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J. Robert Brown, Jr.*

I. Introduction

Congress, in adopting the Dodd-Frank Act,[1] sought to correct some of the abuses believed to have contributed to the financial crisis of 2008-2009.  Executive compensation was one of them.  Formulas used to determine compensation were thought to promote a short-term perspective that encouraged excessive risk taking.[2]  As a result, financial regulators were given the authority to review compensation practices for risk.[3]  Likewise, the Act sought to strengthen the integrity of the compensation approval process[4] and to increase clawbacks of performance-based compensation following certain restatements.[5]

Not all compensation provisions, however, were designed to address risk.  Some were inserted in an effort to expand the role of shareholders in the governance process.  Addressed primarily under the rubric of fairness,[6] the Act gave shareholders an advisory vote on executive compensation.[7] At the same time, Dodd-Frank expanded the information available to shareholders making the determination.  Specifically, Section 953(b) required disclosure of a ratio that compared CEO and employee compensation.[8]  Although hardly noticed at the time of adoption, the provision eventually generated considerable controversy and engendered serious calls for repeal within Congress.

This article will do several things.  First, it will examine the role of compensation ratios in the debate over executive compensation.  Second, the article will discuss Section 953(b), including the broad regulatory authority retained by the Securities and Exchange Commission (“SEC” or “Commission”) in implementing the provision.  Finally, the article will analyze the current controversy surrounding the provision.

II. Compensation and Ratios

Ratios have long been part of the debate over executive compensation.  They typically rely on average CEO compensation as the numerator and average employee compensation as the denominator.  In general, they have been used to show the relative increase of CEO compensation over time.[9]

Ratios, however, have not been a particularly useful metric for shareholders.  For one thing, they are not computed on a company-specific basis.  For another, they are not determined in a consistent fashion.  While average CEO compensation can, for the most part, be computed on a uniform basis,[10] there is considerable variance with respect to employee compensation.  Ratios may rely on the amount paid to the “average production worker”[11] or “private sector” employee.[12]  Some look to the minimum wage.[13]  They can exclude particular sub-categories of employees[14] or resort to medians rather than means.[15]

The lack of consistency and the absence of firm specific data minimize the ability to use the metric to assess CEO compensation within a particular company.  Thus, while they can demonstrate broad trends in compensation, they have not been particularly helpful in providing shareholders with a tool for assessing the reasonableness of compensation in their own company.

III. Dodd Frank and Compensation Ratios

Sponsored by Senator Menendez of New Jersey and originally part of separate legislation,[16] the requirement to disclose compensation ratios was inserted into the Senate version of Dodd-Frank during committee deliberations.  Apparently a late addition, the provision generated no meaningful legislative history.[17]

The requirement addressed many of the concerns that limited the value of compensation ratios to shareholders.  Section 953(b) of Dodd-Frank imposed a mandatory formula for calculating the statistic.[18]  Moreover, it provided for the determination of ratios on a company-specific basis and mandated the use of medians rather than averages.[19]  Implementation was, however, accomplished in a highly complicated fashion.  Rather than simply require disclosure of the ratios, the provision in three instances cross-referenced or incorporated portions of existing regulations.  The result was substantial discretion on the part of the SEC in implementing the requirement.

Specifically, Section 953(b) provided that ratio disclosure must appear in Item 402 of Regulation S-K (or its successor),[20] the SEC provision defining executive compensation.[21]  In effect, Congress opted to write a portion of Item 402, transforming a regulation into a statute.[22]  As a consequence, the Commission could amend or rewrite Item 402 with respect to most compensation matters but, once implemented, could not eliminate ratio disclosure.

Congress also referred to SEC regulations in defining the breadth of the disclosure requirement.  Section 953(b) provided that ratio disclosure was to appear “in any filing of the issuer described in section 229.10(a).”[23]  Because Item 10(a) referred to periodic reports, the reference suggested that the ratios were to be disclosed on a quarterly if not more frequent basis.[24]  Congress, however, left the Commission with the discretion to reduce the frequency through amendments to Item 10.[25]  Deletion of the words “or other” after “annual report” in Item 10 would eliminate the ratios from all periodic reports except the Form 10-K, effectively requiring only annual disclosure of the information.[26]

Finally, Section 953(b) prescribed the method for calculating employee compensation by referencing Item 402(c)(2)(x), the subsection that defined the CEO’s total compensation.[27]  Congress specifically limited the SEC’s authority to change the formula by requiring application of the standard “in effect on the day before the date of enactment of this Act.”[28]  The SEC nonetheless retained considerable discretion over the formula.  The reference to Item 402 specified the categories of compensation that were to be considered[29] but did not prescribe the method of calculating the categories.  That was left to the administrative discretion of the SEC.[30]

The provision, therefore, provided a broad role for the SEC in developing and applying ratio disclosure.  The SEC retained the authority to determine the frequency of ratio disclosure and the method used to calculate employee compensation.

IV. The Ongoing Debate

The imposition of ratio disclosure caused little controversy during the debate over Dodd-Frank.  As implementation approached, however, vigorous opposition developed over the merits of the provision.[31]  Critics asserted that calculation of median compensation for employees would be costly[32] and logistically difficult. [33] In addition, they challenged the value of the information, asserting in part that the ratios did not provide a meaningful basis for comparison.[34]

The concerns attracted attention in Congress.  The Burdensome Data Collection Relief Act called for the repeal of Section 953(b) in its entirety.[35]  On June 22, 2011, the House Financial Services Committee approved the legislation by a vote of 33-21.  The accompanying report reiterated the concerns about the immateriality of the information and the burdensome nature of the calculation.[36] Attempts in the committee to rewrite Section 953(b) to simplify the formula and limit the frequency of disclosure were defeated.  While the matter has not yet passed the House, opposition in the Senate has surfaced.[37]

V. Compensation Ratios Going Forward

Most of the concerns expressed over ratio disclosure can be fixed in the rulemaking process,[38] something that the SEC has indicated will occur before the end of 2011.[39]  As discussed, the SEC has considerable flexibility to limit the frequency of disclosure.[40]  Likewise, while Congress prescribed the categories used in determining employee compensation, the SEC retains broad discretion to determine how these categories are calculated.[41]  As for the treatment of part-time and overseas workers, there may be little administrative discretion over the issue.[42]

With respect to the materiality of the information, ratios have particular importance in the era of “say on pay.”  An advisory vote on compensation gives shareholders an opportunity to comment on the reasonableness of CEO pay.  Reasonableness, however, requires context.  Metrics that allow for a comparison of pay practices among public companies can assist in providing the requisite context.[43]  Moreover, the ratios provide a mechanism for the first time for assessing the reasonableness of the compensation within each particular company.[44]

Variations in the ratio that arise from differences in business models or geographic reach can be addressed through accompanying  disclosure.  Companies can explain the relevant differences through the use of narrative and additional ratios.  Moreover, such information will likely have the benefit of providing shareholders with additional insight into the calculation of CEO compensation and the company’s employment practices.[45]

The most significant impact of the ratio may, however, be on the board of directors.  The disclosure requirement effectively increases the information available to boards when setting executive pay.  Some boards already take ratios into account when determining compensation.[46]  Because a bad ratio may be embarrassing,[47] the board has an incentive to alter compensation in order to avoid adverse disclosure.[48]  Disclosure of the ratio may, therefore, impact the amount of compensation paid to employees and the CEO.[49]

VI. Conclusion

Ratio disclosure raises some legitimate logistical concerns over the method of computation and the frequency of disclosure.  Most can be addressed and resolved by the SEC during the authority process.  The addition of ratio disclosure, when coupled with say on pay, provides shareholders with a more meaningful ability to participate in the compensation process.

 

Preferred citation: J. Robert Brown, Jr., Dodd-Frank, Compensation Ratios, and the Expanding Role of Shareholders in the Governance Process, 2 Harv. Bus. L. Rev. Online 91 (2011), https://journals.law.harvard.edu/hblr//?p=1751.
* J. Robert Brown, Jr. is a Professor of Law and Director of the Corporate-Commercial Law Program at the University of Denver Sturm College of Law.
[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (“Dodd-Frank” or “the Act”).
[2] S. Rep. No. 111-176 (2010), available at http://thomas.loc.gov/cgi-bin/cpquery/?&item=&&sid=cp111FTCKo&&refer=&&r_n=sr176.111&&dbname=cp111&&sid=cp111FTCKo&&sel=TOC_446491&&sid=cp111FTCKo&r_n=sr176.111&dbname=cp111& (noting that legislation addresses “executive compensation practices that promoted excessive risk-taking”).
[3] See Dodd-Frank Act § 956.  Even before the adoption of Dodd-Frank, the SEC required disclosure by public companies of relationship between compensation policies and risk.  See Regulation S-K, 17 C.F.R. § 229.402(s) (2011). The provision was adopted in 2009.  See Proxy Disclosure Enhancements, Exchange Act Release No. 61175 (Dec. 16, 2009).
[4] Dodd-Frank Act § 952.  The SEC has proposed implementing rules with respect to these requirements.  See Listing Standards for Compensation Committees, Exchange Act Release No. 64149 (March 30, 2011).
[5] Dodd-Frank Act § 954.
[6] S. Rep. No. 111-176, supra note 3 (“Congress is empowering shareholders in a public company to have a greater voice on executive compensation and to have more fairness in compensation affairs.”).
[7] Dodd-Frank Act § 951.
[8] Dodd-Frank Act § 953.
[9] Indeed, for the most part, ratios have shown a substantial growth in CEO compensation compared to employees.  See Joel Seligman, Rethinking Private Securities Litigation, 73 U. Cin. L. Rev. 95, 114 (2004) (“These decisions coincided with a dramatic increase in the ratio of the compensation of the corporate CEO to that of the average corporate blue collar employee.  In 1980, this ratio was 42 to 1; by 1990, it had grown to at least 120 to 1; by 2000, it was estimated to be at least 475 to 1.”).  See also Jeffrey N. Gordon, Essay: “Say on Pay”: Cautionary Notes on the UK Experience and the Case for Shareholder Opt-In, 46 Harv. J. on Legis. 323 (2009) (“By the mid-2000s the changing ratio in the compensation level of CEO versus line-worker–from 20-1 in the 1950s to a purported approximate of 350-1 today–created controversy in the political realm as well as the boardroom.”).  For an example of ratios used to show increasing CEO compensation outside the United States, see The High Pay Commission, Interim Report: More for Less: What Has Happened to Pay at the Top and Does It Matter? (2011), available at http://highpaycommission.co.uk/wp-content/uploads/sites/87/2011/09/HPC-IR.pdf.
[10] Companies must disclose total compensation for the CEO using a common formula.  See Regulation S-K, 17 C.F.R. § 229.402 (2011).  Nonetheless, variations exist.  Ratios used an average of CEO compensation, something that could vary depending upon the group selected.  See Sarah Anderson, Eric Benjamin, John Cavanagh, & Chuck Collins, Institute for Policy Studies, Executive Excess 2006: Defense and Oil Executives Cash in on Conflict, available at http://www.faireconomy.org/files/ExecutiveExcess2006.pdf (average CEO compensation for 350 companies with revenues above $1 billion).  Likewise, administrative changes to the formula used for calculating CEO compensation could alter ratios over time.  See Executing Compensation and Related Person Disclosure, Exchange Act Release No. 54302A (August 26, 2006).
[11] See Economic Policy Institute, More Compensation Heading to the Very Top, http://www.stateofworkingamerica.org/files/images/orig/8-Wages_ceo_pay.png (last visited Oct. 6, 2011).
[12] See Anderson, et al., supra note 11 (average pay for private sector workers in 2005 as determined by U.S. Department of Labor, with average including part-time employees).  Others have referred to the compensation paid to the “average” worker.  See Lawrence Mishel, CEO-to-Worker Pay Imbalance Grows, Economic Policy Institute (June 21, 2006), available at http://www.epi.org/economic_snapshots/entry/webfeatures_snapshots_20060621/.
[13] See Heritage Institute, Spotlight on CEO Compensation, available at http://www.heritageinstitute.com/governance/compensation.htm#The_Ratio_of_Average_CEO_and_Worker (last visited Oct. 6, 2011).
[14] Larry Bumgardner, High CEO Pay Could Draw Renewed Attention in Election Year, 11 Graziadio Bus. Rev. (2008), available at http://gbr.pepperdine.edu/2010/08/high-ceo-pay-could-draw-renewed-attention-in-election-year (“One could plausibly argue that the ratio is likely overstated somewhat by including only 350 large companies for CEO pay, and by considering part-time employees in the average worker calculation.”).
[15] Frederic W. Cook, The Business Roundtable, Research on CEO Compensation for Business Roundtable (2006), available at http://www.shrm.org/hrdisciplines/compensation/Documents/20060705002ExecutiveCompensationResearch_FWC_62906.pdf (noting that with respect to an average, “outliers pull the averages up above the median” and that “[m]edian statistics are more representative of the practices of a large group”).  While most compensation ratios used averages, at least one study relied upon the median and produced a substantially lower ratio.  See Bumgardner, supra note 15 (“By contrast, a separate study released in 2006 by a CEO group, the Business Roundtable, concluded that the ratio was starkly lower-179 to 1.”).
[16] The legislation was the Committee on Banking, Housing, and Urban Affairs.
[17] The only mention of the provision in the Senate Report accompanying the legislation was a brief reference by the minority.  See S. Rep. No. 111-176, supra note 3 (“Although provisions like this appeal to popular notions that chief executive officer salaries are too high, they do not provide material information to investors who are trying to make a reasoned assessment of how executive compensation levels are set. Existing SEC disclosures already do this.”).  See also 156 Cong. Rec. S4075 (daily ed. May 20, 2010)  (statement of Sen. Shelby) (“The grab bag includes puzzling items, like a . . . provision that requires disclosure of the ratio of the median employee’s compensation to the chief executive officer’s compensation.  It looks to me like the way is being paved to achieve so-called ‘social justice’ in income distribution.  This is another disturbing example of the government getting its nose under the private sector’s tent.”).
[18] Dodd-Frank Act § 953(b).
[19] Id. (“[T]he median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position) of the issuer”).  Interestingly, calculation of the median cannot include CEO compensation.  The elimination of a single person from the determination of the median is not likely to have any meaningful effect on the calculation.  The same would not be true had employee compensation been computed based upon averages.
[20] See id. (“The Commission shall amend section 229.402 of title 17, Code of Federal Regulations, to require each issuer to disclose in any filing of the issuer described in section 229.10(a) of title 17, Code of Federal Regulations (or any successor thereto)”).
[21] 17 C.F.R. § 229.402.
[22] Regulations affirmed in legislation are elevated to the status of law.  Smith v. Whitney, 116 U.S. 167, 181 (1885) (“This legislative recognition of the Navy Regulations of 1870 ‘must,’ as was said by Chief Justice Marshall of a similar recognition of the Army Regulations in the act of April 24, 1816, ch. 69, § 9, 3 Stat. 298, ‘be understood as giving to these regulations the sanction of the law.’”).
[23] 17 C.F.R. § 229.10(a).
[24] Disclosure in multiple filings does not necessarily require multiple calculations.  The SEC could require a single calculation but mandate that the same calculation appear in an assortment of filings (perhaps through incorporation by reference).
[25] Where Congress did not intend for the SEC to have the authority to amend the applicable language, it said so.  See infra note 31.
[26] See 17 C.F.R. § 229.10(a)(2) (applying Regulation S-K to “annual or other reports under sections 13 and 15(d)”).  The savings clause contained in Item 10(a) would prevent the amendment from having any effect on the applicability of Regulation S-K to quarterly and current reports.  See 17 C.F.R. § 229.10(a) (providing that Regulation S-K applied to “any other document required to be filed under the Exchange Act, to the extent provided in the forms and rules under that Act.”).  So long as the forms for quarterly and current reports provide for the applicability of Regulation S-K, it would apply even if unmentioned in Item 10(a).
[27] The statute specifically requires application of Item 402(c)(2)(x) of Regulation S-K.  17 C.F.R. § 229.402(c)(2)(x).
[28] Dodd-Frank Act § 953(b) (“For purposes of this subsection, the total compensation of an employee of an issuer shall be determined in accordance with section 229.402(c)(2)(x) of title 17, Code of Federal Regulations, as in effect on the day before the date of enactment of this Act.”).  The Commission could, therefore, amend the provision and change the method used to calculate total compensation for top executive officers.  The amendment would not, however, apply to the calculation of the median compensation paid to employees.
[29] See 17 C.F.R. § 229.402(c)(2)(x).  The seven categories are salary, bonus, stock awards, stock options (with both stock awards and stock options measured by their value on the award date), other incentive pay, changes in pension value and other deferred compensation, and all other compensation.
[30] Thus, for example, 17 C.F.R. § 229.402(c)(2)(ix) provides that perquisites are included in CEO compensation only if they exceed $10,000.  The SEC could impose similar thresholds throughout the other categories, effectively limiting employee compensation to the amounts paid in cash.
[31] Although not proposing rules to implement ratio disclosure, the SEC did invite comments.  See http://www.sec.gov/comments/df-title-ix/executive-compensation/executive-compensation.shtml.
[32] See Center on Executive Compensation, The Dodd-Frank Pay Ratio Is Unduly Burdensome and Contrary to Sound Disclosure Policy, Hearing on Legislative Proposals to Promote Job Creation, Capital Formation, and Market Certainty Subcommittee on Capital Markets and Government Sponsored Enterprises House Committee on Financial Services (March 16, 2011), available at http://www.hrpolicy.org/downloads/2011/c11-34%20House%20Fin%20Svcs%20Cmt%20Testimony%20March%2016%202011%20FINAL.pdf.
[33] See Letter from Retail Industry Leaders Association (Oct. 27, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-43.pdf; Letter from Center on Executive Compensation (Sept. 1, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-10.pdf.  One solution might be the use of sampling.  See Letter from Center on Executive Compensation (Aug. 11, 2011), available at http://aflcio.org/corporatewatch/capital/upload/AFL-CIO-Comment-Letter-on-Dodd-Frank-Section-953-b.pdf
[34] Letter from Center on Executive Compensation, supra note 34.  See also Brett Harsen, Matt Ward, & Ted Buyniski, Dodd-Frank Act: The Importance of Putting CEO Pay Multiples into Context 1 (Radford), available at http://www.globalequity.org/geo/sites/default/files/Radford_Whitepaper_DoddFrank_CEO_Pay_Multiples.pdf (“A company involved only in semiconductor chip design will have a much lower CEO pay multiple than a similar entity that designs and fabricates the chips because the latter has a large workforce of lower-paid manufacturing workers. A company that has moved a segment of its workforce to lower cost countries will have a higher CEO pay multiple than one whose workforce is based solely in the United States.”).  Some have described the ratio as “overly simplistic.” Id.
[35] Burdensome Data Collection Relief Act, H.R. 1062, 112th Cong. (2011).
[36] See H.R. Rep. No. 112-142 (2011), available at http://financialservices.house.gov/UploadedFiles/HR1062hreport.pdf.  An amendment designed to fix the major concerns over the calculation of the ratio was defeated by a 27-25 vote.  Id. at 4.
[37] U.S. Senators Robert Menendez (D-NJ), Tom Harkin (D-IA), Sherrod Brown (D-OH), and Carl Levin (D-MI) sent a letter to Charles G. Tharp, CEO of Center on Executive Compensation, urging the organization to reconsider its position and to “stop shielding your member companies from revealing this basic information.”  Letter to Charles G. Tharp (Jul. 6, 2011), available at http://menendez.senate.gov/download/?id=c374a0b8-8413-4bab-a4a7-dd54ce712aff.
[38] At least one company has already disclosed a compensation ratio.  See MBIA Inc., Proxy Statement (Form DEF 14A) (filed March 18, 2011) (“The average and median salary for all employees other than the NEOs (385 employees) were $151,700 and $130,000, respectively. The average and median salary and bonus for all employees were $223,000 and $165,000, respectively. These compare to Mr. Brown’s salary of $500,000 (3.3 times average and 3.9 times median) and salary and bonus of $2,300,000 (10.3 times average and 14.0 times median) for 2010.”), available at  http://www.sec.gov/Archives/edgar/data/814585/000119312511070813/ddef14a.htm.
[39] See Implementing Dodd-Frank Wall Street Reform and Consumer Protection Act — Upcoming Activity, www.sec.gov, http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml (last visited Oct. 11, 2011).
[40] See supra text accompanying notes 24-27.
[41] See supra text accompanying notes 29-33.  Others have suggested the use of sampling techniques.  See Letter from Meridian Compensation Partners (Oct. 19, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-49.pdf . See also Letter from Davis Polk (Nov. 16, 2010), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-51.pdf.
[42] See Letter from Senator Menendez (Jan. 19, 2011), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-59.pdf (“Specifically, I want to clarify that when I wrote ‘all’ employees of the issuer, I really did mean all employees of the issuer.  I intended that to mean both full-time and part-time employees, not just full-time employees.  I also intended that to mean all foreign employees of the company, not just U.S. employees.”).  The inclusion of part time workers and foreign workers in low wage countries will likely lower the median compensation paid to employees and increase the ratio.  See supra note 15.
[43] Shareholders can make comparisons based upon the total compensation paid to the CEO.  The utility of this statistic, however, is limited at least in part by the “Lake Wobegon” effect.  See Letter from Americans for Financial Reform to Elizabeth M. Murphy (Mar. 23, 2011), available at http://ourfinancialsecurity.org/blogs/wp-content/ourfinancialsecurity.org/uploads/sites/18/2011/03/AFR-SEC-953b-3-23-11.pdf (“Existing requirements mandate disclosure of top executive compensation only, encouraging companies to focus unduly on peer to peer comparisons when setting CEO pay. These comparisons help lead to ever increasing levels of CEO pay by virtue of a ‘Lake Wobegon’ effect, where nearly all CEOs claim to be above the average CEO quality level.”).
[44] By making shareholders better informed at the time they vote on compensation, they are in a position to give the board better “advice.”  See Shareholder Approval of Executive Compensation and Golden Parachute Compensation, Exchange Act Release No. 63768 n. 175 (Apr. 4, 2011) (“Even though each of the shareholder advisory votes required by Section 14A is non-binding pursuant to the rule of construction in Section 14A(c), . . . we believe these votes could play a role in an issuer’s executive compensation decisions.”).  Calls for the use of similar ratios have arisen overseas.  See Will Hutton, Hutton Review of  Fair Pay in the Public Sector: Final Report 8 (March 2011) (“The Government should not cap pay across public services, but should require that from 2011-12 all public service organisations publish their top to median pay multiples each year to allow the public to hold them to account.”), available at http://cdn.hm-treasury.gov.uk/hutton_fairpay_review.pdf.
[45] See Letter from Calvert Investment Management (May 27, 2011) (“Investors could use data on median pay to understand U.S. and global compensation trends, and to better understand issuer decisions to move certain operations and jobs overseas.”), available at http://www.sec.gov/comments/df-title-ix/executive-compensation/executivecompensation-75.pdf.
[46] See Whole Foods Market, Annual Report 7 (Form 10-K) (2011) (“We also have a salary cap that limits the total cash compensation paid to any team member in a calendar year to 19 times the average annual wage of all team members. In addition, our co-founder and co-chief executive officer, John Mackey, has voluntarily set his annual salary at $1 and receives no cash bonuses or stock option awards.”), available at http://www.sec.gov/Archives/edgar/data/865436/000110465910059917/a10-19737_110k.htm;  El Paso Corporation, Proxy Statement (Form DEF 14A) (2011) (“We also believe that our executive compensation program must be internally consistent in order to motivate our employees as a whole to create stockholder value. We are committed to internal pay equity and our Compensation Committee monitors, on an annual basis, the relationship between the compensation of our named executive officers and the compensation of our non-managerial employees.”), available at  http://www.sec.gov/Archives/edgar/data/1066107/000095012311030217/h80859ddef14a.htm.  See also James A. Cotton, Toward Fairness in Compensation of Management and Labor: Compensation Ratios, A Proposal for Disclosure, 18 N. Ill. U. L. Rev. 157, 183 (1997) (“At Ben & Jerry’s Homemade, Inc., in Waterbury, Vt., for example, top people get no more than seven times what the lowest-paid full-time person earns.”).
[47] Cotton, supra note 46, at 182 (ratio disclosure “[t]o a large extent . . . will embarrass [directors] into trying to do the right thing rather than face questions at the stockholders meeting or at a meeting of financial analysts. Embarrassment is a rather large factor among a group that considers itself to be as special as this one does.”).
[48] Menendez, supra note 38 (noting that disclosure will encourage “firms to take a harder look at the rising pay discrepancies between CEOs and their workers”).  The rules of the SEC are often designed to affect substantive behavior inside the boardroom.  See J. Robert Brown, Jr., Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure, 57 Cath. U. L. Rev. 45 (2008).
[49] The ratio can be reduced either by raising the median compensation paid to employees or lowering the total compensation paid to the CEO.

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Edward F. Greene*

I. Introduction

Dodd-Frank[1] represents the most sweeping changes to the financial regulatory environment in the United States since the Great Depression. While its enactment was important, the Act is seriously flawed. It does not deal with regulatory fragmentation, sidesteps international coordination, and is overly optimistic in dealing with too-big-to-fail. Going first doesn’t mean you get it right.

To consider my criticisms, we must put Dodd-Frank in context. Major changes to financial institution regulation have been called for by the G-20 on a coordinated basis.[2] Given the reality that major financial institutions increasingly conduct significant portions of their business in many different countries, consistency and cooperation are essential, especially between the US and the EU.[3] Dodd-Frank is not a good example of the necessary paradigm. I will first review the international response and recommendations, the US response, and then highlight some key differences in other markets. 

In the aftermath of the crisis, regulators from around the world convened to discuss solutions and outline a framework for reform on an international basis.[4]This development was, in part, a recognition of the global causes and the global scale of the problem. Since that time, however, as lawmakers and regulators have begun to implement reform in their own countries, we have witnessed some loss of the coordination and cooperation that is critical to creating the framework needed to regulate systemically significant financial institutions operating internationally.

II. Causes of the Crisis

Market participants, government officials, and academics have not reached a consensus as to the causes of the crisis. Despite this, there is general agreement that the regulatory framework in place prior to the crisis was inadequate.

1. Systemic Risk and Too-Big-To-Fail

The shortcomings of the pre-crisis regulatory framework were illustrated by its failure to detect systemic risk posed by “too-big-to-fail” institutions. Of course, the problem with too-big-to-fail firms is that if the market believes that the government will be compelled to bail them out with taxpayer money, it will not exert sufficient oversight or discipline to control or mitigate risky behavior.[5]

2. Resolution Authority

The pre-crisis regulatory regime was also insufficient with respect to managing the failure of large, interconnected, cross-border financial institutions. The system did not have an effective and expeditious resolution authority.

The experience with the Lehman Brothers’ bankruptcy convinced almost all observers that bankruptcy proceedings generally, and in the US in particular, are not suitable for complex financial institutions.[6]

3. Shadow Banking

A third conspicuous shortcoming of the pre-crisis regulatory framework was the large number of non-financial firms that fell outside its scope – the unregulated, shadow-banking sector.[7]Many market actors – including Special Investment Vehicles, so called SIVs, certain mortgage originators, hedge funds and private equity funds, and derivatives market participants – were subject to little or no regulation.

III. International Institutions: G-20 and FSB

1. Group of Twenty (G-20)

At the height of the crisis, there was general recognition of the global nature of the problem and the need for a global response. The G-20 emerged as a leading forum for addressing it. The G-20 strongly recommended that international guidelines and frameworks be developed and that the efforts of national regulators be coordinated.

In terms of strengthening the regulation of systemically important firms, the G-20 recommended: (i) heightened prudential requirements to reflect higher costs of failure; (ii) a requirement to develop firm-specific contingency plans (so-called living wills); (iii) establishment of crisis management groups for major cross-border firms to strengthen international cooperation on resolution; and (iv) strengthening the legal framework for crisis intervention and winding down firms.[8]

The G-20 leaders also called for an international framework of reform which should: (i) build high-quality capital requirements and mitigate pro-cyclicality; (ii) reform compensation and governance practices to support financial stability; (iii) improve transparency and mitigate systemic risk in the OTC derivatives markets; (iv) address cross-border resolution; and (v) adopt a single set of generally accepted and accounting standards.[9]

2. Financial Stability Board

Other international organizations – including the Basel Committee on Banking Supervision, the Financial Stability Board (“FSB”) and the International Monetary Fund (“IMF”) – have also been active participants in leading global financial regulatory reform efforts, in part at the request of the G-20.

 Specifically, the Financial Stability Board has set forth a five-prong policy framework to address the risk associated with systemically important financial institutions: (i) improve resolution regimes to ensure the winding down of any financial institution without disrupting the financial system and without taxpayer support; (ii) require systemically important institutions to maintain loss absorption capacity beyond Basel III standards; (iii) enhance the supervisory oversight of systemically important institutions; (iv) strengthen standards for core financial infrastructure; and (v) engage in peer reviews of the effectiveness and consistency of national policy measures applicable to global systemically important institutions.[10]The Financial Stability Board is in the process of identifying which institutions are globally significant, which raises interesting issues of moral hazard.

IV. Comparing US and Non-US Implementation of Reform

Reform efforts in the United States, however, have made only a modest effort to assure coordination with the G-20 recommendations or the responses proposed or adopted by other regulators, in particular, the EU. Thus, there is the “danger of divergence”, also the title of a report of The Atlantic Council reading, which will have unfortunate consequences.[11]

1. New Systemic Risk Monitors

The G-20 leaders called for regulators to have better access to information about activities and counterparty exposures that pose systemic risk to the financial system.[12] They noted that, while in the past regulators had adequate information about the financial conditions of individual regulated entities, no single regulatory body was charged with overseeing and assessing the risks generally posed to the financial system by both the activities (i.e., derivatives) and interconnectedness of individual financial institutions.[13] There was as well a dearth of information about generally unregulated key players such as hedge funds and private equity funds.

To address this issue, Dodd-Frank created the Financial Stability Oversight Council. Its members include the heads of Treasury, the Federal Reserve Board, the SEC, and the CFTC, and the federal banking regulators, among others. One of its primary charges is to identify risks to financial stability.[14]

The Council is mandated to gather information to identify gaps in regulation or activities that should be subject to more-stringent regulation.[15] To this end, the Council may require reports from any non-bank financial company or bank holding company to assess whether that company, or any financial activity or market in which it participates, is systemically important.[16] The Council may also recommend heightened prudential and capital standards, which must be considered by the primary financial regulator.[17]

The EU has created a similar body, the European Systemic Risk Board.[18] Unlike the Council, it has no regulatory authority. While responsible for monitoring and assessing potential threats to financial stability, the ESRB can only issue warnings and make recommendations to national regulators, who are obligated to explain reasons for not acting upon ESRB proposals, and notify the European Commission if appropriate actions are not taken.[19]

There are many questions one could ask about these new councils. In the case of the United States, would it not have been more effective to consolidate the fragmented financial regulatory structure rather than to further fragment oversight of financial markets? Will the complicated structure and mandated decision-making process of the Council hamper crucial efforts to act promptly? What will the costs be to collect information in a standardized format? How will the US and EU councils work together to coordinate oversight and regulation? With respect to the EU, shouldn’t the Systemic Risk Board have the power to intervene directly and not have to rely entirely on national regulators?

2. Solutions for Too-Big-To-Fail

In addition to enhanced oversight of a wider range of systemically important financial institutions, Dodd-Frank mandates more rigorous capital, liquidity and leverage requirements, as well as restrictions on certain activities to help address the problem of too-big-to-fail. Most importantly, it does not restrict size by growth, only by acquisition.[20] This is a critical judgment since the five largest US financial institutions have grown 20% since the onset of the crisis and currently have over $6 trillion in assets.[21] The judgment was made that size is not necessarily the only concern; many small, sufficiently interlinked institutions engaging in the same activity could pose a systemic risk if that activity should prove riskier than appreciated.[22] But size can be critical, because of the contagion effect of failure.

a. Capital, Liquidity and Leverage Requirements

The Federal Reserve Board has been given the primary responsibility for supervising and regulating systemically important institutions. These institutions include all bank holding companies with more than $50 billion in assets and all Council-designated systemically important non-bank financial companies doing business in the US.[23] These entities will be subject to heightened capital, liquidity and other prudential standards, risk-management requirements, concentration limits for credit exposure to customers, and will have an obligation to prepare living wills as well as to undergo periodic stress tests.[24] And if an insurance company is so designated as a systemically significant non-bank financial company, it will have for the first time a federal regulator, the FRB.[25]

 Regulators have additional tools as well to restrict the size, growth and activities of these systemically important companies, in particular those determined to pose a “grave threat” to financial stability. The regulators, for example, can prohibit these companies from acquiring or merging with other companies and compel the divestiture of assets, and must impose a strict 15:1 debt-to-equity leverage ratio on them.[26]

Dodd-Frank further restricts the ability of large bank holding companies and systemically important non-bank financial companies to grow by acquisition. No financial company will be permitted to merge with or otherwise acquire another if the total consolidated liabilities of the combined company would exceed 10 percent of the total financial consolidated liabilities of all financial companies, unless the institution proposed to be acquired is in default or in danger of default and the FRB approves the acquisition.[27] Of course, at times of crisis, the largest financial institutions are likely to be the only candidates to acquire smaller failing institutions.

b. The Volcker Rule

One of Dodd-Frank’s most controversial provisions has been the Volcker Rule. In brief, the Volcker Rule prohibits banking entities from engaging in some types of proprietary trading and imposes limits on sponsoring or investing in hedge funds or private equity funds.[28]

Both US banking institutions and internationally headquartered banking organizations with US banking operations will be subject to the rule. There is an exception for foreign banking institutions for trading that is solely outside the US. The imprecision in and generality of many of the terms and exceptions as to permitted activities used in the Volcker Rule will require clarification by the regulators. Because the regulators will have a great deal of discretion in how they are defined and applied, they will be under pressure to be expansive as to permitted activities, not restrictive.

Across the Atlantic, the EU and Switzerland have refused to consider banning this type of activity. Instead, they would use enhanced capital requirements to address risk. On the other hand, the Independent Commission on Banking appointed by the UK government has, in its preliminary issues paper, broadly included among its list of reform options limits on proprietary trading and investing by deposit-taking institutions.[29]

c. The Swiss Approach

The Swiss have taken an interesting approach. They have rejected size limitations for banks under any circumstances. Rather, they have proposed reforms to capital requirements and organizational form to control systemic risk. With respect to capital, the Swiss have developed a four-part approach: first, there must be a minimum amount of capital required for the maintenance of normal business activities; second, a capital buffer, allowing banks to absorb losses without falling short of the minimum capital requirement; third, a progressive component of capital, which rises with the degree of an institution’s systemic importance; and finally, convertible or contingent capital which would automatically convert into equity when an institution’s financial condition has materially deteriorated.[30] And indeed, Credit Suisse has recently issued a contingent capital security,[31] a so-called Co-Co, which was oversubscribed, has been keenly followed and which will influence regulators in other markets.

The Swiss proposal also requires banks to have an organizational structure that would allow them, if their capital ratio fell below a certain level, to execute an emergency plan to swiftly transfer their systemically important functions to an independent and new corporate entity, called a bridge bank.[32] Thus, the Swiss believe capital assessment and organizational simplicity are the solution, not activity restriction or size limitations.

3. New Resolution Authority Regime: OLA

To address the concerns about the inability of the existing resolution regimes to handle the failure of a systemically important financial company, Dodd-Frank created a new special insolvency regime, known as the Orderly Liquidation Authority (“OLA”).[33] OLA is intended to avoid the serious, adverse effects of the liquidation of a systemically important financial company that would result if it were resolved under the Bankruptcy Code.

The new OLA regime, however, does not replace existing insolvency regimes. Instead, all companies eligible for orderly liquidation under the new regime remain subject to otherwise applicable insolvency law (generally the Bankruptcy Code) unless federal regulators determine, at the time of the financial company’s impending failure, that the company should be liquidated under OLA. [34]

Under OLA, a failing financial company will be placed into a receivership administered by the FDIC, the sole purpose of which is the liquidation of the financial company. Sick institutions cannot be rescued with interim aid – they must die. When appointed as receiver, the FDIC can borrow from the Treasury to finance a liquidation. If the proceeds from liquidation are insufficient to repay the Treasury borrowings, the FDIC will first recover from creditors any amounts received in excess of what they would have received in an ordinary liquidation. If there is any remaining shortfall, the FDIC can levy an assessment on all Council-designated systemically important non-bank financial companies and all other bank holding companies with $50 billion or more in consolidated assets.

In the US, the decision was made after extensive debate not to create a fund in advance to be available for future crises but rather to impose a post-crisis levy on remaining, viable institutions to fund unmet costs of liquidations.[35] By contrast, the IMF has proposed a “financial stability contribution” to be paid by the industry prior to any failure, and linked to an effective resolution regime, to pay for the cost of any future governmental support to the financial sector.[36] A number of European governments are also considering “bank taxes” that would impose an assessment on financial institutions to create a fund that could be used for future “bail outs”. For example, the European Commission has launched a consultation regarding taxes on financial transactions and financial activities, and it is also seeking input on the introduction of separate bank levy.[37] In addition, the German government has adopted a bank tax and will use those revenues for its Restructuring Fund, which will be used to address future financial crises.[38]

These flexible approaches should be contrasted to Dodd-Frank. OLA and Dodd-Frank restrict any funding that might allow weakened institutions to recover. The only choice is liquidation. Before Dodd-Frank, government aid often served to maintain a company’s operations and to restore its health – as was seen in the infusions of taxpayer funds into AIG, Citibank and Bank of America, among others, as well as guarantees of debt issuances by the FDIC. In the face of public anger about “the bail out of Wall Street”, government aid on an individual basis is no longer available, even though the government has received significant returns from its investments.[39] Some have argued that restricting pre-insolvency assistance, comparable to TARP, and requiring liquidation, will, in fact, exacerbate the consequences of any individual failure because of contagion; instead, they call for an industry tax to create a fund permitting assistance to failing institutions[40]. The new limitations on the FRB and the FDIC to assist individual failing companies and the resulting lack of flexibility under OLA are thought by some to be serious flaws of Dodd-Frank, especially since many believe Dodd-Frank has not adequately addressed too-big-to-fail.[41] I agree with their critiques.

Another difficulty with OLA is that it does not apply to the significant non-US subsidiaries of systemically significant financial companies. Even if OLA had been in place at the time of the Lehman Brothers’ insolvency, Lehman Brothers’ UK entity would still have been resolved under the UK regime. While that regime has been changed, it is not the same as ours.

In response to the G-20’s call, the IMF and the FSB are acting to develop a framework for a coordinated resolution regime. However, it is not clear how it will be implemented domestically.

Critical to coordination and cooperation concerning resolution of global systemically significant institutions is colleges of supervisors, who are expected to consult about coordinated resolution. In this regard, the development of living wills is essential for coordinated resolution in the absence of an international resolution authority. However, there are a number of open questions about how “living wills” will work for non-US financial institutions that have US operations and how US and non-US regulators will cooperate with respect to the companies in their respective jurisdictions over which they have supervisory authority.

Absent further coordination in cross-border insolvencies of systemically important financial institutions, we are left with the dilemma of an uneven treatment of creditors and shareholders and a tendency for the regulators of markets in which large institutions operate to require operations to be conducted through subsidiaries, to ring-fence assets in those domestic subsidiaries, to impose liquidity requirements to protect domestic creditors and to avoid the transfer of assets prior to insolvency. Dodd Frank is silent on this issue.

4. Other Significant US-EU Differences

There are a number of other areas of financial regulatory reform in which the approaches of the US and EU diverge significantly.

a. Derivatives Market Reforms

In particular, the US proposals to reform the derivatives market differ in important ways from the reforms under consideration in the EU, including which types or classes of swaps will be subject to mandatory clearing requirements and how to reduce financial institutions’ interconnectivity risk. Dodd-Frank also includes a controversial “push-out” provision, which prohibits certain forms of Federal assistance—including access to the FRB’s discount window and FDIC deposit insurance—from being provided to swap dealers and major swap participants.[42] The EU almost certainly will not adopt anything similar.[43] The US regime could also end up being more restrictive in areas such as the governance of central clearing counterparties.

In addition, the scope of the exemption from the clearing requirement in the US for “end users” of swaps that use them to hedge or mitigate commercial risk, whether US regulators will defer to EU margin requirements for non-cleared swaps, and how the US reporting requirements can be reconciled with EU privacy laws remain areas of uncertainty. Finally, Dodd-Frank authorizes the CFTC to impose position limits; there are no equivalent provisions in the EU.[44] In the absence of further international coordination, the EU proposes mutual recognition and cooperation arrangements with non-EU regulators if their regimes are deemed to be equivalent.[45] Unfortunately, however, Dodd-Frank does not have a similar provision for mutual recognition.

b. CRAs, Compensation, Hedge Funds & Accounting

Despite being criticized for their role in contributing to the crisis, the US has mandated little reform of credit rating agencies; by contrast, the EU has adopted rules that significantly affect the way credit rating agencies operate.[46] Similarly, the EU reforms to executive compensation and the regulation of hedge fund and private equity funds are much more prescriptive than those in the US. Finally, the different accounting standards between GAAP in the US and IFRS in the EU remain an ongoing point of divergence and contention.

 V. Conclusion: Assessing Dodd-Frank’s Impact and the Perils of Divergent Regimes

Although there are many open questions surrounding the ongoing implementation of regulatory reform, we can begin to assess Dodd-Frank’s effectiveness in addressing the problems that led to the crisis as well as the US efforts to coordinate with the international community. Unfortunately, by either measure, Dodd-Frank does not, in my opinion, do well.

Critically, Dodd-Frank fails to reconfigure in any significant way the fragmented US regulatory structure. Rather than consolidating existing agencies into one or two regulators, each able to act quickly and efficiently, we now require regulators with a history of disagreement and difficulty in operating together to sit collegially around the Council’s table and make key decisions by a vote of a majority or two-thirds of its members, depending on the issue. A single federal regulator may not be the answer, but the number of federal regulators we now have is surely not the right result either. The notion of one bank regulator, one markets regulator and one consumer regulator for all products remains, unfortunately, wishful thinking in the US.

But, more importantly, Dodd-Frank does not address adequately the issue of moral hazard. Despite the many provisions to monitor and reduce systemic risk, it remains unlikely that the Government will allow an institution that is the size of one of the US’s five largest financial institutions to fail, especially in the absence of effective coordinated and consistent resolution mechanisms in key markets. The market will likely make that judgment as well, and those firms will continue to have financing advantages that only increase the likelihood of their failure.

There is also a serious question about whether Dodd-Frank will undermine the competitive position of major US financial institutions. Certain of its provisions, clearly, will not be followed in other key jurisdictions such as the EU – for example, the Volcker Rule. The universal bank model is now accepted globally as the way to do business, and the Volcker Rule is not consistent with that model and is not likely to be replicated elsewhere. Furthermore, the size limitation imposed with respect to growth by acquisition could disadvantage US institutions if the industry consolidates globally.

Regulatory arbitrage remains a real issue as nations enact their financial reforms. Funding resolution and bailout expenditures have been a point of international divergence. As noted earlier, the OLA is not pre-funded, given the desire to avoid the appearance of a bailout. Further, Dodd-Frank restricts regulators’ other tools for financial assistance, such as government guarantees. Meanwhile, the IMF and European governments seem to be moving in the direction of imposing bank taxes to create resolution funds. Thus, the US may face a challenge in coordinating to resolve failing, international institutions if its only choice is liquidation, but other countries have a fund available to provide financial assistance to stave off insolvency.

Dodd-Frank is not as responsive as it should have been to the call of the G-20 for global, harmonized standards. The Atlantic Council’s report on “The Danger of Divergence” surveys the proposed reform proposals in the US and the EU, noting the areas of convergence but also highlighting the many areas in which significant differences remain. The report also sets forth recommendations of how regulators in the US and EU can work together to harmonize reform efforts. In light of the continuing integration of the world’s capital markets, international cooperation in implementing financial regulatory reform is essential if it is to be effective, especially between these two markets.

 

Preferred citation: Edward F. Greene, Dodd-Frank and the Future of Financial Regulation, 2 Harv. Bus. L. Rev. Online 79 (2011), https://journals.law.harvard.edu/hblr//?p=1728.
* Edward F. Greene is a partner at Cleary Gottlieb based in the New York office and was formerly the General Counsel of the SEC. A version of this article was delivered as a keynote at the Harvard Business Law Review’s inaugural symposium on April 1, 2011.
[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) [hereinafter Dodd-Frank Act].
[2] See, e.g., Enhancing Sound Regulation and Strengthening Transparency (Report of G20 Working Group 1, 2009), available at http://www.g20.org/Documents/g20_wg1_010409.pdf.
[3] See Allen N. Berger et al., To What Extent Will The Banking Industry be Globalized? A Study of Bank Nationality and Reach in 20 European Nations, (Bd. of Governors of Fed. Reserve Sys., Int’l Fin. Discussion Paper No. 725, 2002), available at, http://www.federalreserve.gov/pubs/ifdp/2002/725/ifdp725.pdf.
[4] Press Release, SEC, Chairman Cox Statement on Meeting of IOSCO Technical Committee (Nov. 24, 2008), available at http://www.sec.gov/news/press/2008/2008-279.htm.
[5] E.g. James Bullard, Christopher J. Neely, and David C. Wheelock, Systemic Risk and the Financial Crisis: A Primer, 91 Fed. Reserve Bank St. Louis Rev. 403, 403 (2009); Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, Address to Council of Foreign Relations: Financial Reform to Address Systemic Risk (Mar. 10, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm.
[6] See Sheila C.  Bair, Chairman, FDIC, Lecture at the Harvard university John F. Kennedy Jr. Forum:  Ending Too Big To Fail: The FDIC and Financial Reform (Oct. 20, 2010), available at http://www.fdic.gov/news/news/speeches/chairman/spoct2110.html.
[7] For an overview of shadow banking and the risks it poses, see Morgan P. Ricks, Regulating Money Creation After the Crisis, 1 Harv. Bus. L. Rev. 75 (2011).
[8] G-20 Finance Ministers and Central Bank Governors, Declaration on Further Steps to Strengthen the Financial System (Sept. 5, 2009), available at http://www.g20.org/Documents/FM__CBG_Declaration_-_Final.pdf.
[9] G-20 Finance Ministers and Central Bank Governors, Leaders’ Statement: The Pittsburgh Summit (Sept. 25, 2009), available at http://www.g20.org/documents/pittsburgh_summit_leaders_statement_250909.pdf.
[10] Letter from Mario Draghi, Chairman, Financial Stability Board, to G20 Leaders, Progress of Financial Regulatory Reform (Nov. 9, 2010), available at http://www.financialstabilityboard.org/publications/r_101109.pdf.
[11] Atlantic Council, The Danger of Divergence: Transatlantic Cooperation on Financial Reform (2010) [hereinafter Danger of Divergence], available at http://www.acus.org/files/publication_pdfs/403/ACUS_TR_Danger_Divergence_Report.pdf.
[12] Id.
[13] Id.
[14] Dodd-Frank Act §§ 111-112, 12 U.S.C. §§ 5321-5322.
[15] Danger of Divergence, supra note 11.
[16] Id.
[17] Id.
[18] Id.
[19] Id.
[20] Id. at 24.
[21] Thomas M. Hoenig, Too Big to Succeed, NY Times, Dec. 1, 2010, http://www.nytimes.com/2010/12/02/opinion/02hoenig.html.
[22] Danger of Divergence, supra note 11, at 22.
[23] Authority to Designate Financial Market Utilities as Systematically Important, 76 Fed. Reg. 44,763, 44,763 (July 27, 2011).
[24] Id. at 44,767.
[25] See id. at 44,773.
[26] Dodd-Frank Act § 165(j). See also Steven L. Schwarcz, Identifying and Managing Systemic Risk: An Assessment of Our Progress, 1 Harv. Bus. L. Rev. Online 94, 98 (2011), https://journals.law.harvard.edu/hblr//?p=1412.
[27] Danger of Divergence, supra note 11, at 24.
[28] For an overview of the Volcker Rule, see Charles K. Whitehead, The Volcker Rule and Emerging Financial Markets, 1 Harv. Bus. L. Rev. 39 (2011).
[29] Independent Commission on Banking, Issues Paper: Call for Evidence (Sept. 2010), available at http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/sites/87/2010/07/Issues-Paper-24-September-2010.pdf.
[30] Commission of Experts (appointed by the Swiss Federal Council), Final Report of the Commission of Experts for Limiting the Economic Risks Posed by Large Companies (Sept. 30, 2010), available at http://www.sif.admin.ch/dokumentation/00514/00519/00592/index.html?lang=en.
[31]  Jane Merriman, Swiss Give Fresh Momentum to Contingent Bonds, Reuters, Oct. 4, 2010, http://blogs.reuters.com/financial-regulatory-forum/2010/10/04/snap-analysis-swiss-give-fresh-momentum-to-contingent-bonds.
[32] Press Release, Swiss Commission of Experts, Commission of Experts submits package of measures to limit “too big to fail” risks, Oct. 4, 2010, available at http://ow.ly/6ha7L.
[33] Dodd-Frank Act §§ 201–217.
[34] See Harvey Miller & Maurice Horwitz, One Way That Dodd-Frank’s Liquidation Authority Could Achieve Parity With The Bankruptcy Code, 1 Harv. Bus. L. Rev. Online 1 (2010), https://journals.law.harvard.edu/hblr//?p=350.
[35] Jackie Calmes, Taxing Banks for the Bailouts, NY Times, Jan. 14, 2010, http://www.nytimes.com/2010/01/15/us/15tax.html.
[36] International Monetary Fund, A Fair and Substantial Contribution by the Financial Sector: Final Report for the G-20 (June 2010), available at www.imf.org/external/np/g20/pdf/062710b.pdf.
[37] European Commission, Consultation Paper on Financial Sector Taxation (Feb. 22, 2011), available at http://ec.europa.eu/taxation_customs/resources/documents/common/consultations/tax/financial_sector/consultation_document_en.pdf.
[38] See Germany, National Reform Programme 2011 15, (Apr. 6, 2011), available at http://ec.europa.eu/europe2020/pdf/nrp/nrp_germany_en.pdf.
[39] Yalman Onaran and Alexis Leondis, Bank Bailout Returns 8.2% Beating Treasury Yields, Bloomberg, Oct. 20, 2010, http://ow.ly/6hb3G.
[40]  See, e.g., Steven L. Schwarcz, Identifying and Managing Systemic Risk: An Assessment of Our Progress, 1 Harv. Bus. L. Rev. Online 94, 103 (2011), https://journals.law.harvard.edu/hblr//?p=1412.
[41] E.g. Victoria McGrane and Deborah Solomon, Debating Dodd-Frank: Is ‘Too Big to Fail’ Gone?, Wall St. J., July 21, 2011, http://online.wsj.com/article/SB10001424053111904233404576458381947014162.html.
[42] See Dodd-Frank Act §716.
[43] See Proposal for a Regulation of the European Parliament and of the Council on OTC Derivatives, Central Counterparties, and Trade Repositories, COM (2010) 484 final (Sept. 15, 2010), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2010:0484:FIN:EN:PDF (containing no such provision); Kian Abouhossein et al., Regulatory Arbitrage Series: OW European over US IBs, JP Morgan Cazenove 3 (2011) (“. . . all major European banks (except from HSBC) will be unaffected whilst US banks would have to set up a new swap entity to comply with Section 716.”), available at https://mm.jpmorgan.com/stp/t/c.do?i=5930E-12&u=a_p*d_558208.pdf*h_-2igf3ms.
[44] Statement Before the H. Comm. on Agri. Subcomm. On General Farm Commodities and Risk Mgm’t (May 25, 2011) (statement of CFTC Comm. Jill E. Sommers), available at http://www.cftc.gov/pressroom/speechestestimony/sommersstatement052511.html.
[45] See European Commission: Banking, http://ec.europa.eu/internal_market/bank/index_en.htm (last visited Aug. 30, 2011).
[46] Andrew Willis, EU Outlines New Credit Rating Agency Plan, Bloomberg Businessweek, June 4, 2010, http://www.businessweek.com/globalbiz/content/jun2010/gb2010064_765856.htm.

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Jeff Schwartz*

Eleven months after Dodd-Frank was signed into law,[1] the SEC issued final rules pertaining to Title IV of the Act, which calls for the registration of advisers to hedge funds and similar private investment vehicles.[2] This brief essay looks at the legislation and the rulemaking that followed from a procedural perspective. Namely, I focus on how much discretion Congress delegated to the SEC in shaping the final rules and the SEC’s use of that discretion. I find that the legislation granted a great deal of rulemaking authority to the SEC—authority that extended to the central elements of the regulatory scheme—and that the Commission used this power to extend federal oversight to a wide swath of the private-fund marketplace.

1.         Dodd-Frank’s Legislative Framework

Before getting into the lawmaking process, it helps to provide a brief overview of the hedge-fund legislation. Title IV of the Act, entitled “Regulation of Advisers to Hedge Funds and Others,” substantially altered the regulatory landscape for advisers to private funds, i.e., hedge funds, private equity funds, and venture capital funds.[3] Previously, many of these advisers could avoid registration under the Investment Advisers Act (the “IAA”)[4] by making use of the so-called “private adviser exemption,” which provided in essence that advisers to fewer than 15 clients need not register.[5] The Act eliminated this safe harbor,[6] thereby broadly expanding the IAA’s registration requirement. In its place, however, Dodd-Frank added several other exemptions from registration. Most importantly, advisers to private funds with less than $150 million under management were exempted,[7] as were “foreign private advisers”[8] and advisers to venture capital funds.[9]

The Act also put in place recordkeeping and reporting requirements for registered investment advisers. Under Dodd-Frank, these funds must track information pertaining to such things as their use of leverage, including off-balance sheet leverage, their counterparty risk exposure, their trading and investment positions, their asset valuation policies and practices, and the types of assets they hold.[10] The information is to be made available for SEC inspection and for potential filing with the Commission.[11]

Lastly, Dodd-Frank created a new category of investment advisers, “mid-sized advisers.” These are advisers with between $25 million and $100 million in assets under management.[12] Generally speaking, under the Act, if these funds are subject to state registration and examination, then they are not permitted to register with the SEC.[13] This is ostensibly an effort to delegate regulation of smaller funds to the states so that the SEC can focus on those that pose the greatest societal risk. The Commission estimates that this change will cause approximately 3,200 advisers to switch from federal to state registration.[14]

2.         Rulemaking Discretion Granted to the SEC

Congress left the SEC with broad discretion with respect to how to fill in the details of this new regulatory framework. In fact, the provisions in this Title are replete with grants of administrative authority to the agency. At the outset, although the Act greatly expanded the IAA’s registration requirement, it left largely undefined what registration will now entail.[15] Though Dodd-Frank listed out several categories of information that registered advisers must track for the SEC, the Commission was left free to add other disclosure obligations, so long as the agency viewed them as “necessary and appropriate . . . for the protection of investors, or for the assessment of systemic risk.”[16] Moreover, in constructing its disclosure regime, the SEC was empowered to segment registered fund advisers into different categories depending on size or type and to customize the information required accordingly.[17] Finally, subject to Dodd-Frank’s confidentiality restrictions, it was left up to the SEC to decide whether information mandated by the Act or the Commission would be filed with the SEC or merely subject to inspection.[18]

The SEC was also granted broad discretion over the disclosure obligations of private advisers exempted from registration. Even though private-fund advisers with under $150 million in assets under management would not be required to register with the SEC, the agency was free to mandate that they “maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.”[19] Moreover, these advisers would now be subject to systemic-risk oversight—the SEC was tasked with determining whether the advisers’ funds pose systemic risk and empowered to impose regulations that reflect the risk posed.[20]

Nor does the exclusion of venture capital funds from the registration mandate mean that advisers to these funds are free from regulation. First, it was left up to the SEC to define what constitutes a venture capital fund.[21] Second, the agency was left with authority to imposed reporting and recordkeeping requirements on advisers to these funds as necessary to promote the public interest and protect investors.[22]

Finally, what constitutes a mid-sized adviser was also left for further consideration. Though Dodd-Frank applied this label to advisers with between $25 million and $100 million under management, these figures were made subject to alteration by SEC rulemaking.[23]

Thus, the Act, while it put in place a general structure for private-fund regulation, left much to be determined. Most importantly, although Dodd-Frank seemed to draw a bright line at $150 million, the meaningfulness of this threshold for exemption was left in doubt. The distinction would mean a great deal if the SEC chose to enact comprehensive and invasive reporting requirements for registered advisers, while leaving unregistered advisers alone. To the contrary, the line would be all but eviscerated if the Commission chose to subject registered and unregistered advisers to a similar regulatory scheme. In the end, the deferential nature of the Act meant that private-fund advisers would have to wait for final rules to see the nature of the regulatory regime to which they would soon be subject.

3.         The SEC’s Use of Discretionary Power

In carrying out its rulemaking, the SEC behaved as one might expect: it stayed within the outer limits of congressional intent, while extending regulation to the boundaries of the private-fund arena.

In fashioning the final rules, the SEC broadened and deepened the disclosure requirements for registered advisers. Under the newly adopted rules, such advisers will now be required to fill out a revised Form ADV (the investment-adviser registration document).[24] This amended form incorporates a number of changes. As the SEC explains,

As amended, Form ADV requires advisers to provide us with additional information about three areas of their operations. First, we require advisers to provide additional information about private funds they advise. Second, we expand the data advisers provide us about their advisory business (including data about the types of clients they have, their employees, and their advisory activities), as well as about their business practices that may present significant conflicts of interest (such as the use of affiliated brokers, soft dollar arrangements, and compensation for client referrals). Third, we require additional information about advisers’ non-advisory activities and their financial industry affiliations.[25]

In light of these changes, not only are all advisers with greater than $150 million in assets under management now required to register. They are also required to reveal more detailed and comprehensive information than was required under the previous registration regime.

Likewise, unregistered advisers will not be able to hide in the shadows. The SEC rules require that advisers who are exempt from registration because they either supervise less than $150 million in assets or because they oversee venture capital funds must fill out and periodically update Form ADV[26]—the same form required for registered advisers. Exempt advisers are given some relief, however, in that they will be free to leave certain of the items in the form blank.[27] These advisers, for instance, will not be required to complete Part 2 of the form (the so-called “client brochure”),[28] which contains information for clients and potential clients outlining in plain English the adviser’s qualifications, strategy and business practices.[29] On the other hand, however, such advisers remain subject to the reporting obligation of item 7, which mandates disclosure of certain detailed operational aspects of the private funds the advisers’ supervise.[30]

The requirements for exempt advisers is likely the area where the SEC pushed its authority the furthest. In fact, two SEC Commissioners, Kathleen Casey and Troy Paredes, dissented over these provisions. Both of them expressed the view that the regulatory burden on exempt advisers robbed the registration requirement of substance. As Commissioner Casey put it: the new rules mean that there is a “wholesale lack of any principled, meaningful distinction . . . between exempt advisers and registered advisers.”[31] She also lamented that there is “no substantiated justification on public interest or investor protection grounds for the decision to impose [such] requirements.”[32] Commissioner Paredes substantially echoed these concerns, though much of his dissent focused on the regulatory burden such requirements impose on venture capital funds, in particular.[33]

Finally, the SEC was given discretion to adjust the dollar range that Congress put in place to define mid-sized advisers—originally set at $25 million to $100 million.[34] The agency chose not to alter this range per se, but did make a technical amendment. The Commission put in place a buffer of $10 million both above and below the $100 million threshold.[35] Without getting into the details, the buffer is designed to provide advisers who fall near the line with some flexibility with respect to state versus federal oversight.[36]

4.         Conclusion 

Much has been made of the extent to which Dodd-Frank delegated the lawmaking task to administrative agencies. Hedge-fund registration is a case in point. In this instance, Congress was more than willing to delegate work to the SEC. Interestingly, it vested the SEC with authority, not only over technical details or transitional matters, but also over the heart of the regulatory scheme—who would be required to disclose and how much. For its part, the SEC was more than willing to sprint away with the baton. Although the agency never clearly overstepped its bounds, it took full advantage of the inchoate nature of the statute in order to bring transparency, not only to registered funds, but also to those that Congress had seemingly exempted from such oversight.

The process described herein certainly fits the narrative that portrays administrative bodies as the locus of lawmaking power. A narrower reading, however, is also possible. Perhaps the deference in this case can be explained by some combination of the following: (i) the uncertain policy grounds upon which hedge-fund registration rests; (ii) the exigency and breadth associated with Dodd-Frank as a whole; and (iii) Congress’s unfamiliarity with the details of the complex securities laws at issue. In any event, this essay goes to show how limited yet equivocal legislation can lay the groundwork for an expansive and detailed regulatory framework.

 

Preferred citation: Jeff Schwartz, The Crystallization of Hedge-Fund Regulation, 2 Harv. Bus. L. Rev. Online 73 (2011), https://journals.law.harvard.edu/hblr//?p=1688.

* Associate Professor, California Western School of Law.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) [hereinafter Dodd-Frank Act].

[2] See §§ 401-419.

[3] See id.

[4] Investment Advisers Act of 1940, 15 U.S.C. § 80b-1 to -21 (2006).

[5] See Press Release, SEC, SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act (June 22, 2011), available at http://www.sec.gov/news/press/2011/2011-133.htm.

[6] Dodd-Frank Act § 403. The private adviser exemption was formerly § 203(b)(3) of the IAA. See Investment Advisers Act § 203(b)(3).

[7] Dodd-Frank Act § 408.

[8] Id. § 403.

[9] Id. § 407.

[10] Id. § 404.

[11] Id.

[12] Rules Implementing Amendments to the Investment Advisers Act of 1940, 76 Fed. Reg. 42,950, 42,951 (July 19, 2011) [hereinafter, Implementing Release], available at http://www.sec.gov/rules/final/2011/ia-3221fr.pdf. See also Dodd-Frank Act § 410.

[13] Dodd-Frank Act § 410. For the specific conditions limiting this exception, see § 410.

[14] Implementing Release, supra note 12, at 42,952.

[15] See Dodd-Frank Act § 403.

[16] Dodd-Frank Act § 404.

[17] Id.

[18] Id.

[19] Id. § 408.

[20] Id.

[21] Id. § 407.

[22] Id.

[23] Id. § 410.

[24] Implementing Release, supra note 12, at 42,965.

[25] Id.

[26] Id. at 42,981.

[27] Id.

[28] Id. at 42,995, 42,997.

[29] Form ADV, Part 2, OMB No. 3235-0049, available at http://www.sec.gov/about/forms/formadv-part2.pdf.

[30] Implementing Release, supra note 12, at 42,962–63.

[31] Kathleen L. Casey, Prepared Statement at SEC Open Meeting on Rules Implementing Amendments to the Investment Advisers Act of 1940; Exemptions For Advisers to Venture Capital Funds, Private Fund Advisers with Less than $150 Million in Assets under Management, and Foreign Private Advisers (June 22, 2011), available at http://www.sec.gov/news/speech/2011/spch062211klc-items1-2.htm.

[32] Id.

[33] See Troy A. Paredes, Prepared Statement at Open Meeting to Adopt Final Rules Regarding Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets under Management, and Foreign Private Advisers and Final Rules Implementing Amendments to the Investment Advisers Act of 1940 (June 22, 2011), available at http://www.sec.gov/news/speech/2011/spch062211tap-items-1-2.htm. As a law professor, Commission Paredes also had the opportunity to study hedge-fund registration. See, e.g., Troy A. Paredes, On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, And Mission, 2006 U. Ill. L. Rev. 975.

[34] See supra Part 2.

[35] Implementing Release, supra note 12, at 42,957, 42,979, 43,011.

[36] Id. at 42,979. One aspect of SEC rulemaking I did not discuss is the agency’s systemic-risk regulation. This oversight framework is still in the administrative process. See Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Release No. IA-3145, 76 Fed. Reg. 8068, available at http://www.sec.gov/rules/proposed/2011/ia-3145fr.pdf.

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David Mader*

Introduction

The Dodd-Frank Wall Street Reform and Consumer Protection Act[1] (Dodd-Frank) is ambitious and complex legislation designed to significantly transform the way the financial system operates. Yet in a year’s time, the rule-making and regulatory process has not yet delivered the kind of detail or clarity anyone expected. A big reason: The sheer scale of the law—more than 2,300 pages, requiring more than 290 new regulations and 13 new agencies.[2]

This is the kind of systemic challenge strategy consultants face frequently. We typically stand on the periphery of a complex and often conflicted system. From that position, we help public and private sector clients bring clarity, definition, and potential solutions to the key players who otherwise are focused on meeting daily challenges. We are able to help key players visualize the emerging regulatory universe, raise questions about intended and unforeseen consequences, and help all players understand their greatest priorities and how to achieve desired outcomes.

While others can do this work—and often do—strategy consultants tend to draw on the experiences of those working on problems close-in and daily, analyze how each part affects the other, and provide a holistic sense of how to make things work better.

Dodd-Frank, like most major pieces of major reform legislation, resulted from significant shocks to the political system and systemic failures. Its first goal, therefore, is to prevent similar shocks and failures in the future.[3] Understood as a response, rather than a proactive measure, the legislation should therefore be seen as similar to other major legislative reforms—the post-9/11 Homeland Security Act of 2002,[4] the Intelligence Reform and Terrorism Prevention Act of 2004,[5] the Post-Katrina Emergency Management Reform Act,[6] and the Patient Protection and Affordable Care Act passed in 2010.[7]

Like each of these major pieces of legislation, the first year of Dodd-Frank has been a period of maximum confusion, with characteristics similar to a company that has undergone a merger, a consolidation, and a start-up—all at the same time. The focus at the outset within the regulatory and other implementing agencies is to meet deadlines under strict time constraints.[8] This can lead to a series of actions that are merely reactions to deadlines—a web of new reports, plans and policies that meet the requirements of the new law, but lack the kind of planning, coherence, and strategic foresight likely to lead to the legislation’s desired outcomes.

What is almost always lacking is the guiding hand of a systemic approach to the challenge of implementation. And this absence perpetuates the likelihood of conflicting or weak policy and responsiveness.

In such a situation, our goal as strategy consultants is to bring clarity of purpose to all decisions and actions. We want to make sure that participants within a regulatory agency or regulated industry understand where they fit in within the new regulatory universe, and what their priorities should be. We often highlight those areas where challenges remain outstanding—not necessarily to resolve them, but merely to elevate them so the participants themselves can begin to work on them.

With Dodd-Frank, this is a challenge for both government entities and private sector players. Government entities are trying to understand and meet new responsibilities to see whether previously held responsibilities now belong to a new agency, and to learn whether their authority has been sublimated in any way. For the private sector, the primary challenge is to identify who its new regulators are, how expectations are different, and how the new regulatory universe will affect its business.

 

Where’s my turf?

The regulatory community is still trying to figure out its responsibilities, and where the water’s edge is for their oversight. While Dodd-Frank aimed to create clear authorities over financial services institutions (particularly those judged too big to fail), it is not immediately clear to us as strategy consultants how certain regulatory overlaps will be resolved—for example, the question of judging the credit health of banks is a responsibility shared in various ways between the Federal Reserve, the FDIC and the Treasury.[9] In many cases, regulators are not seeking to expand their authority but to focus it. The assumption that regulators are always seeking to amass more power is incorrect; some regulators resist the requirement to do more, and hope to see others assume responsibilities for which they lack resources or expertise.

In the case of Dodd-Frank, we recommend a process guided by desired outcomes—as defined by the law itself, and shepherded by strong regulators who understand the impact they can have if they set out the new regulatory universe in a methodical way. Government agencies are not naturally hostile to overlap and regulatory rivalries. That was a feature of the pre–Dodd-Frank world and sometimes serves the public’s needs. The goal should not be to arbitrate all those disputes, but to make sure they do not get in the way of good regulatory action and market impacts.

In our work so far, we have found that many policy makers generally do want to understand whom they should collaborate with, how to effectively share information with the right players, and how their decisions will impact the overall marketplace. However, they are unable to focus on such large issues because they have such stringent requirements set to meet certain deadlines and maintain compliance with the new law. Fundamentally, no matter how valuable it would be for regulators to focus on establishing a good working relationship with a fellow regulator on a matter of shared concern, additional responsibilities and daily demands hamper that ability.

 

Know thy regulator

The private sector has had a voice in the shaping of the legislation and the regulatory work that has followed, but that does not mean they understand its full impact, or what they need to focus on next. We have found that merely presenting a visual map of the legislation—doing an inventory of authorities, showing the affected agencies and their roles and responsibilities, recognizing those regulatory fault-lines where they exist, and understanding the implications of those overlaps—is essential to setting priorities and sequencing decisions in response to Dodd-Frank.

Just as a good road map shows not only the way from point A to point B, but also the alternatives and the potential pitfalls, a visual map of the legislation makes clear where leadership needs to be most focused, and wherein lies the route to success in meeting regulatory demands.

For instance, Dodd-Frank created the two major new entities, the Financial Stability Oversight Council[10] and the Consumer Financial Protection Bureau,[11] in addition to other new offices and agencies.[12] The private sector is trying to understand who is in charge of what, whether authority was taken away from some places and redistributed elsewhere, how best to share the right information with the right people, and how to build a government-relations infrastructure to interact with offices that previously did not exist. Simply looking at the legislation and its requirements is not enough to meet all these needs. One has to be guided by an understanding of how each individual part relates to the greater whole.

Any effort to bring clarity to the new regulatory universe is bound to help strengthen public confidence in the legislation. While the general public is rarely expected to understand or appreciate the difference between concepts such as a derivative and a swap, the public has grown to appreciate that the regulation of financial markets can have an outsized impact not only on the overall economy, but also on its personal financial well-being. When strategic consultants deploy an outsider’s informed perspective, it helps bring clarity to key issues within the legislation; the lessons learned from that exercise can be broadly applied by agencies and regulated entities as they explain how they have improved their practices to the general public. That greater clarity is likely to lead to better outcomes, as both regulators and the regulated better understand the rules of the road, and who is enforcing them.

 

What’s next

We expect that over the next year, regulators will remain as focused on meeting the obligations of the law, even as they respond to constantly changing macroeconomic conditions. For public entities, this challenge will have the same character as the last year: a near-singular focus on meeting deadlines, often at the expense of thinking about the long-term ambitions of Dodd-Frank and its strategic imperatives. The fact that implementation is likely to remain behind schedule should not be a surprise, simply because of the sheer size and complexity of the law. At the same time, leadership within the public sector must not forget that they are shaping the way a significant share of our economy is regulated, and should act with that interest in mind. That means taking the time to consider how agencies will interact with each other and evaluate how to achieve the core purposes of the law.

Among private sector entities, the impulse to wait out the current transition period would be a mistake. The lack of definition at this stage is not unusual and in a year’s time, this period may well be forgotten as the legislation is implemented to a far more detailed degree. Since the industry is likely to see a significant increase in reporting requirements, for example, now is a good time for firms to evaluate their own compliance with existing reporting requirements, and to study the emerging reporting rules as they take shape. For those firms that have rarely had any reporting requirements, now is a good time to develop a working understanding of best practices. A rolling understanding of the legislative implementation process, informed by an appreciation of the way regulations will affect the daily operations of the financial services industry, is the most certain way to achieve success once Dodd-Frank is put fully into effect.

 

Preferred citation: David Mader, A Consultant’s View of Dodd-Frank, 2 Harv. Bus. L. Rev. Online 68 (2011), https://journals.law.harvard.edu/hblr//?p=1676.

* Mr. Mader is a Senior Vice President at Booz Allen Hamilton, where he leads he firm’s business in support of U.S. Department of Treasury, FDIC, and NCUA, as well as the Executive Office of the President, Congress, Office of Management & Budget, Office of Personnel Management, General Services Administration, and Government Accountability Office. He is a former Assistant Deputy Commissioner of the IRS.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[2] See, e.g., A. Nicole Clowers, Testimony before the House Committee on Financial Services Subcommittee on Oversight and Investigations (July 14, 2011), http://www.gao.gov/new.items/d11808t.pdf.

[3] See, e.g., President Barack Obama, Remarks at Signing of Dodd-Frank Wall Street Reform and Consumer Protection Act (July 21, 2010), http://www.whitehouse.gov/the-press-office/remarks-president-signing-dodd-frank-wall-street-reform-and-consumer-protection-act.

[4] Homeland Security Act of 2002, Pub. L. No. 107-296, 116 Stat. 2135.

[5] Intelligence Reform and Terrorism Prevention Act of 2004, Pub. L. No. 108-458, 118 Stat. 3761.

[6] Post Katrina Emergency Reform Act of 2006, Pub. L. No. 109-295, 120 Stat. 1355.

[7] Patient Protection and Affordable Care Act, Pub. L. No. 111-148, 124 Stat. 119 (2010).

[8] See, e.g., Silla Brush, CFTC May Delay Until December Dodd-Frank Swap Regulations Slated for July, Bloomberg, June 14, 2011, http://www.bloomberg.com/news/2011-06-14/cftc-may-delay-until-december-dodd-frank-swap-regulations-slated-for-july.html.

[9] See Proposed Rule, Credit Risk Retention, 76 Fed. Reg. 24090, 24090 (April 29, 2011).

[10] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 § 111, 124 Stat. 1376, 1392-94 (2010).

[11] Id. §§1011-1013, 1017, 124 Stat. at 1964-73, 1975-79.

[12] E.g., id. §152, 124 Stat. at 1413 (establishing the Office of Financial Research).

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Kenneth W. Muller, Jay G. Baris and Seth Chertok*

The Investment Advisers Act of 1940, as amended (the “Advisers Act”) requires “investment advisers” within the meaning of the Advisers Act with assets under management (“AUM”) in excess of the new statutory floor to register with the Securities and Exchange Commission (“Commission” or “SEC”), unless they qualify for an exemption from registration. Among other things, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) repealed Section 203(b)(3) of the Advisers Act, the “private adviser” exemption, which many investment advisers relied upon. Section 203(b)(3) exempted from registration certain investment advisers having fewer than 15 clients in any 12-month period if they met certain conditions.[1] In applying the numerical limit in the old Section 203(b)(3), which the Dodd-Frank Act repealed, the SEC generally permitted investment advisers to count as a single “client” any fund they advise, but the SEC did not require such funds to count the individual investors as separate clients. Accordingly, private fund managers had been able to rely upon the private advisers exemption in Section 203(b)(3) and advise a substantial number of separate funds (not more than 14 in any 12-month period) without becoming subject to SEC registration.

An investment adviser that is required to register, that is not otherwise exempt (and that previously relied on the “private adviser” exemption in Section 203(b)(3) on July 20, 2011), may delay registering with the SEC until March 30, 2012.[2] Initial applications for registration can take up to 45 days to be approved. Thus, advisers relying on this transition provision to remain unregistered until March 30, 2012 should file a complete application, both Part 1 and a brochure(s) meeting the requirements of Part 2 of Form ADV at least by February 14, 2012.

However, the Dodd-Frank Act does not require all investment advisers to register with the SEC. Although the Dodd-Frank Act replaced the Section 203(b)(3) exemption with a more narrow exemption, it generally raised the floor (discussed below) on Advisers Act registration for most “investment advisers” to register with the SEC and added certain new exemptions from the registration requirements in the Advisers Act.

Definition of “Investment Adviser”

“Investment adviser” is defined in Section 202(a)(11) of the Advisers Act to mean “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities,” subject to certain carve-outs. Certain investment advisers that do not advise about securities may therefore not be subject to the Advisers Act. However, the definition of “securities” under the Advisers Act is very broad.

Advisers Act Jurisdiction

In Release No. IA-3222,[3] the Commission stated that non-U.S. investment advisers, even with no place of business in the United States and no U.S. clients may be subject to registration under the Advisers Act, unless exempt, if there is sufficient U.S. jurisdictional means. It is possible that the SEC will determine that non-U.S. investment advisers falling within the definition of “investment adviser” that use U.S. jurisdictional means, since they are not subject to state law regulation, registration or examination, will generally be required to register with the SEC at any size, unless otherwise exempt.

The Commission has suggested that the test of jurisdictional means for non-U.S. investment advisers is whether there are “conduct or effects” in the United States.[4] A foreign investment adviser could also potentially be subject to U.S. jurisdictional means by using U.S. mails or any means or instrumentality of U.S. interstate commerce.[5] Section 202(a)(10) defines “interstate commerce” to include “trade, commerce, transportation, or communication . . . between any foreign country and any State . . . .”

In certain cases, the Commission has allowed a non-U.S. investment adviser to use limited U.S. jurisdictional means without being subject to Advisers Act jurisdiction. In Gim-Seong Seow, a no-action letter,[6] the SEC staff noted that a non-U.S. investment adviser to clients residing outside the United States may use limited U.S. jurisdictional means without triggering the registration requirements of the Advisers Act. In that no-action letter, the non-U.S. investment adviser obtained information about securities issued by U.S. issuers through U.S. jurisdictional means, gave advice abroad about those securities to its non-U.S. clients and effected transactions in securities through U.S. broker-dealers on behalf of those clients.[7] In contrast, the SEC staff said in that no-action letter that a domestic adviser dealing exclusively with foreign clients must register if it uses any jurisdictional means in connection with its advisory business.[8]

Non-U.S. investment advisers can, in certain cases, be subject to U.S. jurisdiction if they are affiliates of U.S. registered investment advisers.

Raising the Floor for Advisers Act Registration

The concept of “covered mid-sized investment adviser” is central to understanding the applicable Advisers Act floors. The Dodd-Frank Act generally defines a covered mid-sized investment adviser as an investment adviser with between $25 and $100 million in assets under management, and that is subject to registration and examinations as an investment adviser with the state in which it maintains its principal office and place of business.[9] Wyoming, New York and Minnesota do not currently subject investment advisers to registration and examination. Investment advisers with a principal place of business in Wyoming, New York or Minnesota, would not currently be considered subject to registration and examinations in the state where they maintain their principal office and place of business, and therefore would not be covered mid-sized investment advisers.[10]

Small investment advisers with under $25 million in assets under management generally may not register with the SEC, unless the state in which they maintain their principal office and place of business has not enacted an investment adviser statute (e.g., Wyoming), or unless they act as an investment adviser to a registered investment company, in which case they must register with the SEC under the Advisers Act, unless otherwise exempt.[11] Thus, an investment adviser with its principal office and place of business in Wyoming will have to register at any size, unless otherwise exempt. Presumably, non-U.S. investment advisers with their principal office and place of business in a foreign country falling within the definition of “investment adviser” that use U.S. jurisdictional means,[12] since they are not subject to a state law investment adviser statute, will generally be required to register with the SEC at any size, unless otherwise exempt. However, it is possible that the SEC could take the position that non-U.S. investment advisers that met the requirements of U.S. jurisdictional means and that had less than $25 million in assets under management would not have to register with the SEC if it had assets under management of less than $25 million and if the foreign country where they are located had enacted an investment adviser statute.

Second, non-covered mid-sized investment advisers with between $25 million and $100 million in assets under management will generally be required to register with the SEC, unless an exemption applies.[13] As discussed above, the Dodd-Frank Act generally defines a “covered mid-sized investment adviser” as an investment adviser with between $25 and $100 million in assets under management, and that is subject to registration and examinations as an investment adviser with the state in which it maintains its principal office and place of business.[14] The Commission noted that advisers with their principal office and place of business in Minnesota, New York and Wyoming with assets under management between $25 million and $100 million must register with the Commission, unless otherwise exempt. Presumably, mid-size non-U.S. investment advisers with their principal office and place of business in a foreign country falling within the definition of “investment adviser” that use U.S. jurisdictional means,[15] since they are not subject to state law registration or examination, will generally be required to register with the SEC, unless otherwise exempt. However, it is possible that the SEC could take the position that such a foreign investment adviser would not have to register with the SEC if the foreign country required investment adviser registration and examinations.

Third, covered mid-sized investment advisers with between $25 million and $100 million in assets under management will generally be prohibited from registering with the SEC unless (1) they advise a registered investment company or a company that has elected to be a “business development company,” in which case they are required to register under the Advisers Act, unless otherwise exempt;[16] or (2) they are required to register with 15 or more states, in which case they will be permitted to register under the Advisers Act.[17] If the covered mid-sized investment adviser has between $100 million and $110 million in assets under management, it will be permitted, but not required, to register with the Commission.[18] It is uncertain whether foreign investment advisers that are subject to registration and examinations as an investment adviser with the country in which they maintain their principal office and place of business would fall within the definition of a “covered mid-sized investment adviser.”

Fourth, investment advisers with more than $110 million in assets under management will generally be required to register with the SEC, unless an exemption applies.[19]

As a result, the minimum assets under management threshold for Commission registration for most U.S. investment advisers that do not manage registered investment companies or business development companies will be $100 million in general, and $25 million for advisers that would either (1) not be subject to registration and examination in the state in which they maintain their respective principal offices and places of business or (2) otherwise be required to register with 15 or more states. If the investment adviser has its principal office and place of business in a state that has not enacted an investment adviser statute, then it would be required to register at any size, unless otherwise exempt.

If a mid-sized adviser is prohibited from registering with the Commission, the Commission noted that it would be possible for a mid-sized investment adviser to receive an order permitting the adviser to register with the Commission.[20]

The New Exemptions

Although it eliminated the “private adviser” exemption, the Dodd-Frank Act created several new exemptions.[21] The most important of these exemptions for investment advisers are as follows:

  • Advisers Solely to Venture Capital Funds – Section 203(l) provides that “no investment adviser that acts as an investment adviser solely to 1 or more venture capital funds shall be subject to the registration requirements of this title with respect to the provision of investment advice relating to a venture capital fund.”[22]
  • Advisers Solely to Private Funds with less than $150 Million in AUM – Section 203(m) provides that the Commission shall provide an exemption from the registration requirements to any investment adviser of “private funds,” if each of such investment adviser acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million.[23]
  • Foreign Private Advisers – Section 203(b)(3), as revised, created a new exemption for “foreign private advisers.”
  • Family Offices – The Dodd-Frank Act adds an exclusion from the definition of “investment adviser” in Section 202(a)(11) that will apply to any “family office,” as defined by rule, regulation or order of the Commission.[24]

Rule 204-4 requires Section 203(l) and Section 203(m) exempt reporting advisers to file reports with the Commission electronically on Form ADV through IARD using the same process used by registered investment advisers.[25] A Section 203(l) or Section 203(m) exempt reporting adviser must submit its initial Form ADV within 60 days of relying on the exemption from registration under Section 203(l) or Section 203(m) of the Advisers Act.[26] Each Form ADV is considered filed with the Commission upon acceptance by IARD.[27] As amended, Rule 204-1 requires a Section 203(l) or Section 203(m) exempt reporting adviser, like a registered adviser, to amend its reports on Form ADV: (1) at least annually, within 90 days of the end of the adviser‘s fiscal year; and (2) more frequently, if required by the instructions to Form ADV. Similarly, the Commission amended General Instruction 4 to Form ADV to require a Section 203(l) or Section 203(m) exempt reporting adviser, like a registered adviser, to update promptly Items 1 (Identification Information), 3 (Form of Organization), and 11 (Disciplinary Information) if they become inaccurate in any way, and to update Item 10 (Control Persons) if it becomes materially inaccurate. Section 203(l) or Section 203(m) exempt reporting advisers must file their first reports on Form ADV through IARD between January 1 and March 30, 2012.

State Registration

Investment advisers that register with the SEC will not be subject to state registration requirements.[28] “Investment advisers” that do not register under the Advisers Act as a result of falling short of the applicable floor may have to register under applicable state law instead, although some states are considering granting exemptions if the investment adviser otherwise qualifies for an exemption under the Advisers Act. If an investment adviser does not register with the SEC on the basis of an exemption, it may also be required to register as an investment adviser under applicable state law, but some states provide exemptions to investment advisers that are exempt under the Advisers Act. California, for example, is currently considering granting an analogous exemption with respect to the Section 203(m) exemption if the investment adviser has more than $100 million in assets under management, and an analogous Section 203(l) exemption. In the event a state does not grant such an exemption, if an investment adviser is eligible for SEC registration (but SEC registration is not required), many investment advisers will choose to register with the SEC rather than register with the applicable state authorities because state registration can be more onerous as it may require registration in multiple states and compliance with certain state rules regarding investment advisers and investment adviser representatives.

Transition to State Registration

The SEC adopted new Rule 203A-5 to provide for an orderly transition to state registration for mid-sized advisers that will no longer be eligible to register with the Commission. The transition requirements are addressed to existing registrants and new applicants.

Existing Registrants. Under the Rule, each adviser registered with the Commission on January 1, 2012 must file an amendment to its Form ADV no later than March 30, 2012.[29] These amendments will respond to new items in Form ADV and will identify mid-sized advisers no longer eligible to remain registered with the Commission.[30] Advisers will determine their assets under management based on the current market value of the assets as determined within 90 days prior to the date of filing the Form ADV.[31] Mid-sized advisers that are no longer eligible for Commission registration under Section 203A(a)(2) of the Advisers Act, and are not otherwise exempted by Rule 203A-2 from such prohibition, must withdraw their registrations with the Commission after filing their Form ADV amendments by filing Form ADV-W no later than June 28, 2012.[32] Mid-sized advisers registered with the Commission as of July 21, 2011 must remain registered with the Commission (unless an exemption from Commission registration is available) until January 1, 2012, which is the date by which the Commission expects the programming of IARD will be completed.[33]

New Applicants. Until July 21, 2011, when the amendments to Section 203A(a)(2) took effect, advisers applying for registration with the Commission that qualify as covered mid-sized advisers under Section 203A(a)(2) of the Advisers Act may register with either the Commission or the appropriate state securities authority. Thereafter, all such advisers are prohibited from registering with the Commission and must register with the state securities authorities. Covered mid-sized advisers registered with the Commission as of July 21, 2011 must remain registered with the Commission (unless an exemption from Commission registration is available) until January 1, 2012. Covered mid-sized investments advisers that are no longer eligible for Commission registration under Section 203A(a)(2) of the Advisers Act, and are not otherwise exempted by Rule 203A-2 from such prohibition, must withdraw their registrations with the Commission after filing their Form ADV amendments by filing Form ADV-W no later than June 28, 2012. Mid-sized investment advisers that previously relied on the “private adviser” exemption in Section 203(b)(3) on July 20, 2011 that register with the appropriate state securities authority, if required to register under the Advisers Act, will generally be permitted to remain unregistered under the Advisers Act, until March 30, 2012, but should file a complete application, both Part 1 and a brochure(s) meeting the requirements of Part 2 of Form ADV at least by February 14, 2012. Generally speaking, advisers that have assets under management of more than $100 million (for permissive registration) and more than $110 million (for mandatory registration) will continue to register with the Commission (unless, with respect to mandatory registration, an exemption from registration with the Commission otherwise is available).[34] Larger investment advisers that previously relied on the “private adviser” exemption in Section 203(b)(3) on July 20, 2011 will generally be permitted to remain unregistered under the Advisers Act, until March 30, 2012, but should file a complete application, both Part 1 and a brochure(s) meeting the requirements of Part 2 of Form ADV at least by February 14, 2012. Registration under the Advisers Act will preempt state law registration. [35]

Switching between State and Commission Registration

Rule 203A-1 is designed to prevent an adviser from having to switch frequently between state and Commission registration as a result of changes in the value of its assets under management or the departure of one or more clients. The SEC decided that eligibility for registration is to be determined annually as part of an adviser’s annual updating amendment. This allows an adviser to avoid the need to change registration status based on fluctuations that occur during the course of the year.[36]

Rule 203A-1(b) provides rules for switching to or from Commission registration. If an investment adviser is registered with a state securities authority, it must apply for registration with the Commission within 90 days of filing an annual updating amendment to its Form ADV reporting that it is eligible for Commission registration and is not relying on an exemption from registration under Sections 203(l) or 203(m) of the Advisers Act.[37] This safe harbor period would only be available to an adviser that has complied with all applicable reporting requirements of exempt reporting advisers as such (as opposed to all Commission reporting requirements). If an investment adviser is registered with the Commission and files an annual updating amendment to its Form ADV reporting that it is not eligible for Commission registration and is not relying on an exemption from registration under Sections 203(l) or 203(m) of the Advisers Act, it must file Form ADV-W to withdraw its Commission registration within 180 days after its fiscal year end (unless it is then eligible for Commission registration).[38] During the period while an investment adviser is registered with both the Commission and one or more state securities authorities, the Advisers Act and applicable State law will apply to its advisory activities.

Timeline of Compliance Deadlines for Advisers Act Registration and Reporting

July 21, 2011 – Until July 21, 2011, when the amendments to section 203A(a)(2) took effect, advisers applying for registration with the Commission that qualify as covered mid-sized advisers under section 203A(a)(2) of the Advisers Act may register with either the Commission or the appropriate state securities authority.

September 17, 2011 (60 days after publication of Release No. IA-3221 in the Federal Register) – Advisers may begin relying on the Commission amendment to the buffer in Rule 203A-1. Advisers may rely on the Commission’s amendments to Rule 203A-2. Form ADV amendments will become effective on such date.

January 1, 2012 – Mid-sized advisers registered with the Commission as of July 21, 2011 must remain registered with the Commission (unless an exemption from Commission registration is available) until January 1, 2012. Exempt reporting advisers may begin filing their first reports on Form ADV through the IARD on January 1, 2012.

February 14, 2012 – Because initial applications for registration can take up to 45 days to be approved, advisers relying on the “private adviser” exemption transition provision to remain unregistered until March 30, 2012 should file a complete application, both Part 1 and a brochure(s) meeting the requirements of Part 2 of Form ADV at least by February 14, 2012.

March 30, 2012 – Registered advisers registered with the SEC on January 1, 2012 must file an amended Form ADV by March 30, 2012. Exempt reporting advisers must file their first reports on Form ADV through the IARD by March 30, 2012. An investment adviser that is not otherwise exempt that previously relied on the “private adviser” exemption in section 203(b)(3) on July 20, 2011, may delay registering with the SEC until March 30, 2012.

June 13, 2012 – Registered advisers, exempt reporting advisers and foreign private advisers must comply with the ban on third-party solicitation in the “pay to play” rule by June 13, 2012.

June 28, 2012 – Mid-sized advisers that are no longer eligible for Commission registration under section 203A(a)(2) of the Advisers Act, and are not otherwise exempted by Rule 203A-2 from such prohibition, must withdraw their registrations with the Commission after filing their Form ADV amendments by filing Form ADV-W no later than June 28, 2012.

Conclusion

The new rules substantially change the registration regime under the Advisers Act. Investment advisers that previously did not have to register may now have to register, while investment advisers that previously registered may now be unable to register. Many non-U.S. investment advisers that were previously exempt may now have to register as well. In the event a state does not grant an exemption from registration to an investment adviser, if an investment adviser is eligible for SEC registration (but SEC registration is not required), many investment advisers will choose to register with the SEC rather than register with the applicable state authorities. State registration can be more onerous as it may require registration in multiple states and compliance with certain state rules regarding investment advisers and investment adviser representatives.

Registration and exemption issues will affect compliance obligations. Compliance obligations of investment advisers under the Advisers Act will vary depending upon whether the investment is unregistered, a Section 203(l) or Section 203(m) exempt reporting adviser or a registered investment adviser. In addition, there are special compliance rules for non-U.S. investment advisers exempt as “foreign private advisers.”

Unregistered investment advisers will generally be subject to Section 206, the anti-fraud provision of the Advisers Act, and Section 203(e)(6), the supervision provision of the Advisers. Section 203(l) and Section 203(m) exempt reporting advisers, in addition to being subject to the obligations of unregistered investment advisers, will be subject to filing a limited Form ADV, and to submitting to the SEC’s “pay to play” rules. “Foreign private advisers” exempt under Section 203(b)(3) will be subject, in addition to the obligations of unregistered investment advisers, to the SEC’s “pay to play” rules, with respect to its U.S. clients and investors. The SEC staff previously has taken the position that the substantive provisions of the Advisers Act generally should not govern the relationship between an investment adviser located outside the U.S. and its foreign clients, even though the adviser is registered under the Advisers Act.

In Release No. IA-3222: Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less than $150 Million in Assets under Management, and Foreign Private Advisers, the Commission noted that nothing in that release was intended to withdraw any prior statement of the Commission. Presumably, this same logic would apply with respect to an exempt foreign private adviser. To the extent an investment adviser registers with the SEC, it will become subject to the full scope of the Advisers Act (including, without limitation, the obligations of unregistered investment advisers). A brief summary of these obligations include: (1) filing current disclosures on Form ADV; (2) record keeping requirements; (3) examinations by the SEC’s Office of compliance Inspections and Examinations; (4) establishing, maintaining and implementing compliance programs; (5) establishing, maintaining and implementing a code of ethics; (6) custody requirements; (7) restrictions on principal transactions; (8) complying with advertising rules; (9) restrictions on performance fees; and (10) compliance with “pay to play” rules. Compliance is complex and you would be well advised to consult with counsel familiar with these issues.

The SEC staff previously has taken the position that the substantive provisions of the Advisers Act generally should not govern the relationship between an investment adviser located outside the U.S. and its foreign clients, even though the adviser is registered under the Advisers Act. In Release No. IA-3222, the Commission noted that nothing in that release was intended to withdraw any prior statement of the Commission. To enable the Commission to monitor and enforce a registered foreign adviser’s performance of its obligations to its U.S. clients and to ensure the integrity of U.S. markets, a registered foreign adviser must comply with certain Advisers Act recordkeeping requirements and provide the Commission with access to foreign personnel with respect to all its activities.[39] In one no-action letter, the SEC staff suggested that the Advisers Act could govern a relationship between a foreign adviser and its non-U.S. clients if the adviser’s activities involved conduct or effects in the United States.[40] In a later no-action letter in 1998, subject to heavy conditions and representations, the SEC staff said it would not recommend enforcement action when registered investment advisers did not comply with the Advisers Act with respect to their foreign clients if they comply with applicable foreign law.[41] Of course, a registered foreign adviser would always have to comply with the Advisers Act with respect to its U.S. clients. It should be noted that when a foreign adviser advises a foreign client that is an intermediate conduit used to advise U.S. clients, Section 208(d) of the Advisers Act would operate to prevent the adviser from considering the conduit as a foreign client. In such event, the full compliance obligations of the Advisers Act would apply. It is uncertain what the compliance obligations of a foreign adviser would be with respect to U.S. investors, as opposed to U.S. clients.

 

Preferred citation: Kenneth W. Muller, Jay G. Baris & Seth Chertok, The SEC’s New Dodd-Frank Advisers Act Rulemaking: An Analysis of the SEC’s Implementation of Title IV of the Dodd-Frank Act, 2 Harv. Bus. L. Rev. Online 57 (2011), https://journals.law.harvard.edu/hblr//?p=1623.

* Kenneth W. Muller is a Partner in San Francisco at Morrison & Foerster LLP and serves as Co-Chair of its Private Equity Fund Group. Jay G. Baris is a Partner in New York at Morrison & Foerster LLP and serves as Chair of its Investment Management Group. Seth Chertok is a Senior Associate in San Francisco at Morrison & Foerster LLP and is a member of the firm’s Private Equity Fund Group and Investment Management Group.

[1] The exemption did not apply to advisers to registered investment companies and “business development companies.”

[2] Rule 203-1(e); Release No. IA-3221, Rules Implementing Amendments to the Investment Advisers Act of 1940.

[3] See Release No. IA-3222, Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less than $150 Million in Assets under Management, and Foreign Private Advisers.

[4] See, e.g., The National Mutual Group, 1993 SEC No-Act. LEXIS 384 (March 8, 1993).

[5] Advisers Act, Section 203.

[6] Protecting Investors: A Half Century of Investment Company Regulation, 1992 SEC LEXIS 3489 (May, 1992); Gim-Seong, SEC No-Action Letter, 1987 SEC No-Act. LEXIS 2789 (Nov. 30, 1987).

[7] Id.

[8] Id.

[9] Dodd-Frank, Section 410; Advisers Act, Section 203A(a)(2)(B).

[10] Form ADV, Part 1A, Items 2.A.(3), 2.A.(4).

[11] Advisers Act, Section 203A(a)(1).

[12] U.S. jurisdictional means in discussed in “Non-U.S. Advisers” below.

[13] Rule 203A-1(a); Advisers Act, Section 202(a)(11); Dodd-Frank Act, Section 410.

[14] Dodd-Frank, Section 410; Advisers Act, Section 203A(a)(2)(B). A mid-sized adviser that relies on an exemption from registration with its home state would not be considered to be “required to be registered” with its home state. See Form ADV: Instructions for Part 1A, instr. 2.b.

[15] U.S. jurisdictional means in discussed in “Non-U.S. Advisers” below.

[16] Release No. IA-3221, Rules Implementing Amendments to the Investment Advisers Act of 1940, at fn. 106.

[17] Section 203A(a)(2)(A) of the Advisers Act provides as follows: “No investment adviser described in subparagraph (B) shall register under Section 203, unless the investment adviser is an adviser to an investment company registered under the Investment Company Act of 1940, or a company that has elected to be a business development company pursuant to Section 54 of the Investment Company Act of 1940, and has not withdrawn the election, except that, if by effect of this paragraph an investment adviser would be required to register with 15 or more States, then the adviser may register under Section 203.

[18] Rule 203A-1(a).

[19] Advisers Act, Section 203A; Section 202(a)(11); Rule 203A-1(a).

[20] Form ADV, Part 1A, Item 2.A.(12).

[21] In Release No. IA-3222, the Commission voted unanimously to implement the venture capital, private funds and foreign private advisers exemptions as set forth in Section 203(l), Section 203(m) and 203(b)(3) of the amended Advisers Act. In Release No. IA-3220, the Commission adopted Rule 202(a)(11)(G)‑1 under the Advisers Act, which defines the term “family office.” For a discussion of the nuances of these exemptions, Kenneth Muller, Jay Baris and Seth Chertok, SEC Dodd-Frank Advisers Act Rulemaking: Parts I and II Insights (forthcoming).

[22] Dodd-Frank Act, Section 407.

[23] Dodd-Frank Act, Section 408.

[24] Dodd-Frank Act, Section 409.

[25] Rule 204-4(b).

[26] See Form ADV: General Instruction 13.

[27] Rule 204-4(c).

[28] Advisers Act, Section 203A(b).

[29] Rule 203A-5(b). The Commission stated that after this period, it expected to cancel the registration of advisers no longer eligible to register with the Commission that fail to file an amendment or withdraw their registrations in accordance with the Rule. See Advisers Act, Section 203(h).

[30] The Commission stated that advisers will report the current market value of their assets under management determined within 90 days of the filing.

[31] Rule 203A-5(b).

[32] Rule 203A-5(c)(1). During this period while an investment adviser is registered with both the Commission and one or more state securities authorities, the Advisers Act and applicable State law will apply to the investment adviser’s activities. Id. If, prior to the effective date of the withdrawal from registration of an investment adviser on Form ADV-W, the Commission has instituted a proceeding pursuant to Section 203(e) of the Advisers Act to suspend or revoke registration, or pursuant to Section 203(h) to impose terms or conditions upon withdrawal, the withdrawal from registration shall not become effective except at such time and upon such terms and conditions as the Commission deems necessary or appropriate in the public interest or for the protection of investors. Rule 203A-5(c)(2).

[33] Rule 203A-5(a).

[34] Advisers Act, Section 202A(a)(2).

[35] Advisers Act, Section 203A(b).

[36] Rule 203A-1(b)(2).

[37] Rule 203A-1(b)(1).

[38] Rule 203A-1(b)(2).

[39] Murray Johnstone Holdings Limited; Murray Johnstone Limited; Murray Johnstone International Limited, 1994 SEC No-Act. LEXIS 734 (Oct. 7, 1994).

[40] The National Mutual Group, 1993 SEC No-Act. LEXIS 348 (March 8, 1993).

[41] Royal Bank of Canada, Royal Bank of Canada Investment Management (US) Limited, Royal Bank of Canada Investment Management (USA) Limited, 1998 SEC No-Act. LEXIS 620 (June 3, 1998).

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J.C. Boggs, Melissa Foxman, and Kathleen Nahill*

Addressing a joint session of Congress for the first time in February 2009, President Obama asked Congress to “put in place tough, new common-sense rules of the road so that our financial market rewards drive and innovation, and punishes short-cuts and abuse.”[1] Nine months later, on November 3rd, then-Financial Services Committee Chairman Barney Frank (D-MA) introduced the Financial Stability Improvement Act.[2] The bill grew exponentially throughout the month of November, and by the time H.R. 4173 came before the full House of Representatives on December 10th, Rep. Frank’s 380-page bill had expanded to 1,279 pages. When the final conference bill was signed into law on July 21, 2010, not only was it the most significant regulatory overhaul since the New Deal, but at almost 2,400 pages,[3] it was more than twice the length of the three previous regulatory bills – the Securities Act of 1933, the Securities Exchange Act of 1934 and Sarbanes-Oxley – combined.

In the year since Dodd-Frank was enacted, Republicans have launched countless attacks against it, claiming that it is too costly and unnecessarily increases the size of government.[4] They have argued that the Volcker rule and derivative regulations harm U.S. competitiveness overseas, that regulatory agencies are overfunded, and that the Consumer Financial Protection Bureau (CFPB) and Office of Financial Research (OFR) have too much power and are not subject to enough oversight.[5] Republicans, especially those in the House, have introduced bills to repeal Dodd-Frank in its entirety or scale back, defund, delay or otherwise prevent regulators from implementing individual provisions.

Given the rules of the House and the strength of the Republican majority, House Democratic proponents of Dodd-Frank have little recourse but to criticize attempts to overturn Dodd-Frank or portions of it. The Democratic-controlled Senate is another story. In the upper chamber, some have described Senate Banking Committee Democrats as circling the wagons around Dodd-Frank and fending off any and all attempts to amend or repeal it.[6] The committee’s oversight agenda has been noticeably less active than in past years, and some claim the reason is that the new Senate Banking Committee Chairman Tim Johnson (D-SD) is trying to refute Democratic colleagues’ criticisms that he has been too ‘pro-bank’ in the past.[7]

Most of the Republican arguments fall into one of two categories: Dodd-Frank will cost too much and its regulatory requirements will create too much uncertainty for businesses to function properly and plan for the future. Dodd-Frank created thirteen new regulatory agencies, while only eliminating one: the Office of Thrift Supervision. The Congressional Budget Office estimates that it will cost $2.9 billion over the next 5 years to implement Dodd-Frank,[8] and some claim there could be up to $1 trillion in broader economic costs resulting from the Act.[9] The Act also creates more than 2,600 new positions at regulatory agencies, with some agencies, like the Office of Financial Research, lacking any size limitations on their budgets or staffs.[10]

Congressional Republicans have taken on some of the cost issues by using the annual appropriation process to impose deep cuts in agency budgets for the 2012 fiscal year. The 2012 Financial Services Appropriations Bill includes $12.2 billion for the Treasury Department, which is $929 million below last year’s level and nearly $2 billion below the president’s request. The bill also limits mandatory funds for the Consumer Financial Protection Bureau (CFPB) to $200 million and subjects it to annual appropriations, giving the House more oversight capability. In addition, the bill limits funding to the Office of Financial Stability to $200 million. The bill provides $1.2 billion for the Securities and Exchange Commission (SEC), which is equal to last year’s levels and $222 million below the president’s request.[11] The 2012 Agriculture Appropriations Bill includes $172 million for the Commodity Futures Trading Commission (CFTC), a 15 percent cut from last year and nearly half of the $308 million the President requested.[12]

The regulatory uncertainty has been harder to tackle. The sheer volume of deadlines contained in the almost 400 rulemakings required by the Act is overwhelming the regulatory agencies as well as the private sector. The CFTC announced in June that it will miss the July 16th deadline for its rules on derivatives and extended the rulemaking period until December 2011.[13] The Securities and Exchange Commission (SEC), which shares the CFTC’s responsibility for promulgating new derivative rules, has extended its deadlines as well.[14] While some welcome the delays – like Senate Minority Leader Mitch McConnell (R-KY), who recently said that “anything we can do to slow down, deter or impede” these regulations would be “good for our country”[15]– others, like some in industry who view the rules as inevitable, want the SEC and CFTC to finalize the rules as soon as possible so that firms have adequate time to implement them.[16]

Adding more drama are studies and analyses of various aspects of Dodd-Frank. The Government Accountability Office (GAO) released a study in early July 2011 saying that the U.S. regulators do not yet know enough about Wall Street’s proprietary trading to effectively police it.[17] This study pertains to the Act’s Volcker Rule, named after the former Federal Reserve Chairman Paul Volcker and which restricts banks, their affiliates and holding companies from engaging in proprietary trading and sponsorship of hedge funds and private equity funds. The original rule was proposed by Senators Jeff Merkley (D-OR) and Carl Levin (D-MI) as an amendment to the Senate bill, but Sen. Richard Shelby (R-AL), Ranking Member of the Senate Banking Committee, blocked it from coming to a vote.[18] Ultimately, the House-Senate conference committee passed a strengthened Volcker rule by adopting the language offered by Senators Merkley and Levin. However, conferees changed the proprietary trading ban to allow banks to invest up to three percent of Tier 1 Capital in hedge funds and private equity funds at the request of Sen. Scott Brown (R-MA), whose vote was needed in the Senate to pass the bill.

House Republicans have used the non-partisan GAO report to argue that the new requirements put American companies at a competitive disadvantage compared to foreign firms. “The GAO report confirms that neither European nor Asian regulators or legislators will establish similar proprietary trading restrictions that the Dodd-Frank Act imposed on U.S. financial institutions,” said House Financial Services Committee Chairman Spencer Bachus (R-AL). “This will unquestionably harm the ability of American companies to compete and create jobs. Once again, the rhetoric of Dodd-Frank supporters that the world would follow the U.S. lead on financial regulatory reform is shown to be a myth.”[19] At the same time, Senate Democrats have been quick to criticize the report, calling the study “woefully incomplete.”[20] Neither the House nor the Senate has taken any recent legislative steps to further scale back the Volcker Rule, and many large U.S. banks are actively divesting their proprietary trading businesses to prepare for the July 21, 2012 compliance deadline.

Congress continues to debate Dodd-Frank’s costs and regulatory deadlines, but the U.S. Treasury Department’s Assistant Secretary for Financial Markets Mary Miller recently warned that, “Scaling back or repealing major parts of the Dodd-Frank Act or not providing regulators with the funds they need to implement the Act will leave our economy exposed to a cycle of collapses and crises.”[21] In anticipation of the one-year anniversary, House Republicans gave the Dodd-Frank Act a failing report card in mid-July, saying that Dodd-Frank has failed in five categories, including its impact on strengthening the economy, streamlining financial rules and stabilizing the housing market.

At Dodd-Frank’s passage last year, then-Senate Banking Committee Chairman Sen. Chris Dodd (D-CT) said, “No one will know until this is actually in place how it works.”[22] In the year since, there is still little understanding of when most of Dodd-Frank’s extensive provisions will actually be in place and how they might affect the nation’s financial systems and economy. The only certainties are that the hearings will continue, the partisan battles will rage on, and for better or worse, many of the Act’s requirements could remain in limbo until well into the future.


* J.C. Boggs, Melissa Foxman, and Kathleen Nahill are professionals at Blank Rome Government Relations and contributors to www.financialreformwatch.com.

[1] Remarks of President Barack Obama – As Prepared for Delivery Address to Joint Session of Congress (Feb. 24, 2009), available at http://www.whitehouse.gov/the_press_office/Remarks-of-President-Barack-Obama-Address-to-Joint-Session-of-Congress/

[2] H.R. Res. 4173, 111th Cong. (2010) (enacted).

[3] H.R. Rep. No. 111-517 (2010).

[4] See, e.g., Phil Mattingly, Republicans Would ‘Remedy’ Unwanted Dodd-Frank Effects, Bloomberg, Feb. 1, 2011, http://www.bloomberg.com/news/print/2011-02-01/house-panel-to-remedy-dodd-frank-s-unintended-consequences-draft-shows.html.

[5] See id.; Victoria McGrane, Dodd-Frank-Created States Office Comes Under Fire, Wall St. J. Washington Wire Blog, July 14, 2011, http://blogs.wsj.com/economics/2011/07/14/dodd-frank-created-stats-office-comes-under-fire/.

[6] Victoria McGrane, Senate Democrats: Still Making the Case for Dodd-Frank, Wall St. J. Washington Wire Blog, May 11, 2011, http://blogs.wsj.com/washwire/2011/05/11/senate-democrats-still-making-the-case-for-dodd-frank/

[7] See Fight Over Dodd-Frank Headlines U.S. Senate Panel, Reuters, Feb. 17, 2011, http://www.foxbusiness.com/2011/02/17/fight-dodd-frank-headlines-senate-panel/.

[8] Press Release, Representative Barney Frank, Frank statement on the cost of Dodd-Frank implementation (Mar. 30, 2011), http://democrats.financialservices.house.gov/press/PRArticle.aspx?NewsID=1410.

[9] Daniel Indiviglio, Dodd-Frank’s Derivatives Rules Could Cost Main Street $1 Trillion, The Atlantic, Jun. 30, 2010, http://www.theatlantic.com/business/archive/2010/06/dodd-franks-derivatives-rules-could-cost-main-street-1-trillion/58989/.

[10] House Financial Services Committee, One Year Later: The Consequences of the Dodd-Frank Act, http://financialservices.house.gov/UploadedFiles/FinancialServices-DoddFrank-REPORT.pdf

[11] Press Release, House Appropriations Committee, Appropriations Committee Releases Fiscal Year 2012 Financial Services Appropriations Bill (Jun. 15, 2011), http://appropriations.house.gov/News/DocumentSingle.aspx?DocumentID=246626.

[12] House Appropriations Committee, Summary: Fiscal Year 2012 Agriculture Appropriations Bill (Jun. 13, 2011), http://appropriations.house.gov/UploadedFiles/6.13.11_FY_12_Agriculture_Conference_Summary.pdf.

[13] Press Release, Commodity Futures Trading Commission, CFTC Clarifies Effective Date for Swaps Regulation Under the Dodd-Frank Act (Jul. 14, 2011), http://www.cftc.gov/PressRoom/PressReleases/pr6073-11.html.

[14] Press Release, Securities and Exchange Commission, SEC Provides Additional Guidance, Interim Relief and Exemptions for Security-Based Swaps Under Dodd-Frank Act (Jul. 1, 2011), http://www.sec.gov/news/press/2011/2011-141.htm.

[15] Tom Braithwaite and Richard McGregor, McConnell attacks financial regulators, Financial Times, Jun. 23, 2011, http://www.ft.com/intl/cms/s/0/4841ccc6-9d22-11e0-997d-00144feabdc0.html.

[16] This viewpoint was expressed by witnesses at the June 29, 2011 Senate Banking Subcommittee on Securities, Insurance and Investment Hearing which included several derivatives industry executives. See, e.g. Testimony of Neal B. Brady, CEO of Eris Exchange, available at http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=6d382a10-f899-49d7-8040-fae575cfc140.

[17] U.S. Gov’t Accountability Office, GAO-11-529, Proprietary Trading: Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented (2011).

[18] P.K. Semler, Volcker rule unlikely to move forward in Senate, lawmakers say, Financial Times, Feb. 1, 2010, http://www.ft.com/intl/cms/s/2/76c55844-0f4b-11df-8a19-00144feabdc0.html.

[19] Peter Schroeder, GAO: Regulators need more info before curbing proprietary trading, Financial Times, Jul. 13, 2011, http://thehill.com/blogs/on-the-money/banking-financial-institutions/171309-gao-regulators-need-more-info-before-curbing-proprietary-trading.

[20] Alan Zibel, Senate Democrats Criticize GAO Study Related to Volcker Rule, Wall St. J. L. Blog (Jul. 13, 2011, 3:59 PM), http://blogs.wsj.com/economics/2011/07/13/senate-democrats-criticize-gao-study-related-to-volcker-rule/.

[21] Cheyenne Hopkins and Ian Katz, Treasury’s Miller Warns Against ‘Scaling Back’ Major Parts of Dodd-Frank, Bloomberg, Jul. 13, 2011, http://www.bloomberg.com/news/2011-07-13/treasury-s-miller-warns-against-efforts-to-change-dodd-frank-act.html.

[22] David Cho, Jia Lynn Yang & Brady Dennis, Lawmakers guide Dodd-Frank bill for Wall Street reform into homestretch, Washington Post, Jun. 26, 2010, http://www.washingtonpost.com/wp-dyn/content/article/2010/06/25/AR2010062500675.html.

 

Preferred citation: J.C. Boggs, Melissa Foxman, & Kathleen Nahill, Dodd-Frank at One Year: Growing Pains, 2 Harv. Bus. L. Rev. Online 52 (2011), https://journals.law.harvard.edu/hblr//?p=1614.

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