further review in the third stage. The FSOC will send a notice of consideration to each nonbank financial company that will be reviewed in Stage 3, and will give those nonbank financial companies an opportunity to submit materials within a time period specified by the FSOC .

The  FSOC will determine whether to subject a nonbank financial company to supervision by the Fed and the prudential standards based on the results of the analyses conducted during the three-stage review process.

Looking at those thresholds from the perspective of the private equity industry, it’s the $20 billion in debt threshold that most concerns me.

I’m looking for guidance on whether it should be aggregated across funds and from the portfolio companies. It would seem that debt in a portfolio company should not be consolidated to the fund if it’s not recourse to the fund. Similarly, debt in separate funds should not be consolidated since the debt will not be recourse from one fund to another.

Of course the FSOC could take the opposite view and consolidate all of the debt under a fund manager together for purposes of clearing the Stage 1 hurdle and then work on the “too big to fail” analysis in Stage 2.

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Proposed Identity Theft Red Flags Rules

Identity theft is a serious problem. Title X of the Dodd-Frank Wall Street Reform and Consumer Protection Act increased the scope of firms that would be subject to federal regulatory requirements on identity theft rules. The Securities Exchange Commission and the Commodities Futures Trading Commission just published a proposed rule addressing that new scope.

Section 10889(a)(8), (10) of Dodd-Frank amended the Fair Credit Reporting Act by adding the CFTC and SEC to the list of federal agencies required to create and enforce identity red flag theft rules. The new rule proposal would require SEC-regulated entities to adopt a written identity theft program that would include reasonable policies and procedures to:

  • Identify relevant red flags.
  • Detect the occurrence of red flags.
  • Respond appropriately to the detected red flags.
  • Periodically update the program.

The proposed rule would include guidelines and examples of red flags to help firms administer their programs.

As newly registered investment adviser, this looked like a daunting prospect. The rule does list specific entities in its definition of “financial institution.” That means investment advisers and private fund managers are not excluded.

However, the requirements are further limited to a “transaction account: a deposit or account on which the depositor or account holder is permitted to make withdrawals by negotiable or transferable instrument, payment orders of withdrawal, telephone transfers, or other similar items for the purpose of making payments or transfers to third parties or others.” 12 U.S.C. 461(b)(1)(C).

Smartly, the SEC recognizes that most registered investment advisers (and private fund managers) are unlikely to hold transaction accounts and would not qualify as a “financial institution”. One of the questions soliciting comments in the proposed rule is whether the rule should “omit investment advisers or any other SEC-registered entity from the list of entities covered by the proposed rule?”

I think it makes sense to look at the account itself and not just the institution. Particularly in the case of private fund managers, there is usual limited windows when cash can come out of the accounts and be returned to investors.

Even if the limited partner interests are not a transaction account. It may make sense to look at the final rule as a model for some internal policies and procedures.

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Dodd-Frankenstein

You would expect that a publication with a libertarian tilt like The Economist would not look favorably at the Dodd-Frank Wall Street Reform and Consumer Protection Act. They call it Too big not to fail. Being The Economist, the article argues with the facts on its side.

  • Dodd-Frank: 848 pages
  • Federal Reserve Act of 1913: 32 pages
  • Glass-Steagall act: 37 pages
  • Sarbanes Oxley: 66 pages

“The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.”

It’s not a matter of more regulation. The focus should be on better regulation. Much of Dodd-Frank is just tacked on because it had the momentum to become law. I’m pretty sure extractive minerals had nothing to do with the financial crisis. But Section 1502 of Dodd-Frank requires public companies to make extensive disclosures on the use of conflict minerals in their supply chain.

There are some good things. An unregulated derivatives market was a bad thing. Although, I’m not sure they are getting the regulations right in the new regulated derivatives market.

The test will be the next financial crisis. I assume one will come. Inevitably there will be an oversupply of capital in some area of investment and investors will run in to trouble. Companies will be in trouble, consumer will be in trouble, and investors will be in trouble. Will Dodd-Frank succeed in reducing that likelihood and reducing the impact? Only time will tell.

Tighter Rules on Advisory Performance Fee Charges

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client was a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication. Those levels are now officially increased.

The original standard was that the client had to have at least $500,000 under management with the adviser immediately after entering into the advisory contract (“assets-under-management test”) or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into (“net worth test”). Those levels were increased to $750,000 and $1.5 million in 1985 to adjust for inflation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act called for Section 205(e) of the Advisers Act to adjust those levels for inflation and re-adjust the levels every five years. The SEC also decided to toss out the value of a person’s primary residence, just as they did with the new accredited investor standards.

The rule now requires “qualified clients” to have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

The SEC is using the same primary residence calculation they used in the new accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. As the SEC did with the accredited investor standard, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce. One of the questions from the SEC in the proposed rule was whether the PCE index was the appropriate measure of inflation. They’ve decided to use this index and continue to benchmark it against the original test amounts. In five years, you will be able to predict what the new levels will be.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

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Comment Period Extended for Volcker Rule

The Securities and Exchange Commission and federal banking regulators have extended the comment period on the Volcker Rule proposed regulations from January 13, 2012 to February 13, 2012. In Release No. 34-66057, the regulators noted that the extension of the comment period is appropriate “due to the complexity of the issues involved and to facilitate coordination of the rulemaking among the responsible agencies as provided in section 619 of the Dodd-Frank Act.” The proposed rule was released in October. The Volcker Rule is scheduled to go into effect July 21, 2012.

The extension’s Release cites comment letters from the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce (November 17, 2011); American Bankers Association et al. (November 30, 2011); and Representative Neugebauer (R-TX) (December 20, 2011). The ABA letter points out the 1400 questions asked in the proposed regulations.

The Dodd-Frank Act put the Volcker Rule in place to restrict the ability of bank and non-bank financial companies to engage in proprietary trading and to limit their ability to have interests in, or relationships with, a hedge fund or private equity fund.  The concept is simple, but difficult in execution. All banks and financial institutions engage in some form of proprietary trading to hedge the risks in their loan portfolios. Add in the extensive use of securitizations. Sprinkle in the decision by the remaining Wall Street firms to become bank holding companies after the 2008 crisis to get part of the bailout. Whip it all up with the difficulties in defining a non-bank financial company.

Feel free to add handfuls of industry lobbying to the mix, depending on your level of cynicism.  For example, Representative Schweikert is asking the regulators to exclude venture capital investing under Section (d)(1)(J)

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The New Accredited Investor Standard

After thinking about it for almost year, the Securities and Exchange Commission has finalized the new definition of “accredited investor.” On January 25, 2011, the SEC proposed amendments to the accredited investor standards in the rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Section 413(a) of the Dodd-Frank Act required the SEC to adjust the accredited investor net worth standard that applies to natural persons individually, or jointly with their spouse, to “more than $1,000,000 . . . excluding the value of the primary residence.” Previously, this standard required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth. Under Section 413(a), the change to remove the value of the primary residence from the net worth calculation became effective upon enactment of the Dodd-Frank Act. This rule merely clarifies a few points.

Section 415 of Dodd-Frank requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” The SEC lets us know that they may take a more thorough revision of the accredited investor standard after that report comes out in July 2013.

Under the rule, owning a home can only decrease your net worth. To the extent your mortgage debt is less than the fair market value of your house, you can’t include that equity in calculating net worth. To the extent your mortgage is in excess of the value of your house, the amount underwater is counted against net worth.

Just to really screw up things, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

This new 60 day rule will be a pain in the neck. On the other hand, I saw some shady operators touting the ability to leverage up your home to get you over the threshold into accredited investor land. That scheme would seem to be targeted right at the vulnerable class of “house-poor”. Apparently state securities regulators were also concerned about advising investors to use equity in their home to purchase securities.

One of the other comments was that mortgage debt in excess of the home value should not count when the loan is non-recourse or the lender is prohibited by state law from collecting a shortfall after foreclosure. The SEC dismissed that idea as being too complicated and requiring a detailed legal analysis. They also counter with some data from a 2007 Federal Reserve Board Survey that suggests that the number of households nationwide that qualify as accredited investors is not affected by whether the net worth calculation includes or excludes the underwater portion of debt secured by the primary residence.

The rule ends up amending:

  • Rule 144(a)(3)(viii),
  • Rule 155(a),
  • Rule 215, and
  • Rule 501(a)(5) and 501(e)(1)(i) of Regulation D
  • Rule 500(a)(1)
  • Form D under the Securities Act;
  • Rule 17j-1(a)(8) under the Investment Company Act of 1940and
  • Rule 204A-1(e)(7) under the Investment Advisers Act of 1940

The rule is adopted with only a limited grandfather provision. The old accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities, only if

  1. the right was held by a person on July 20, 2010 (the day before the enactment of  Dodd-Frank)
  2. the person qualified as an accredited investor on the basis of net worth at the time the right was acquired and
  3. the person held securities of the same issuer, other than the right, on July 20, 2010.

Otherwise, the new rule goes into effect 60 days after it’s published in the Federal Register. That will the rule will be effective by the end of February 2012.

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The SEC and Rating Agencies

The SEC examined all 10 firms registered Nationally Recognized Statistical Rating Organization (.pdf 23 pages) and found all 10 had “apparent failures”. The SEC has requested remediation plans from each of the agencies within 30 days and is continuing its investigation.

The issues found included “apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest.”

Personally, I think the rating agencies have not gotten enough of the blame for their roles in the events leading up to the 2008 financial crisis. Without the golden top rating they issued to the toxic mortgage-backed securities,  I think the popping of the housing bubble would not have been so vicious.

In 2006, the Credit Rating Agency Reform Act granted the authority to establish a registration and oversight program for credit rating agencies to the SEC and gave them oversight over those credit rating agencies that register with the Commission as Nationally Recognized Statistical Rating Organizations (“NRSROs”). However, it expressly prohibits the SEC from regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.

The Dodd-Frank Wall Street Reform and Consumer Protection Act enhanced the regulation and oversight by imposing new reporting, disclosure, and examination requirements. The new law also requires the SEC to conduct an examination of each NRSRO at least annually.  The 2011 Summary Report of t Commission’s Staff Examinations of Each Nationally Recognized Statistical Rating Organization (.pdf 23 pages) is the first to look at the ten under the new framework.

  1. A.M. Best Company, Inc.
  2. DBRS Inc.
  3. Egan-Jones Rating Company
  4. Fitch, Inc.
  5. Japan Credit Rating Agency, Ltd.
  6. Kroll Bond Rating Agency
  7. Moody’s Investors Service, Inc.
  8. Morningstar Credit Ratings, LLC
  9. Rating and Investment Information, Inc.
  10. Standard & Poor’s Ratings Services

The SEC did not determine that any finding discussed in this Report constitutes a “material regulatory deficiency”. That would have meant a referral to the Division of Enforcement and gotten more lawyers involved. The SEC does not single out by name any credit-rating agency for questionable actions in the report, but it does describe specific problems it found.

It will be interesting to see what happens next year. As most compliance people know, the failure to fix a problem pointed out by the SEC is likely to lead to trouble the next time they show up.

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Nationally Recognized Statistical Rating Organization (.pdf 23 pages)

Conflicts of Interest and Securitizations

The Big Short highlighted some of the difficulties of taking an investment position in a real estate downturn. The situation was taken a step further with Goldman Sachs’ help in putting together mortgage backed securities with the primary purpose of helping a client take an investment position that the securities will default. It turned out very well for Goldman’s client and terrible for the purchasers of the securities.

Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security from engaging in a transaction that would involve or result in certain material conflicts of interest. It then leaves it up to the Securities and Exchange Commission to issue rules for the purpose of implementing this new prohibition.

The SEC published a proposed rule at its Open Meeting on Sept. 19, 2011: Prohibition against Conflicts of Interest in Certain Securitization (.pdf).

The proposed rule could — if certain conditions are otherwise met — prohibit a firm from packaging Asset Backed Securities, selling them to an investor, and subsequently shorting the Asset Backed Securities to potentially profit at the same time as the investor would incur losses.

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