By R. Christian Bruce

The Federal Reserve Board Dec. 20 asked for comment by March 31 on a tougher set of regulatory standards for financial firms critical to the well-being of the financial system, leaving some specific items, such as a special risk-based surcharge, to be addressed in follow-up proposals.

The 173-page proposal, which implements Sections 165 and 166 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, mandates new capital, liquidity, stress testing, risk management, and other requirements for banking firms with $50 billion or more in assets.

It also sets the basic ground rules for a class of nonbank financial firms that the Financial Stability Oversight Council (FSOC) may later determine to be, in the words of the proposal, “a grave threat to financial stability.”

Broad Impact Certain

Experts said the importance of the Dec. 20 proposal is almost impossible to exaggerate. Joseph Engelhard, senior vice president of Capital Alpha Partners, a Washington, D.C., area firm that provides research and analysis for institutional investors, called Section 165 “the single most important section of Dodd-Frank” for banks.

Michael E. Bleier, a partner in the Pittsburgh offices of Reed Smith, Dec. 20 called the Fed’s rules the most significant since 1971, when the Fed reshaped bank holding company regulation with the release of Regulation Y.

“They will likely have a major impact on investors and how these companies’ share price is impacted, and what steps they must take to meet the higher capital requirements that will surely be an outcome of the rulemaking process,” Bleier told BNA…

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By David N. Anthony, Alan D. Wingfield, and Virginia Bell Flynn, Troutman Sanders, Richmond

Background

In 2007 and 2008, the United States experienced a near collapse of its financial markets. While pundits continue to debate the reasons for the financial crisis, likely contributors have been identified as including poorly-underwritten subprime residential mortgages and the meltdown of “CDOs” and credit default swaps based on those mortgages, the high level of leverage employed by banks and other financial institutions and other “risky or exotic” consumer financial products taxing consumer’s buying power. The immediate response of Congress, the Department of Treasury and the Federal Reserve were dramatic emergency steps to shore up the financial system, including creating the Troubled Asset Relief Program (TARP), cutting interest rates, and lending billions of dollars to and taking a majority stake in companies such as American International Group, Inc.

Given that the immediate response to the crisis was perceived as a bailout of the financial institutions deemed “too big to fail,” many self-described consumer advocates focused on the tangible impact that the financial meltdown had on consumers. Many Americans experienced the decline in the value of their homes, lost their jobs, suffered income declines, defaulted on residential mortgage loans, took on unprecedented amounts of debt, suffered from questionable lending practices and accepted risky consumer financial products – all while funding the bailout as American taxpayers.

Passage of Dodd-Frank and Creation of the CFPB

In an attempt to address the perceived causes of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which President Obama signed into law on July 21, 2010. Dodd-Frank represented the most comprehensive legislative overhaul of federal financial regulation since the Glass-Steagall Act passed during the Great Depression. Dodd-Frank’s sixteen titles address many perceived problems with the United States financial market, including the stability and accounting of financial institutions, transparency in financial products, needed regulatory reform and oversight, investor safety and consumer protection…

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By David J. Levine, Raymond Paretzky and Adam M. Taylor, McDermott Will & Emery LLP, Washington, D.C.

I. Introduction

Even as global supply chains become ever more byzantine, a new US law and proposed implementing rule of the US Securities and Exchange Commission (“SEC”) will add another wrinkle. Companies whose products use “Conflict Minerals” must understand – and control – their supply chains to an unprecedented degree and will be required to comply with extensive new reporting requirements. Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted last July (“Dodd-Frank” or “Act”) imposes these requirements in an effort to undercut funding of militias that have devastated the Democratic Republic of Congo (“DRC”) for the past several years. As with other provisions of Dodd-Frank, Congress assigned implementing responsibility for section 1502 to the SEC, which regulates public companies but has little expertise in international affairs. Therein lies a source of confusion for companies trying to plan for the impending requirements: the SEC final rulemaking has been delayed while the agency figures out how to implement the law faithfully without binding companies to unworkable measures.

Section 1502 of the Act specifically targets four mineral resources that provide the region’s militias with significant revenues: tungsten, tantalum, tin and gold (“three Ts and G” or “3T+G” – the “Conflict Minerals”) as well as the ores from which they are derived. Through section 1502, Congress sought to bring transparency to, and thereby to curtail, the Conflict Minerals trade by requiring companies to report on their use. Last December, the SEC published and sought comments on a proposed implementing rule, which hewed closely to the legislative language. The proposal would require companies who use any of the 3T+G in their products to file an audited “Conflict Minerals Report” with the SEC each year to demonstrate that no Conflict Minerals they used were from sources that benefited the militias in the DRC region. The SEC’s statutorily-imposed deadline to finalize the rule passed in the spring, but the final rule still remains unpublished. The SEC and interested companies and industries have demonstrated continued uncertainty about the final rule, as highlighted in a day-long public Roundtable hosted by the SEC on October 18, 2011, at which SEC commissioners, staff, and numerous industry representatives exchanged ideas and concerns. The SEC is working to adopt the new rule as soon as practicable. This article alerts companies to the key requirements and likely regulations so that they can prepare adequately by answering the critical questions: who, what, and when.

II. Who is Affected?

Section 1502 applies to “issuers” for whom Conflict Minerals are “necessary to the functionality or production of a product” “manufactured or contracted to be manufactured by” the issuer.

Issuer. The regulations will apply to any public company required to file annual reports with the SEC under sections 13(a) or 15(d) of the Exchange Act, 15 USC §§78m(a), 78o(d). Companies not subject to these provisions will not be subject to the Conflict Minerals regulations…

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By Kevin L. Petrasic, Paul, Hastings, Janofsky & Walker LLP.

The interagency Volcker Rule proposal issued last month by the Securities and Exchange Commission (SEC), Federal Reserve Board (FRB), Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) (collectively, the Agencies) solicits comment on a wide array of questions, issues and complexities, the totality of which highlight the significant regulatory challenges confronting the Agencies in implementing a final rule. The almost 400 questions raised in the proposed rule to implement Section 619 of the Dodd-Frank Act address the Volcker Rule’s restrictions on the ability of a bank to engage in proprietary trading and to sponsor or invest in hedge funds and private equity funds. The proposal also seeks comment on a number of complicated and controversial recordkeeping, reporting and related compliance questions. In the aggregate, it appears clear that the Agencies, along with the Commodities Future Trading Commission (CFTC) which abstained from signing onto the proposal, face substantial hurdles in implementing a final rule by the Volcker Rule’s July 21, 2012, statutory effective date.

The most challenging regulatory aspects of the proposal are contained in Subparts B and C of the proposed rule. Subpart B, which addresses proprietary trading restrictions, accounts for over 200 questions, and Subpart C, which discusses covered fund activities and investments, accounts for another 100+ questions. Subpart D, which accounts for approximately 30 questions, sets forth the proposal’s compliance program requirement, also highlighting significant potential compliance burdens and challenges for the industry to implement and the Agencies to manage. Finally, there are numerous themes and issues highlighted throughout the proposal that have significant implications for banks, and that will require careful planning and execution to model a program to assure and maintain compliance…

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By Thomas A. Zaccaro, Adam D. Schneir, Eleanor K. Mercado and Kai S. Bartolomeo,
Paul Hastings LLP, Los Angeles 

On October 24, 2011, the Commodity and Futures Trading Commission’s (CFTC) whistleblower rules became effective and its Whistleblower Office opened for business. The new Whistleblower Office is charged with implementing the CFTC’s recently adopted whistleblower rules mandated by Section 748 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and Section 23 of the Commodity Exchange Act (CEA). Under the new rules, the CFTC may pay an award to an eligible whistleblower who voluntarily provides the agency with original information about a violation of the CEA that leads to a successful enforcement action.

The CFTC first published its proposed rules in December 2010 and invited public comment. During the comment period, industry groups urged the CFTC to require a whistleblower to first report the information internally to an entity to be eligible for an award in order to preserve the integrity of internal reporting systems. After the public comment period closed, the CFTC revised the proposed rules to promote harmonization with the Securities and Exchange Commission’s (SEC) whistleblower rules and program, which became effective on August 12, 2011, and to respond to concerns raised during the public comment period.

The final rules, which largely mirror the SEC’s whistleblower rules, were adopted by the CFTC on August 4, 2011 in a 4-1 vote. While the final rules do not require a whistleblower to first internally report the information, they do provide incentives for whistleblowers to use a firm’s internal compliance system as part of the reporting process and disincentives for whistleblowers who bypass or thwart these systems.

Significant Elements of the Whistleblower Rules

Section 23 of the CEA requires the CFTC to pay awards to qualified whistleblowers who voluntarily provide the agency with original information regarding violations of the CEA that lead to the successful resolution of a judicial or administrative action or successful enforcement of a related action. To be eligible for an award, the whistleblower must also (1) follow the submission process set forth in Section 165.3; (2) be the original source of the information; (3) provide the CFTC with additional information as appropriate; and (4) enter into and adhere to the terms of a confidentiality agreement if requested by the CFTC.

Whistleblower

Under the rules, a whistleblower is defined as any individual, or group of individuals acting jointly, who voluntarily provide the CFTC with original information about a potential violation of the CEA in the manner set forth by Section 165.3.  The whistleblower does not, however, need to be employed by the entity about which he or she is reporting…

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By Yin Wilczek

The Securities and Exchange Commission Oct. 26 unanimously adopted a rule that will require hedge and other private fund advisers to report information—scaled to the size and types of funds—that will be used by the Financial Stability Oversight Council to assess systemic risk.

The final rule—a joint rulemaking by the SEC and the Commodity Futures Trading Commission—was substantially modified from a proposal issued in January (43 SRLR 198, 1/31/11) to ease the requirements for industry. The changes include higher reporting thresholds, less reporting detail, less frequent reports, and extension of compliance deadlines.

The CFTC is expected to consider adoption of the rule within the next week. The SEC will not post its adopting release or new Form PF—the form on which the systemic risk data is reported—unless and until the CFTC approves the rule.

Coordination, Consultation

In her opening remarks, SEC Chairman Mary Schapiro said the new rule and Form PF—for “private funds”—was the result of consultations with FSOC and international regulators, and input from industry participants. As a result, Form PF “will address the dramatic lack of private fund information available to regulators today while easing the burden on private fund managers producing the data, so that the same data collection approaches and protocols apply cross-border where appropriate,” she said.

The requirements for hedge and other private fund advisers to report systemic risk data and to register with the SEC were both mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Confidential Data

In recommending that the commission adopt the systemic risk reporting rule, Eileen Rominger, director of the SEC’s Division of Investment Management, stressed that the information provided will be kept confidential—a concern that many participants voiced. “Division staff is focused on helping design controls and systems for the use and handling of Form PF data in a manner that respects the sensitivity of this data, and is consistent with the enhanced protections established in the Dodd-Frank act,” she said.

Rominger added that two factors also should help reduce the sensitivity of the reported information. First, Form PF does not require the reporting of position-level data, she said. Second, most of the filing deadlines have been significantly extended…

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By K. Susan Grafton, Gibson, Dunn & Crutcher, Washington, D.C.

On July 27, 2011, the Securities and Exchange Commission (“SEC” or “Commission”) adopted Rule 13h-1 and Form 13H under the Securities Exchange Act of 1934 (“Exchange Act”), which requires persons who are deemed to be large traders to register with, and to provide certain information about themselves and their affiliates to, the Commission.

I. Obligations of Large Traders

A. Introduction

If a person meets the definition of “large trader,” it (or he or she, as discussed below) is required to register with the SEC on Form 13H, to provide certain information about itself and its affiliates, and to obtain a larger trader ID (“LTID”). Because a single transaction of sufficient size or value can cause a person to be deemed a large trader, the SEC signaled its intent not to limit the reporting requirement to active traders. Nevertheless, as discussed below, many routine corporate transactions are not counted in determining if a person is a large trader (e.g., share repurchases, stock lending, employee compensation plans involving stock awards and option grants, business combinations, and offerings off an exchange). Large traders must file their first Form 13Hs with the SEC by December 1, 2011.

B. Large Trader Definition

Rule 13h-1(a)(1)(i) defines “large trader” as any person that “[d]irectly or indirectly, including through other persons controlled by such person, exercises investment discretion over one or more accounts and effects transactions for the purchase or sale of any NMS security for or on behalf of such accounts, by or through one or more registered broker-dealers, in an aggregate amount equal to or greater than the identifying activity level.” A person who voluntarily registers with the SEC by filing Form 13H is also a “large trader.”

1. Definition of “Person”

A “person” is defined as “a natural person, company, government, or political subdivision, agency, or instrumentality of a government,” and also includes “two or more persons acting as a partnership, limited partnership, syndicate, or other group, but does not include a foreign central bank.” Contrary to Form 13F, natural persons are not exempt from filing Form 13H. Foreign entities can also be large traders.

2. Definition of “Control”

“Control” (which includes “controlling,” “controlled by” and “under common control with”) is defined in Rule 13h-1(a) as “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of securities, by contract, or otherwise.” Control is presumed to exist if a person, directly or indirectly, has the right to vote, or the power to sell or to direct the sale of 25% of more of a class of voting securities of an entity, or, in the case of a partnership, the right to receive, upon dissolution, or has contributed, 25% or more of the capital of an entity.

3. Definition of “Investment Discretion”

For purposes of Form 13H, the SEC used the definition of “investment discretion” in Section 3(a)(35) of the Exchange Act:

a person exercises ‘investment discretion’ with respect to an account if, directly or indirectly, such person (A) is authorized to determine what securities or other property shall be purchased or sold by or for the account, (B) makes decisions as to what securities or other property shall be purchased or sold by or for the account even though some other person may have responsibility for such investment decisions, or (C) otherwise exercises such influence with respect to the purchase and sale of securities or other property by or for the account as the Commission, by rule, determines, in the public interest or for the protection of investors, should be subject to the operation of the provisions of this title and rules and regulations thereunder.

Employees who exercise investment discretion within the scope of their employment are deemed to exercise investment discretion on behalf of their employer.

C. Parents and Subsidiaries

A large trader can comply with Rule 13h-1 by either the ultimate control person registering and filing Form 13H on a consolidated basis for all accounts that it controls; or one or more persons controlled by the large trader collectively complying with respect to all of the large trader’s accounts.  If affiliates comply separately, each entity under common control must identify the ultimate parent as well as any other affiliate on its Form 13H.

D. Identifying Activity Levels

Form 13H must be filed if a person effected transactions in “NMS securities” by or through one or more registered broker-dealers that, in aggregate, equaled or exceeded the “identifying activity level.” An “NMS security” is defined in Rule 600(b)(46) of Regulation NMS as “any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.” Generally, NMS securities include all equity securities and options listed on a national securities exchange.

The “identifying activity level” is (1) 2 million shares or $20 million during any calendar day, or (2) 20 million shares or $200 million during any calendar month. The following transactions should be excluded when determining if the identifying activity level is met:

1. transactions pursuant to options exercises or assignments;

2. employer option grants and stock awards;

3. creations and redemptions of exchange traded funds (“ETFs”); ⁵

4. transactions to effect a business combination, self-tenders, other buybacks or equity repurchase agreements, and stock loan agreements;

5. transactions that are part of an offering of securities by or on behalf of an issuer or by an underwriter on behalf of an issuer, so long as the transaction is not effected through the facilities of a national securities exchange;

6. gifts;

7. transactions by an executor, administrator, or fiduciary pursuant to distribution of a decedent’s estate;

8. transactions effected pursuant to a court order; and

9. transactions pursuant to the rollover of a qualified plan or trust assets.

⁵ While this exemption excludes the transfer of such securities between an authorized participant and an ETF, it does not exempt secondary market transactions related to the acquisition or disposition of securities in connection with the creation or redemption of ETF shares.

The calculation of the identifying activity level must be on a gross basis across all controlled entities, and cannot be offset (e.g., by hedging transactions). Affiliate’s trading activity must be included even if there are effective information barriers for purposes of Regulation M or other regulatory requirements. The volume or fair market value of the underlying equity securities is used to calculate the activity level of options…

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By Yin Wilczek

Federal banking regulators Oct. 11 issued a controversial and long-awaited proposalto bar, with certain exemptions, banking entities from engaging in proprietary trading, and to limit their investment and sponsorship of hedge and private equity funds.

The rule proposal by the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of Currency implements Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, popularly known as the “Volcker rule.” The rule, named after former Federal Reserve Chairman Paul Volcker, seeks to prohibit Wall Street practices perceived to be central to the 2008 financial crisis.

The proposal will be submitted for publication in the Federal Register for a 90-day comment period that ends Jan. 13, 2012.

The Securities and Exchange Commission, also part of the joint rulemaking, signed off on the proposal at an Oct. 12 open meeting.

Anticipated Pushback

Significant pushback on the rulemaking is expected from banks and other financial institutions, given the revenues generated by proprietary trading. In July, the Government Accountability Office analyzed data on stand-alone proprietary trading desks at the six largest U.S. bank holding companies from June 2006 through December 2010. In 13 quarters during that period, stand-alone proprietary trading produced revenues of $15.6 billion, according to the report.

At an Oct. 11 FDIC meeting, acting chairman Martin Gruenberg—setting the stage for what promises to be a long and grueling rulemaking—promised that his agency will move in a “careful and deliberative” manner on the proposal. Moreover, he said, the 90-day comment period will allow “ample opportunity” for the public to weigh in.

Also at the meeting, John Walsh, acting comptroller of the currency, said the rulemaking has been controversial “pretty much from the outset.” He expressed “relief” at the release of the “official” proposal, given the many draft versions that have been obtained by the media and others (97 BBR 592, 10/11/11)…

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By Richard Hill

Several financial industry experts said Sept. 22 that one of their key fears as regulators implement the Dodd-Frank Wall Street Reform and Consumer Protection Act is that bigger industry participants with the means to do so will decide to conduct business in jurisdictions outside the United States with friendlier regulatory environments.

“One of the impacts many of us fear will occur is that large institutions—which are well-capitalized and have flexibility—will in fact take a lot of their business” to jurisdictions that have less stringent oversight, Sharon Brown-Hruska, vice president of the securities and finance practice at National Economic Research Associates, said at a forum on U.S. and global financial reform sponsored by Georgetown University’s McDonough School of Business and PricewaterhouseCoopers.

Brown-Hruska, a former Commodity Futures Trading commissioner who also has served as the agency’s acting chairman, said that if that flight were to occur, “the impact could be significant and trickle down” to investors and commercial end-users of swaps.

Her comments came as U.S. and international regulators—most significantly in the European Union—strive to complete the first rules for swaps trading. Domestic regulators are working to implement the 2010 Dodd-Frank law by sometime in 2012. Group of 20 countries have stated a goal of completing rulemaking by the end of 2012.

Robert Colby, a partner at Davis Polk and Wardwell LLP and a former deputy director of the Securities and Exchange Commission’s Division of Trading and Markets, agreed with Brown-Hruska. He said that if the United States finalizes relatively stricter rules for over-the-counter derivatives, companies “are naturally going to try to deal outside this environment.”

Kathleen Cronin, managing director, general counsel, and corporate secretary for CME Group, observed that while many industry participants focus on the CFTC and SEC rulemaking process, there is a larger perspective to be observed. “It’s not just in the United States. … We also have concerns about how foreign coordination will work. All of the international interplays are very important,” she said…

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By Thecla Fabian

The Federal Deposit Insurance Corporation (FDIC) Sept. 13 cleared a final rule on so-called living wills mandated for certain large banks and critical nonbank financial firms, along with some extra time to put those plans in place.

The rule, mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act, affects three classes of institutions:

• Bank holding companies with $50 billion or more in assets;

• Foreign bank holding companies regulated by the Federal Reserve Board with $50 billion or more in assets, and;

• Nonbank systemically important financial institutions (non-bank SIFIs) designated as risks to U.S. financial stability by a new council of regulators and made subject to bank-like regulation by the Fed.

No one yet knows which companies make up that last group. The Financial Stability Oversight Council (FSOC), which Dodd-Frank created to monitor and respond to systemic risks, is working on rules that will govern how it designates certain firms that might cause wider damage should they collapse.

The FSOC has not yet put any firm in that category, but once it does, any firm designated as systemically important would have to submit to regulators its own so-called living will, which would be a detailed plan showing how the firm would unwind itself under the Bankruptcy Code.

The rule approved by the FDIC Sept. 13 sets out the requirements for those plans.

Fed Must Approve

The Federal Reserve Board also must approve the joint rule, which will come into effect 30 days after it is published in the Federal Register. The Fed is expected to act soon.

The final rule currently applies to some 124 bank holding companies, most of which are foreign-owned, an FDIC official said. In the future, it also will apply to companies designated by FSOC as systemically significant, he added.

A Sept. 9 FDIC staff memo to the board stressed that the final rule did not focus on simple disclosure of additional information about business operations, but rather required a strategic analysis by the company of how it can be resolved in a way that does not pose systemic risk to the financial system.

This strategic analysis will require a number of key analytical elements, including a description of the company’s critical thinking detailing how, in practice, it could be resolved under the Bankruptcy Code, as well as analytical support for the plan, its key assumptions, and how it would be implemented under different stress scenarios.

If the company cannot be resolved under the Bankruptcy Code and resolution goes to the FDIC under Title II of the Dodd-Frank Act, the living will give the FDIC access to enhanced understanding of the company’s foreign operations if the U.S. regulator and its foreign counterparts must develop a comprehensive and coordinated resolution strategy for a cross-border firm.

Rules Crafted with Lehman In Mind

A Treasury Department official recently said the FSOC is working on a revised set of rules for designating which firms should be considered as nonbank SIFIs (97 BBR 289, 8/23/11).

However, the Dodd-Frank Act also gives the FDIC new authority to resolve those firms under separate procedures if a traditional bankruptcy filing would cause wider damage.

The new procedures are designed to avoid a replay of financial stress that came in the wake of the September 2008 Lehman Brothers bankruptcy.

The FDIC rule takes effect 30 days following publication in the Federal Register. The Fed is expected soon to approve its version of the regulation.

The rule could affect money market funds, insurance companies, hedge funds, and other non-bank financial firms that might be designated as nonbank SIFIs by the FSOC.

However, the final rule will apply right away to 124 bank holding companies, most of which are foreign-owned, an FDIC official said…

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