Dodd Frank Act Will Transform the Investment Management Industry in Coming Years
John Schneider*
A year after its enactment, the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act[1] will likely result in the most comprehensive overhaul of financial market regulation since the Great Depression. Under Dodd-Frank, US regulatory agencies are required to adopt a total of 243 separate rules. The Securities and Exchange Commission (SEC) alone must adopt 95 of these rules, which will primarily affect the investment management industry. Dodd-Frank also mandates 16 separate studies of financial markets, with five of these studies to be recurring.
Although Dodd-Frank’s scope is significant, the legislation marks only the beginning of a broader regulatory sea of change that will transform the investment management industry in coming years. Some changes are underway. Under Dodd-Frank, most alternative investment managers will be required to register with the SEC by March 30, 2012.[2] As part of the registration process, these new registrants will be required to identify a Chief Compliance Officer (CCO), develop and implement a governance and compliance program, and will be subject to periodic inspection by the SEC ’s examination staff.[3]
Other changes bearing on asset managers include enhanced disclosure requirements for filings made on Form ADV Part 2[4], an investment adviser disclosure document, which has evolved from a ‘check the box’ format to a narrative document with expanded information requirements.
Another notable change concerns new reporting requirements for monitoring systemic risks required under Form PF. The new Form PF filing will require investment managers to report various attributes of their portfolio holdings on a periodic basis.[5] Other changes indirectly affecting investment managers include changes to regulation of over-the-counter (OTC) derivatives and potential changes to industry fiduciary standards. Lastly, Dodd-Frank aside, other regulatory changes bearing on investment managers are in the works, including a new custody rule, ‘pay-to-play’ restrictions, Reg. SHO concerning short-selling, and new proxy voting rules and disclosures. These regulatory changes may serve as a catalyst to accelerate certain trends that have been underway within the industry. Specifically, product convergence among asset classes that traditionally have remained separate and distinct, may accelerate now that the SEC registration requirement no longer serves as a barrier to entry. We have seen some private equity fund managers starting to offer hedge fund products to their investors and some companies contemplating moves into the alternative segment by offering hedge funds and similar products.
Outside of regulatory change, other trends that continue are the consolidation of investment managers, fee compression, and managers’ movement to open architecture models. In addition, technology and greater transparency have caused the investment management industry to become more global in terms of strategies and distribution. Although this global business approach has led to opportunity and growth, it remains uncertain whether global regulatory coordination will continue to lag, and potentially impede access to certain regions or countries due to the competitive disadvantages created by increased regulation.
During the financial crisis, the US and other national regulatory regimes continually voiced that regulatory reform must be a sustained and coordinated global effort.[6] The rationale behind this goal, in part, was to ensure that regulation did not create a competitive disadvantage for one region versus another.[7] With limited success in coordinating globally, the US and Europe at least, appear to have enacted similar regulatory changes.
Whether other regions and countries will follow suit remains unclear. As firms manage the raft of regulatory change, we should pause to place these changes in context. In the aftermath of the financial crisis, regulators have developed a new set of standards and regulations to protect consumers and the integrity of financial markets. It is critical that firms ensure they are interpreting the intent of the rules based on their individual business models. What we have seen is that the ‘new’ rules are not completely prescriptive, and often there is scope to build a case, as long as the proper support structure is in place.
Lastly, institutional investors have had a hand in influencing the investment management industry and regulatory change. For example, institutional investors have pushed the industry for increased transparency, enhanced due diligence processes, and greater risk and management reporting.[8] Institutional investors have also influenced regulatory changes including the ‘pay-to-play’ restrictions and the custody rule. Industry pressures together with government-inspired regulatory changes will continue to alter the landscape of the investment management industry for some time to come. We believe that now is the time for investment managers to start change programs that will enable them to remain competitive – even in the face of such dramatic industry change – and find the best fit for their businesses.
* John Schneider is the US head of KPMG’s Investment Management Regulatory practice. This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP. KPMG LLP, the audit, tax and advisory firm (www.us.kpmg.com), is the U.S. member firm of KPMG International Cooperative (“KPMG International.”) KPMG International’s member firms have 138,000 professionals, including more than 7,900 partners, in 150 countries.
[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
[2] See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3221 (proposed June 22, 2011), available at http://www.sec.gov/rules/final/2011/ia-3221.pdf.
[5] Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Investment Advisers Act Release No. IA-3145, 76 Fed. Reg. 8,068 (Feb. 11, 2011) (proposed Jan. 26, 2011).
[6] E.g., James Quinn, G20 summit: Timothy Geithner calls for global regulation, Daily Telegraph, Mar. 26, 2009, http://www.telegraph.co.uk/finance/g20-summit/5057267/G20-summit-Timothy-Geithner-calls-for-global-regulation.html.
[8] See generally Anthony Cowell et al., Transformation: The Future of Alternative Investments (KPMG 2010), available at http://www.kpmg.com/IM/en/IssuesAndInsights/ArticlesPublications/ Pages/TransformationTheFutureofAlternativeInvestments.aspx.
Preferred citation: John Schneider, Dodd Frank Act Will Transform the Investment Management Industry in Coming Years, 2 Harv. Bus. L. Rev. Online 15 (2011), https://journals.law.harvard.edu/hblr//?p=1446.
Dodd-Frank Act Has its First Birthday, But Derivatives End Users Have Little Cause to Celebrate
Michael Sackheim and Elizabeth M. Schubert*
A year has passed since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Title VII of the Dodd-Frank Act, entitled the Wall Street Transparency and Accountability Act of 2010 (“Title VII”) created a new transparent exchange-type trading marketplace for over-the-counter swaps subject to regulation by the Commodity Futures Trading Commission (“CFTC”) and security-based swaps subject to regulation by the Securities and Exchange Commission (“SEC”) (collectively, “OTC derivatives” or “swaps”). This article will discuss the significant impact Title VII has, and will continue to have, on the end user, or “buy” side, of the derivatives markets.[1]
Background. Title VII repealed most of the exemptions for OTC derivatives created by the Commodity Futures Trading Modernization Act of 2000 (the “CFMA”). The new statute was enacted to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (1) providing for the registration and comprehensive regulation of swap dealers and large end users, termed “major swap participants;” (2) imposing clearing and trade execution requirements on standardized OTC derivative products; (3) creating recordkeeping and real-time reporting regimes; and (4) imposing margin, capital, and position limits requirements on market participants.
The CFMA opened the door for institutional traders having total assets exceeding $10 million, termed “eligible contract participants” (“ECPs”), to enter into privately negotiated OTC derivatives for both hedging and speculative purposes, with credit terms tailored to the needs of the parties, free from burdensome government regulation. Since the passage of the CFMA, the volume of OTC derivatives transactions increased dramatically. Commercial end users who qualified as ECPs under the CFMA were able to use OTC derivatives as risk management tools and to negotiate the terms of bilateral equity, commodity, interest rate, and currency OTC derivatives, in most instances without being required to tie up capital as collateral. For derivatives end users who have grown accustomed to the liberal regulatory regime under the CFMA, compliance with Title VII will require major adjustments. These include possible registration as a major swap participant, central clearing of swaps transactions, complying with margin requirements, position limits, and recordkeeping and reporting requirements.
Registered Entities. Title VII creates two categories of regulated entities in the swaps markets, the swap dealer and the major swap participant.[2] Entities that fall under either of these definitions will have a significantly higher regulatory burden to meet than those that do not. Regulation will require, among other things, registration with either the CFTC or the SEC, business conduct standards, margin and capital requirements, recordkeeping and real time reporting of swap activity.
The majority of end users will not qualify as swap dealers.[3] With respect to the major swap participant definition, the regulators’ stated focus is to identify swap market participants that “do not cause them to be dealers, but could still pose a high degree of risk to the U.S. financial system.”[4] If the proposed rules on these definitions are adopted without major change, few end users will clear this high bar. The proposed definition is premised on whether the entity in question maintains a substantial position in major categories of swaps[5] and whether its swaps create substantial counterparty exposure that could have serious adverse affects on the financial stability of the U. S. banking system or financial markets. An additional prong of the major swap participant test covers any financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by the appropriate Federal Banking agency and that maintains a substantial position in swaps.[6]
Tests for what constitutes a “substantial position” are based on uncollateralized exposure or potential future exposure. Uncollateralized exposure is, simply put, mark-to-market exposure a counterparty may have to an end user, for which the end user has not posted collateral.[7] Potential future exposure is measured by taking into account total notional principal amount of positions adjusted using a multiplier that takes into account the type of swap and remaining duration of the swap.[8] The thresholds for what constitutes a substantial position are very high: a daily average of $1 billion for most swap categories and $3 billion for rate swaps.[9] In all likelihood these thresholds will capture only the very largest of high volume end users. Similarly, the “substantial counterparty exposure” prong of the major swap participant test looks at uncollateralized exposure and potential future exposure, but across all categories of swaps. For swaps, thresholds are $5 billion for uncollateralized exposure and $8 billion for combined uncollateralized and potential future exposure.[10] For security-based swaps, thresholds are $2 billion for uncollateralized exposure and $4 billion for combined uncollateralized and potential future exposure.[11] For the final prong, the definition of financial entity is broad and captures private investment funds.[12] The regulators have not yet given clarity on what constitutes “highly leveraged” and have proposed ratios of 8 to 1 and 15 to 1 with respect to an entity’s total liabilities to equity at the close of business on the last business day of the applicable fiscal quarter.[13]
The Clearing Requirement. Title VII requires swaps to be centrally cleared.[14] The transition to central clearing marks a major change for end users who currently trade swaps over-the-counter (“OTC”). An end user to an OTC swap faces its counterparty directly. The documentation governing this relationship creates a bilateral credit relationship so both end user and dealer alike are able make demands for payments or collateral from the other and also to call one another in default if either party fails to perform its obligations. Central clearing creates one central counterparty to all swap transactions, the clearinghouse. Most end users do not face the clearinghouse directly, however, but through a clearing member that is typically a bank affiliate (a registered futures commission merchant, broker, dealer or security-based swap dealer).[15] Unlike the OTC regime where an end user faces its counterparty directly, with a centrally cleared trade, the end user enters into a trade with an executing dealer, the trade is reported to the clearinghouse and if neither the end user or executing dealer has exceeded any clearinghouse imposed trading limits, the trade is accepted for clearing by the end user’s clearing member. The clearing member then acts as the end user’s agent facing the clearinghouse. To the extent the clearinghouse calls for margin on the end user’s trade, the call will be made to the end user’s clearing member and passed on to the end user. If the end user is owed margin on a trade, the margin will be paid out to the end user’s clearing member who will in turn pass through the margin payment to the end user.
For most end users, the most fundamental component of the transition to central clearing is that the end user is no longer an “equal” party to the swap transaction.[16] For OTC transactions, events of default and termination rights are negotiated bilaterally and apply equally to both end user and its counterparty. Under a centrally cleared trade, an end user typically has no right to call its clearing member in default, and if it does not negotiate its clearing agreements carefully, its clearing member may have the right to call an event of default or close out open transactions at any time if at any time it feels it needs to do so for its own protection.[17] In addition, under the OTC model, end users have grown accustomed to negotiating the margin terms and any elective termination rights for their swap transactions at the time of the trade. Under a centrally cleared trade, a clearing member has the right to call for an unlimited amount of margin and also a liberal right to terminate the relationship and elect to terminate open positions. Finally, in managing an end user’s counterparty risk, under the OTC model, an end user always has the right to call its counterparty in default. In addition, many end users have grown accustomed to negotiating for segregation of collateral so that if a counterparty becomes insolvent, the end user will be able to recover any posted collateral. At this point, the regulatory protections of customer collateral for cleared swaps are still unclear so end users do not yet have the knowledge required to prepare to manage counterparty risk in cleared swaps transactions.
Margin Requirements. An additional burden on end users will be margin requirements for swap transactions. As Congress was concerned that non-cleared swaps pose counterparty and systemic risks, cleared swaps will be subject to the margin rules imposed by the applicable clearinghouse. For non-financial entity commercial end users that engage in swaps to hedge or mitigate commercial risk, section 723 of Title VII permits the avoidance of clearinghouse margin requirements by creating an exemption from mandatory clearing, allowing the commercial end user to instruct its dealer to not have its swaps cleared. The end user to a non-cleared swap may also require that its collateral be segregated with a third-party custodian, the additional costs of which will presumably be passed on by the dealer to the end user. To qualify for this non-clearing exemption, the end user must also notify the regulator how it generally satisfies its obligations with respect to non-cleared swaps and, if it is an SEC reporting company, an appropriate committee of its board or governing body must authorize the use of this exemption.
Sections 731 and 734 of Title VII require that the CFTC and the bank regulators impose margin requirements for non-cleared swaps on swap dealers. The CFTC has not proposed mandatory margin requirements for non-bank swap dealers. Instead, the CFTC requires non-bank swap dealers to enter into written credit support arrangements with their end user counterparties. For commercial end users, the CFTC will allow non-bank swap dealers to establish a threshold of unsecured exposure, but margin must be collected weekly. The CFTC also proposed that for non-cleared swaps with non-bank swap registrants, two-way bilateral margin should be required, resulting in dealers possibly passing on any related costs to the end users. The CFTC proposal does not require non-bank swap dealers to collect margin from their commercial end user counterparties, but parties must have a written credit support arrangement that (i) requires margin in the event the end user is out of the money above an agreed threshold, (ii) limits eligible collateral, (iii) imposes valuation haircuts and (iv) permits the commercial end user to require that its collateral be held in a segregated account with a third-party custodian, again, however, resulting in potential increased costs. By contrast to the CFTC, the bank regulators proposed mandatory margin collection rules for swap dealers that are insured depository institutions. Bank swap dealers will be required to collect initial and variation margin from both financial entities and commercial end users for non-cleared swaps, regardless of the end user’s creditworthiness, as opposed to simply entering into a credit support arrangement as required by the CFTC for non-bank swap dealers.
Under the CFMA swaps safe harbor that has been repealed by Title VII, creditworthy commercial end users rarely entered into credit support arrangements or posted collateral, therefore they weren’t required to tie up their capital as illiquid collateral. Because CFTC regulated non-bank swap dealers need only enter into credit support arrangements with commercial end users rather than collect mandatory margin as bank swap dealers must, this lack of harmonization may result in commercial end users choosing to trade derivatives with swap dealers that are not banks.
Position Limits. Title VII imposes limits on the amount of swaps a trader can enter into. Position limits specify the maximum number of contracts in specified commodities that any one non-hedging market participant may hold. The CFTC has historically considered position limits in futures necessary to minimize market disruptions and price distortions resulting from excessive speculative trading. This has been a controversial issue and many market participants have argued that there is no evidence that speculative trading resulting in large positions causes these types of problems. Nevertheless, these objections have not had any traction. Section 737 of Title VII requires the CFTC to include swaps in addition to futures contracts under its position limits regime. In January 2011, the CFTC proposed new position limits for futures contracts and “economically equivalent” swaps involving energy, metals and agricultural products. Under the proposed rules, a swap is considered “economically equivalent” to a core futures contract if either (1) the price of the swap refers to a covered futures contract settlement price; or (2) the swap is priced on the same commodity delivered at the same location, or at locations with substantially the same supply and demand characteristics, as that of any of the core futures contracts.
The position limits regime has always included some form of hedging exemption. The rationale is that end users that use the futures markets to reduce the risks inherent in operating commercial enterprises are not speculators and should therefore not be constrained by position limits in their legitimate hedging activities. The CFTC also proposed a narrow bona fide hedging exemption from the position limits for physical hedging transactions that are economically appropriate for the reduction of risks by a commercial end user, and represents a substitute for transactions made or to be made on positions taken or to be taken at a later time in a physical marketing channel, or arises from the potential change in the value of assets that a commercial end user owns, produces, manufactures, processes or merchandises or anticipates doing so. The proposed bona fide exemption will be applicable only to physical commodity hedging, and will not be applicable to financial end user hedgers involving energy, metals and agricultural products.
The CFTC proposal would significantly narrow the availability of the bona fide hedging transaction compared to its pre-Dodd-Frank Act rules. Unlike the current definition, the proposal allows the exemption only for transactions that represent a substitute for a physical market transaction. The concern of many market participants is that this appears to exclude legitimate hedging strategies, such as portfolio hedging, that are currently used by mutual funds and other financial entities.
Commercial end users will be required to apply in advance to the CFTC to use the bona fide hedging exemption. Under the CFTC’s proposal, commercial end users that rely on the bona fide hedging exemption to acquire positions in excess of the limits must submit detailed information to the CFTC no later than 9 a.m. on the next business day after the limits are exceeded. Commercial end users engaged in “anticipatory hedging” to hedge unsold anticipated commercial production or unfilled commercial requirements in an energy, metals or agricultural product must submit a request to the CFTC at least 10 days in advance of the date their positions will exceed the limits. These new filing requirements will impose a substantial administrative burden on commercial end users.
In enforcing the positions limits regime, the CFTC relies on a daily large trader reporting requirement to monitor positions of market participants. Violators of the CFTC’s position limits rules will be subject to enforcement remedies including fines and trading bans. End users of derivatives will need to put in place systems to assure compliance with the new position limits rules for futures and swaps, adding to their hedging costs.
Reporting and Recordkeeping. Title VII also imposes reporting and recordkeeping requirements on swaps markets participants. To date, the CFTC has been more explicit than the SEC about the recordkeeping requirements for non regulated swaps market participants and has proposed that all non regulated entities must keep a record for recorded swap information for the life of a swap transaction and for five years following termination.[18] Such records must be retrievable within 3 business days and are subject to inspection by the Department of Justice, the SEC and the CFTC.[19] Many swap end users currently keep similar records to comply with existing regulatory requirements so in many cases the new recordkeeping requirements will not be a substantial burden for end users.
Swaps data reporting requirements, however, may cause concern for certain end users. The CFTC and the SEC have both proposed that comprehensive information about every swap transaction, whether cleared or uncleared, be reported to a swaps data repository.[20] Such information will be accessible to foreign and domestic regulators. Two key areas of end user concern related to swaps data reporting are the timing of reporting and the public dissemination of reported information.
For swaps that are executed and confirmed electronically, swaps transaction data must be reported as soon as technologically practicable and in no event later than 15 minutes of execution.[21] These short time frames for reporting will compress the time periods during which swaps market participants are accustomed to negotiate the terms of their swap transaction confirmations.[22] In addition, the reporting time frames leave little time for a swap dealer to enter into a hedge for a new swap transaction. If compliance with swaps data reporting requirements results in swaps dealers entering into unhedged swap transactions, end users will in all likelihood have to pay higher prices for these transactions.
Public dissemination of swaps data[23] raises additional concerns for end users, particularly those that do a high volume of swaps trading in connection with a proprietary trading strategy. A threshold concern for high volume end users is whether their identity will be publicly disclosed along with the material terms of their swap transactions. Such disclosure could result in other market participants either mimicking or trading against the end user, both of which will undermine the end user’s strategy. The CFTC has made clear that identifying information shall not be publicly disseminated, however, the SEC has proposed that an identifying number for each swap transaction participant be publicly disclosed.[24] End users have grave concerns that it will be very easy to identify which end user is affiliated with which identifying number. For those end users that trade in high volumes and in large notional amounts, even absent identifying information, there is concern that publicly disseminated information about their trades will draw unwanted attention in the market place.
Conclusion. Many end users, particularly the high volume end user, face a significantly restricted environment for their over the counter derivatives transactions as a result of changes made by the Dodd-Frank Act. Central clearing of swaps transactions, complying with margin requirements, position limits and recordkeeping and reporting requirements are major changes for derivatives end users. As end users brace to comply with their new regulatory regime, what is especially frustrating is the lack of clarity they still have from regulators on the specifics of the many changes the Dodd-Frank Act seeks to implement.
[*] Michael Sackheim is a partner at Sidley Austin LLP, where he focuses on futures and derivatives regulatory, transactional and enforcement matters. Elizabeth M. Schubert is a partner at Sidley Austin LLP, where she focuses on futures and derivatives.
[1] Generally speaking, an end user is the party to a derivative contract that is a “customer” to a financial institution, or the non-dealer party to the transaction.
[2] Section 731 of Dodd-Frank Act creates Section 4s of the Commodity Exchange Act, which requires registration and regulation of swap dealers and major swap participants. Section 764 of the Dodd-Frank Act creates Section 15F of the Securities Exchange Act of 1934, which requires registration and regulation of security-based swap dealers and major security-based swap participants.
[3] Initially some commentators noted that a liberal interpretation of Title VII’s definition of swap dealer could be construed to include a high volume end user of derivatives. In proposed rules on the definition of swap dealer, the CFTC and SEC have both clarified that most high volume end users will not be characterized as swap dealers.
[4] See Definitions of “Major Swap Participant” and “Major Security-Based Swap Participant,” 75 Fed. Reg. 80,174, 80,185 (proposed Dec. 21, 2010).
[5] The “substantial position” prong of the definition expressly excludes positions held for hedging or mitigating commercial risk and positions maintained by or contracts held by any employee benefit plan for the primary purpose of hedging or mitigating risks directly associated with the person or plan. Categories of swaps subject to regulation by the CFTC are rate swaps, credit swaps, equity swaps and commodity swaps. Categories of swaps subject to regulation by the SEC are security-based credit derivatives and other security-based swaps. Id. at 80,186.
[14] Section 723 of the Dodd-Frank Act covers swaps while Section 763 covers security-based swaps. In both cases, the clearing requirement applies only to swaps that are required to be cleared. As of this writing, no regulatory guidance exists as to which products this will cover, although the market is assuming that any product currently eligible for clearing will be subject to the clearing requirement.
[15] Section 724 of the Dodd-Frank Act requires that any person accepting collateral for a cleared swap be a registered futures commission merchant. Section 763 of the Dodd-Frank Act requires that any person accepting collateral for a cleared security-based swap be a registered broker, dealer or security-based swap dealer.
[16] In the bilateral swaps market, where swaps transactions are traded under the ISDA Master Agreement, the end user and bank counterparty come to the table as equals, however, the dealer typically has more bargaining power than the end user and will usually negotiate stronger terms for itself than it is willing to give to its end user client.
[17] The operative agreement for most clearing arrangements is a futures customer agreement. A futures customer agreement is not a standardized contract like the ISDA Master Agreement, the operative document for most OTC swap transactions. A customary term in most futures customer agreements is that the client can be called in default at any time for any reason. In addition, open positions can be closed out at any time for any reason.
[18] Swap Data Recordkeeping and Reporting Requirements, 75 Fed. Reg. 765,574, 76,599 (proposed Dec. 8, 2010) (to be codified at 17 C.F.R. 45).
[20] See id.; Regulation SBSR–Reporting and Dissemination of Security-Based Swap Information, 75 Fed. Reg. 75,208, 75,284 (proposed Dec. 2, 2010) (to be codified at 75 C.F.R. 240, 242).
[21] The regulators have proposed slightly longer timeframes for reporting swaps data if such transactions were not executed and confirmed electronically. Both the CFTC and the SEC allow up to 30 minutes to report a transaction that was executed but not confirmed electronically and 24 hours to report swaps transaction data for a transaction that has been neither executed or confirmed electronically. Regulation SBSR, supra note 20, at, 75, 242; Swap Data Recordkeeping and Reporting Requirements, 75 Fed. Reg. 76,574, 76,599, 76,600 (proposed Dec. 8, 2010) (to be codified at 17 C.F.R. 45).
[22] Section 5-701(b) of the New York General Obligations Law (“GOL”) acknowledges creates the “qualified financial contract” exception to its general requirements that every agreement, promise or undertaking is void unless it or some note of memorandum thereof is in writing. The New York GOL defines “qualified financial contract” broadly and in a manner that would include most swap transactions. For a “qualified financial contract,” there is sufficient evidence that a contract has been made if there is evidence of electronic communication (including the recording of a telephone call) sufficient to indicate that in such communication a contract was made between the parties; and a confirmation in writing sufficient to indicate that a contract has been made between the parties. Such evidence is sufficient against the sender if it is received by the party against whom enforcement is sought no later than the fifth business day after such confirmation is made and the sender does not receive on or before the third business day after such receipt written objection to a material term of the confirmation. Market practice has developed around these requirements. N.Y. Gen. Oblig. § 5701(b) (2010).
[23] Both the CFTC and the SEC have proposed that all reported swaps transaction data be publicly disseminated immediately through the internet or some other electronic data feed. Real-Time Public Reporting of Swap Transaction Data, 75 Fed. Reg. 76,140, 76,172 (proposed Dec. 7, 2010) (to be codified at 17 C.F.R. pt. 43); Regulation SBSR, supra note 20, at 75,284.
Preferred citation: Michael Sackheim and Elizabeth Schubert, Dodd-Frank Act Has its First Birthday, But Derivatives End Users Have Little Cause to Celebrate, 2 Harv. Bus. L. Rev. Online 1 (2011), https://journals.law.harvard.edu/hblr//?p=1493.
Straight Talk from a Practitioner: Notes from Under the Wall
Steven Lofchie* with assistance from Theresa Perkins**
As a financial regulatory lawyer, I am accustomed to being cautious in my pronouncements. Equivocal and timid. When clients ask me for hard advice, rather than answer them, I often just rub my hands together like Uriah Heep and mumble, “that is a very good question.” If you search me on the Internet, you will see that my writing resulted in one commenter describing me as “the world’s most boring man.”[1]
Nonetheless, I can tell you with absolute certainty, flat opinion—none of those scrivener “it’s the better view” qualifications—that Dodd-Frank just does not work. It’s a horrorshow. In fact, sometimes I get so agitated in my opposition to the statute that, when I speak, my hands tremble as with palsy, my eyes redden with little flecks, and I let fly bits of spittle.[2]
So it surprises me, frustrates me, infuriates me, that the statute has its many and public defenders. The newspapers still love it.[3] So I bemoan and let fly.
Two Debates?
There are, in fact, two debates going on about Dodd-Frank. Actually, “debates” is the wrong word. Dodd-Frank proponents (the newspapers, the general public, even my wife I am sad to say) believe that when it comes to financial regulation, we need “more.” Or, alternatively, that we should have “reform.”
But to a working lawyer, “more” and “reform” are empty phrases. Might as well tell me that financial regulation requires more mom and apple pie, allowing us to have more chickens with our more pots, cars and garages.
At a slightly more sophisticated level, the public proponents might toss out a term like “transparency.” Now “transparency” sounds weightier than simply “more,” or even than “reform.” So step back and I will let fly a bit.
The Government Needs More Information About Swaps
CFTC Chairman Gensler leads the public side of the debate about swaps. He has made the case for “transparency” as follows:
The [Dodd-Frank] Act includes robust recordkeeping and reporting requirements for all swaps transactions. It is important that all swaps – both on-exchange and off – be reported to data repositories so that regulators can have a window into the risks posed in the system and can police the markets for fraud, manipulation and other abuses.[4]
At the level of complete and meaningless generality at which the public debate operates, I have no quarrel with Chairman Gensler. If it will be useful for the U.S. government to have more information about swaps so that it can do the job of financial regulation properly, I am happy for it. I don’t have any philosophical objections, nor do I believe that there is some right of privacy with respect to financial instruments. Given that I am accustomed to working with closely-regulated financial entities, I assume that everything that I, or my clients, do or write is subject to the review of the government.
In fact, my concession is more abject than Chairman Gensler’s demands. Chairman Gensler only wants information about “swaps.” For myself, I am willing to concede that the government may require information as to every contract that is either (i) entered into in the United States or (ii) that is entered into outside the United States but could have an effect on the United States.
Suppose that, instead of only asking for swaps information, Dodd-Frank had said “any agency of the U.S. government may require any individual or entity doing business or having offices in the United States, or doing business outside the United States that may have an effect on the United States, to report such information on any contract into which it enters as any such U.S. agency may require, in such form and on such timing as the agency requires, in the public interest.” It would be ok with me. I am not a libertarian. I understand that there may be certain specific types of contracts protected by the First Amendment (such as who buys particular books), but that is a detail. Very few financial contracts, and no swaps, are protected in this regard.
Now, having said that I completely and utterly concede to Chairman Gensler in his desire to protect the economy, let me impose my few caveats (of reasonableness). (i) The cost of collection of the information by market participants and the transfer of that information to the government should be reasonable. (ii) The government should be able to make some reasonable use of that information, at a reasonable cost, and that cost should be reasonable in light of the other tasks of the government, given that the government does not have infinite resources.
Under the CFTC’s proposed rules, firms entering into swaps regulated by the CFTC must report somewhere around 30 or 40 data items about the swap within 15 minutes of the trade.[5] Among these data items are whether (i) the swap is uncleared, which means that it will be subject to individually negotiated collateral terms, and (ii) whether the swap is “bespoke,” which the CFTC defines as a term, not reported, that is “material” to the transaction.
Now, if either of these two boxes is checked, all the rest of the 30 or 40 data items of information reported to the CFTC are essentially worthless. Even if the two boxes are not checked, the other 30 or 40 fields of information are just too much data to be cheap to deliver, and too little data to be useful.
For example, let’s say that the trade is a currency option on an Asian currency. The CFTC’s data form provides for 8 fields of information about options, each of the 8 fields having multiple choices, including “other,” meaning again that all of the collected information will be useless. Now, it so happens that one of the major risks with trading in Asian currencies is that the currency may become inconvertible. In that case, the parties may seek to get out of the trade, or they may be stuck with a trade or with currencies that they do not want to hold, and they will have to make arrangements to deal with this contingency. Without knowing how the parties dealt with the non-convertibility issue on an Asian currency swap (which is not one of the CFTC data items), all of this other information is useless.
Cost/Benefit
It is that way for pretty much everything that the CFTC wants to collect on swaps: too much information to be done cheaply; too little information to be useful.
Except that the CFTC says that this information collection effort is not expensive. In fact, the expense of collecting these 30 or 40 items of data (each of which has numerous possible choices and calculations) and reporting them to the regulators is so “minimal,”[6] that the CFTC says it is not even worth the bother of trying to determine the cost.
Really? That minimal?[7]
I, on the other hand, am not persuaded that the CFTC is making a serious effort to determine what the costs of obtaining this information will be, what the costs of using this information will be, and how useful this information will be to market participants.[8]
In the best of all Panglossian worlds where there was an infinite amount of money to be spent on financial regulation, both as to the costs of compliance by the regulated and as to the costs of regulation by the government, these questions of practicality and benefit would not matter. If the regulators adopt rules that don’t work, it is just money down the drain; plenty more where that came from.
In the harsh MMA-world in which we actually live, where we are running up against the debt ceiling, where we know at some point the taxes are likely to go up, and government support payments are likely to go down, the way in which we spend our regulatory dollars does matter. There is a limited tonnage of these dollars. Money wasted collecting useless information about swaps is money that could be spent on something that better protects the economy or investors.
Moreover, wasteful regulation has other negatives. Building systems to comply with useless reporting regulations is expensive, driving small players out of the industry, reducing competition, worsening the problem of “too big to fail.” Regulatory costs are essentially a tax that must be paid by somebody, presumably at least in part by customers. In addition, bad or expensive regulations lose jobs, drives them overseas. Beyond that, bad and expensive regulations result in a reduction of respect for the government. It makes one feel that the government just can’t act effectively, and I would very much like to believe that it can.
How to Do It Better
While I do not believe that any good can or will come out of Dodd-Frank, there are ways to make it less of a waste. Start with smaller regulations and test their effectiveness. It would be more reasonable to start with collecting monthly aggregate swaps data, as that would give a sense of the parameters and scope of the task of collecting individual trade data and give some guidance as to what individual trade data would be useful.
Or try a pilot program. Under Dodd-Frank, the CFTC has been collecting information on “pre-existing” pre-Dodd-Frank swaps for a considerable period. (I am curious if any benefit has come from this collection.) On the basis of this information, the CFTC could design a limited pilot program for reporting trade data on particular types of swaps: soybean swaps, hurricane swaps, an EU sovereign swap, a Ringgit swap. Then the results of the pilot program could be published. Maybe a sequence of transaction information could be released gradually through a week of trading days, just as the CFTC imagines its system will work. That would give market participants (buy- and sell-side) and economists a chance to analyze the information and see whether it is of any use and would also allow a better opportunity to analyze costs.
If the tests in a pilot program show that all of this information the CFTC wants to collect about swaps is useful and cost-effective, I have no objection. We will have waited an additional few months for our data on soybean swaps, but I suspect that the economy can survive that. The risk to the financial regulatory system of building a useless information trash receptor seems greater to me than the risk of delay, test and evaluate.
Lastly, understand I just picked the topic of trade reporting because it is fairly simple. The statute is 2,000 pages, and more than a problem per page.
* Steven Lofchie is a Partner at Cadwalader, Wickersham and Taft in New York. He is Co-Chairman of the Financial Services Department at Cadwalader, and is a senior fellow for legal studies at the Center for Financial Stability. See Center for Financial Stability, http://www.centerforfinancialstability.org.
** Theresa Perkins is a summer associate at Cadwalader, Wickersham and Taft and a J.D. Candidate (2012) at Boston University School of Law.
[1] Steven Lofchie, We Salute You!, Small Thoughts, Mar. 26, 2009, http://xerpentine. blogspot.com/2009/03/steven-lofchie-we-salute-you.html.
[2] See also Feodor Dostoevsky, Notes from the Underground 1 (“I am a sick man…. I am a spiteful man. I am an unattractive man. I believe my liver is diseased.”).
[3] See, e.g., Edward Wyatt, Financial Reforms of Dodd-Frank Act Still Under Fire a Year Later, N.Y. Times, July 19, 2011, at B1, B5.
[4] Gary Gensler, Chairman, U.S. Commodity Futures Trading Comm’n, Remarks on the OTC Derivatives Reform to the Economic and Monetary Affairs Committee in Brussels, Belgium (Mar. 22, 2011).
[5] Highlighting the unrealistic nature of the 15 minute reporting requirement, when the Transaction Reporting and Compliance Engine system (“TRACE”) was introduced, reporting took 75 minutes, and “reporting requirements for swaps are significantly more complex.” See Kenneth E. Bentsen, Comment to the CFTC Regarding Real-Time Reporting and Swap Data Recordkeeping, International Swaps and Derivatives Association, Inc. 12 (Feb. 7, 2011).
[6] See Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants, 75 Fed. Reg. 236, III(C) (proposed Dec. 9, 2010) (to be codified at 17 C.F.R. pt. 23).
[7] Problems arise with regards to both the amount of data collected and the recordkeeping form the data must be stored in. See id. at 32 (noting the difficulties in gathering data on pre-execution communications, up to the minute timestamps for quotations given or received before an execution, and swap portfolio reconciliations because “industry participants do not typically capture all this data”); id. at 31 (noting the significant costs associated with “aggregating transaction data from all systems into a single . . . file,” maintaining records for five years after the life of a swap, and making real-time records instantly accessible given the large volume of transactions occurring each day).
[8] Failing to obtain, or making any serious effort to obtain, such a cost estimate seems contrary to President Obama’s Executive Order 13,563. See Exec. Order No. 13,563, 76 Fed. Reg. 3821 (Jan. 21, 2011) (requiring agencies to “propose or adopt a regulation only upon reasoned determination that its benefits justify its costs”).
Preferred citation: Steven Lofchie and Theresa Perkins, Notes from Under the Wall, 2 Harv. Bus. L. Rev. Online 10 (2011), https://journals.law.harvard.edu/hblr//?p=1473.
Debit Interchange Regulation: Another Battle or the End of the War?
Stacie E. McGinn and Mark Chorazak*
As one governor of the Board of Governors of the Federal Reserve System (the “Board” or “Federal Reserve”) recently observed, “the financial crisis spawned or strengthened many reform agendas—among them consumer protection, securities and commodities market regulation, and traditional bank regulation.”[1] The crisis also created opportunities unrelated to these reform agendas. At least one group—merchants—realized a legislative goal that had been unimaginable a year earlier: giving the Federal Reserve the authority to set debit interchange rates.
Still reeling from the financial crisis and preoccupied with defending innumerable other measures in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”),[2] retail bankers big and small watched as an unprecedented government rate-setting amendment was approved in the U.S. Senate by a bipartisan vote of 64 to 33.[3] Under the so-called Durbin Amendment, named for U.S. Senator Richard Durbin, an estimated $7.2 billion—or roughly 45%—of interchange revenue paid to banks for facilitating debit card transactions will be eliminated.
This article explores the events that led to passage of the Durbin Amendment and describes the likely impact of this historic legislation on the banking industry, payments companies, merchants and consumers. Finally, we discuss whether the Durbin Amendment represents the final battle on debit interchange in the United States, or merely a skirmish in a long-running war.
The Durbin Amendment was preceded by a long-running feud over interchange, with retailers on one side, and payment networks and the banking industry on the other.
The seeds of the dispute were sown by payment processing arrangements and the success of debit cards with American consumers.
Understanding the battle over interchange begins with understanding interchange itself. When a consumer uses a debit card to make a purchase, the merchant does not receive the full purchase amount, because a portion of the sale is deducted to compensate other parties to the transaction. In particular, the merchant’s bank (the “acquirer”), the bank that issued the card (the “issuer”), and the card network that processes the transaction (the “network”) all receive a portion of the transaction, with the largest portion paid to the card-issuing bank as an interchange fee.[4] This multi-party relationship is shown in the simplified chart, below.[5]
The level and growth of debit interchange rates became increasingly controversial. Retailers felt their costs for accepting cards were too high and increasing. The total costs to merchants who accept debit cards did rise over time, in part because of the extraordinary success of the product.[6] Consumers rapidly substituted debit cards for cash and checks. Debit share of U.S. Personal Consumption Expenditure (PCE), for example, grew 75% in five years—it represented 9.7% of PCE in 2003 (for a total of $585 billion), and represented 17% of PCE in 2008 (for a total of $1.3 trillion).[7] Payment networks report there were approximately 37.7 billion debit and prepaid card transactions in 2009, valued at over $1.45 trillion.[8] At the same time, interchange revenue became increasingly important to card issuers of all sizes. Smaller issuers, such as community banks and credit unions, rely on interchange fees as a significant source of revenue for their card operations, and card operations were highly profitable activities for large banks, as well.
Faced with escalating processing costs, merchants sought relief in the courthouse and in Congress.
As interchange revenues climbed in the mid-nineties, payment networks began to face antitrust litigation over their practices. Beginning in 1996, various class action and Department of Justice lawsuits were filed against Visa U.S.A. Inc., MasterCard International and issuers, in some cases, claiming violations of federal antitrust laws. In the intervening decade, most of these claims were settled, and both Visa and MasterCard became publicly-owned institutions.[9]
With judicial challenges proceeding slowly through the courts, merchants took their cause to Capitol Hill. Largely under the auspices of the Merchants Payments Coalition,[10] and with the support of Senator Durbin, merchants made several unsuccessful attempts at legislation regulating interchange rates. In 2009, they were able to attach an interchange provision to a major piece of credit card legislation, the 2009 Credit Card Accountability, Responsibility, and Disclosure Act (the “CARD Act”). The provision directed the Government Accountability Office (“GAO”) to conduct a study of interchange.[11] The resulting GAO study found no competitive concerns or the need for government rate-setting.[12]
But 2010 ushered in the perfect storm for long time opponents of interchange regulation. Few in Congress understood the issues surrounding interchange, and industry leaders and members of Congress already were grappling with the complexities of other provisions of the 2,300 page bill that ultimately became Dodd-Frank. Senator Durbin’s influence in the Senate was at an all-time high, and influence (and trust) of the banking industry was at an all-time low. From the midst of this chaos, retail bankers, big and small, watched as Senator Durbin’s unprecedented government rate-setting amendment was approved in the Senate and ultimately became law.[13]
The Durbin Amendment was designed to change fundamentally the economic underpinnings of debit payment processing and shift decision-making power as to transaction processing in favor of merchants.
In adopting final interchange regulations, Federal Reserve Governors and staff believed their hands were tied by a narrow statutory mandate.
Dodd-Frank required the Board to establish its interchange fee standards no later than April 21, 2011, with final rules effective on July 21, 2011.[14] Prior to issuing its rule, Board staff held numerous meetings with debit card issuers, payment card networks, merchant acquirers, merchants, industry trade associations and consumer groups. Interested parties also provided written submissions.[15] The Board also distributed three surveys to industry participants (an issuer survey, a network survey and a merchant acquirer survey) to assist the Board in developing its rules.[16]
Section 1075 of Dodd-Frank and the Board’s regulations fundamentally change the status quo in debit processing in three ways: introducing government regulation of interchange fees, prohibiting “exclusive” arrangements between an issuer and a network, and allowing merchants to “steer” a customer to use one type of card rather than another. Each is described below.
Regulation of Interchange Fees. Under Dodd-Frank, the amount of any interchange fee with respect to an electronic debit transaction received or charged by an issuer must be “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.”[17] Dodd-Frank directs the Federal Reserve to prescribe regulations to establish standards for assessing whether the amount of any interchange transaction fee is “reasonable and proportional” to this cost.[18] Dodd-Frank permits the Board to allow in its regulation for an adjustment to the fee amount for costs incurred by the issuer in preventing fraud, provided the issuer complies with fraud-related standards established by the Board.[19]
In setting new interchange rates, the Board’s final rule caps the maximum debit interchange fee that an issuer may receive per transaction at the sum of 21 cents,[20] plus 5 basis points (0.05% of the transaction amount) to account for fraud losses. The Board provides an additional allowance for fraud prevention equal to 1 cent per transaction, provided the issuer adopts fraud prevention procedures established under the regulation.[21] While a significant improvement over the proposed rule, which capped interchange rates at 12 cents, the final rule will decrease interchange revenue by about 45% for covered issuers.[22]
Certain entities and programs are exempt from the rate provisions of Dodd-Frank. Issuers that, together with all affiliates, have less than $10 billion in assets are exempt from the Board regulations, under the “small issuer” exemption.[23] In addition, prepaid cards used in connection with government-administered payment programs and certain general purpose prepaid cards are exempt.[24]
During consideration of the final interchange regulations, the Board staff acknowledged they could not predict the impact of the statute on small banks or the effectiveness of the small-issuer exemption. Staff noted that while the major payment networks have indicated their intentions to adopt a “two-tier” pricing structure that accounts for small issuers, there is no certainty interchange rates for small banks will remain at current levels.[25] Moreover, Board staff acknowledged they have no authority to require networks to maintain a two-tier structure. Governor Elizabeth Duke objected to the Board’s final rules largely on the basis of the uncertainty surrounding the impact on small banks.
The statute also provides that the Federal Reserve may regulate fees charged by payment networks, but only for the purpose of ensuring that the network fee is not used to circumvent the interchange fee provisions. To prevent circumvention or evasion of the limits on interchange fees, the rule prohibits an issuer from receiving net compensation from a debit card network, excluding interchange fees. In other words, the total amount of compensation provided by the network to the issuer, such as rebates, incentives or payments, may not exceed the total amount of fees paid by the issuer to the network.
Elimination of “Exclusive” Arrangements. In addition to prescribing rules regarding restrictions on interchange fees, the Board also is required by Dodd-Frank to prescribe certain rules regarding transaction routing. The Board regulations must provide that neither an issuer nor a payment network may (i) restrict the number of payment card networks on which a transaction is processed to only one network, or (ii) inhibit a merchant who accepts debit cards from directing the routing of transaction processing over any payment card network that may process such transaction.[26]
Board regulations provide that an issuer or payment card network may not restrict the number of payment card networks over which an electronic debit transaction may be carried to fewer than two unaffiliated networks. Under this approach, it is sufficient for an issuer to issue a debit card that can be processed over one signature-based network and one PIN-based network, or alternatively, two signature-based networks, provided that the networks are not affiliated.[27] The final rule also adopts the statutory prohibition on routing restrictions. In practice, this means issuers will choose two or more unaffiliated payment card networks over which an electronic debit transaction may be carried, and merchants (not issuers or networks) will be able to direct the routing of the transaction from among the networks chosen by the issuer.
Merchant Steering. The statute provides that a network may not keep a merchant from offering a discount or other in-kind incentive for payment by the use of cash, checks, debit cards, or credit cards, provided the discount does not distinguish on the basis of issuer or payment card network (in the case of debit or credit cards).[28] In accordance with Dodd-Frank, the Board prohibits issuers and payment card networks from restricting the ability of a merchant to direct the routing of electronic debit transactions over any of the networks that an issuer has enabled on its card.
Application of Interchange Fee Restrictions to ATM and “closed-loop” networks. The rule defines “payment card networks” to exclude three-party, or so-called closed-loop networks, such as American Express, and ATM networks.
Effective dates. While the statute provides that final rules should be effective July 21, 2011, the final rule takes a more practical approach. The Board rule ensures that the fraud prevention adjustment would apply at the same time as interchange fee provisions become effective, and provides additional time to account for technology challenges. Specifically,
- The restrictions on interchange fees and routing restrictions will take effect on October 1, 2011 (including, on an interim basis, the fraud prevention adjustment).
- The prohibitions on network exclusivity take effect on October 1, 2011 for payment card networks and April 1, 2012 for issuers.
- A delayed effective date of April 1, 2013 applies to certain cards with particular technological challenges, such as health benefit and certain other prepaid cards.
Industry participants must weigh carefully their responses.
The Dodd-Frank interchange provisions change the economic relationships between issuers (large and small), networks and merchants, and the steps they take in response will ultimately impact consumers.
Issuers. In the short run, issuers will seek new ways to make up some of their lost revenue. Several banks have already announced plans to increase fees on other bank products and services.[29] Small banks should benefit from fee increases by larger banks, as they too may increase prices, while interchange rate regulation purports not to affect these institutions.
Some issuers will seek to take advantage of the exemptions. Those issuers operating within a “closed loop” system would appear to be less impacted by declines in interchange rates, although market pressure on interchange rates generally and new powers of merchants to route transactions and discount may put pressure on interchange rates of these companies, as well. At least one financial institution has introduced a new general purpose prepaid card, which would appear to be exempt from the Board’s interchange restrictions. Prepaid products need to be carefully structured to meet regulatory requirements, and as prepaid cards become more prevalent as a payment device, the industry can expect increased supervision and examination by the newly-formed Consumer Financial Protection Bureau.[30]
Debit card issuers will need to review existing arrangements with payment card networks in light of the “exclusivity” provisions of the Federal Reserve’s regulations. They will also need to ensure that the total amount of compensation provided by the network to the issuer, such as rebates, incentives or payments, does not exceed the total amount of fees paid by the issuer to the network.
Issuers that wish to collect the additional fraud adjustment will need to ensure their fraud prevention activities are (and remain) consistent with standards established by the Federal Reserve regulation.
Issuers will need to rethink their debit card offers in view of “allowable costs” under the rule. Issuers might consider increasing fees for debit card transactions, or taking other measures that would have the effect of causing consumers to steer away from debit card use. A more likely scenario is the elimination of benefits: rewards on debit cards will likely be curtailed, if not eliminated altogether. The final rule also may impact issuers’ willingness to spend money on innovation with regard to payment methods that fall within the rule, as issuers will be unable to recoup their fixed development costs.[31]
Networks. The networks will need to reset interchange rates. One of the most difficult issues networks will face in this regard is whether to establish a two-tier system for large and small banks (Visa and MasterCard have both indicated their intention to do so) and where to set rates. Competitive pressure, created by merchants’ ability to direct network routing and offer consumer discounts, will be a factor.
New routing and steering powers of merchants are likely to drive change. Networks (and issuers) may need to make adjustments to network operating rules and payment processing protocols to account for the merchant routing provisions. While historically responsive to merchant needs, networks have additional incentives following Durbin to compete for merchant business.
Merchants. Merchants will receive a reduction in their processing costs and will face the question of how much, if any, of these cost savings they will pass on to consumers. Federal Reserve staff indicated that, while they cannot predict merchant behavior, they would expect merchants in highly competitive markets operating on smaller margins were most likely to pass the savings on to consumers, whereas merchants with less competition were likely to retain the cost savings.[32]
Merchants must consider how to implement new routing and steering powers. Some merchants (and their acquirers) might make technological investments to allow merchants to take advantage of routing provisions. Merchants will also consider whether to offer consumer discounts for use of particular payment methods.
Consumers. The impact on consumers will depend largely on steps taken by issuers, networks and merchants, as outlined above, and consumer behavior in response to these changes. Costs of banking services generally, and debit cards in particular, may increase, to the detriment of consumers. Merchants in highly competitive markets might pass on cost savings to consumers in the form of lower prices. And issuers and merchants might both take action to steer consumers to use one payment product over another. How consumers modify their behaviors in response to these changes will affect the costs and benefits associated with the products and services they ultimately receive.
Legal challenges to the Federal Reserve’s rule are possible.
While the Federal Reserve carefully balanced its final decisions within the constraints of the statutory language, few are pleased with the final rule. One bank sued the Federal Reserve even before the Federal Reserve’s proposed rule was released, citing a number of constitutional claims.[33] Moreover, on the day the Federal Reserve announced the final rule, the Merchants Payments Coalition publicly announced its dissatisfaction with the result and the fact that it was looking at ways to “challenge” the rule.[34] It would appear from these comments the final battle over interchange has not yet been fought.
* Ms. McGinn is a partner and Mr. Chorazak is an associate in the regulatory practice of the Financial Institutions Group of Simpson Thacher & Bartlett LLP. The authors acknowledge the substantial contribution to this article by Randy Benjenk (Harvard J.D. candidate, 2012).
[1] Daniel K. Tarullo, Governor, Fed. Reserve System, Speech at the Peter G. Peterson Institute for International Economics (June 3, 2011).
[2] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (July 21, 2010)
[3] Section 1075 of Dodd-Frank amends the Electronic Fund Transfer Act (“EFTA”) (12 U.S.C. § 1693 et seq.) by adding a new provision regarding interchange transaction fees and rules for payment card transactions.
[4] The Federal Reserve defines an “interchange transaction fee” as “any fee established, charged, or received by a payment card network and paid by a merchant or an acquirer for the purpose of compensating an issuer for its involvement in an electronic debit transaction.” Debit Card Interchange Fees and Routing, 12 C.F.R. § 235.2(j) (2011).
[5] This describes what is known as a “four-party,” or “open-end” processing relationship. Processing arrangements also can involve a “three-party,” or “closed-end” processing system, in which the network itself acts as both issuer and acquirer. For a more detailed description of the debit card industry, see Proposed Rule, Debit Card Interchange Fees and Routing, 75 Fed. Reg. 81,722, 81,723 (Dec. 28, 2010).
[6] Merchants claimed processing costs also rose as a consequence of increased interchange rates since rate increases were used by payment networks to compete for issuers. See Understanding the Federal Reserve’s Proposed Rule on Interchange Fees: Implications and Consequences of the Durbin Amendment: Hearing Before the Subcomm. on Financial Institutions and Consumer Credit of the H. Comm. On Financial Services, 112th Cong. 4-5 (Feb. 17, 2011) (statement of Doug Kantor, Counsel, Merchants Payments Coalition).
[7] U.S. Consumer Payment Systems, Nilson Report #939 at 10, December 2009.
[8] Proposed Rule, Debit Card Interchange Fees and Routing, 75 Fed. Reg. 81,722, 81,725 (Dec. 28, 2010).
[9] At least one lawsuit, which consolidated approximately 55 complaints, has been pending for the last six years. See Second Consolidated Amended Class Action Complaint, In Re Payment Card Interchange Fee and Merchant-Discount Antitrust Litigation, No. 1:05-md-1720-JG-JO (E.D.N.Y. Jan. 29, 2009).
[10] The Merchants Payments Coalition is a merchant trade association representing over 2.7 million merchants in the challenge to interchange fees.
[11] GAO was directed to review (1) how the fees merchants pay have changed over time and the factors affecting the competitiveness of the credit card market, (2) how credit card competition has affected consumers, (3) the benefits and costs to merchants of accepting cards and their ability to negotiate those costs, and (4) the potential impact of various options intended to lower merchant costs.
[12] U.S. Government Accountability Office, Credit Cards: Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges (2009).
[13] Opponents of the Durbin Amendment waged an unsuccessful attempt to change the law. Senator Jon Tester of Montana introduced a bill to delay implementation of the Durbin Amendment by a year. Tester’s proposal called for a study of the effect of the Durbin Amendment and the Board’s proposed rule on all costs associated with debit card programs to issuers and networks, the costs to consumers, including the impact on fraud prevention services and the cost and accessibility of debit services, and the effectiveness of the small issuer exemption. Any adverse finding would result in a withdrawal of the proposed rule and the issuance of a new rule. On June 8, 2011, Tester’s amendment received 54 votes in the Senate, but failed to obtain a filibuster-proof majority.
[14] On March 29, 2011, Board Chairman Ben Bernanke wrote in a letter to Congressional banking committee leaders that the Board was unable to meet the April 2011 deadline provided in the statute for the final rule, due to the high volume of comments the Board received and the complexity of the issues raised by the comments. The final rules were approved by the Board, with one objection, on June 29, 2011, and covered issuers have until October 1, 2011 to comply with the interchange fee restrictions, as described in greater detail below.
[15] Meeting summaries and written submissions are available on the Regulatory Reform section of the Board’s web site, at http://www.federalreserve.gov/newsevents/reform.htm.
[16] The card issuer survey was distributed to 131 financial organizations with assets of $10 billion or more. The Board received 89 responses; it received no communication at all from 26 of the 131 organizations that were sent the survey.
[17] 15 U.S.C. § 1693o-2(a)(2).
[18] Id. § 1693o-2(a)(3). The statute notes several factors that must be considered by the Board in prescribing its regulations. The Board must consider the functional similarity between debit transactions and check transactions. In addition, the Board must distinguish between (i) “the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular” debit transaction, which costs must be considered; and (ii) other costs incurred by the issuer which are not specific to a particular transaction, which costs shall not be considered. Id. § 1693o-2(a)(4). The latter considerations were particularly controversial during the rulemaking process.
[19] Id. § 1693o-2(a)(5). The Board was required to establish such fraud standards within nine months of Dodd-Frank’s enactment.
[20] In arriving at the 21 cent figure, the Federal Reserve took into account from its survey of covered issuers the average per-transaction allowable processing costs for issuers at the 80th percentile of the survey. Allowable costs are those total fixed and variable transaction processing costs related to authorization, clearance and settlement, as well as network processing fees (e.g., switch fees), and the costs of processing chargebacks and other non-routine transactions, and transactions monitoring.
[21] This additional fraud allowance was based on the median of reported issuer fraud losses from the Federal Reserve survey.
[22] Based on a comparison of the Federal Reserve survey data (which reflects debit interchange rates for all transactions of 1.14% and an average debit transaction amount of $38.03), the Federal Reserve’s final rule on debit interchange will cause average debit interchange rates to decline about 45%, from approximately 1.14% to approximately 0.63%. Put another way, average per transaction rates will decline from around 44 cents to 24 cents.
[23] For a list of institutions qualifying as small issuers, see Interchange Fee Standards: Small Issuer Exemption, http://www.federalreserve.gov/paymentsystems/debitfees.htm.
[24] To qualify for this exemption, the payment device must be (i) linked to funds or other assets that are loaded on a prepaid basis, (ii) not used by the card holder to access the cardholder’s account (other than a recordkeeping subaccount of an omnibus account), (iii) redeemable at unaffiliated merchants or service providers, (iv) used to transfer or debit funds, and (v) reloadable and not marketed or labeled as a gift card. In addition, the card must be the only means to access the underlying funds, except when all remaining funds are provided to the cardholder in a single transaction (as when the account is closed out). In other words, transactions using prepaid cards that provide regular access to funds underlying the card through check or ACH would be subject to interchange restrictions.
[25] See Staff Memorandum, Final Rule on Debit Interchange Fees and Routing and Interim Final Rule on Fraud Prevention Adjustment 18 (June 22, 2011), available at http://www.federalreserve.gov/aboutthefed/boardmeetings/20110629_FINAL_RULE.BOARD_MEMO.06_22_2011.SGA.FINAL2.pdf.
[26] Exemptions for small issuers and government and prepaid cards do not apply to these routing restrictions.
[27] Merchants argued in favor of requiring issuers to have at least two payment card networks for each authentication method an issuer offers. This would have meant that an issuer that used both signature and PIN-based authorization would have to enable its debit cards with two unaffiliated signature-based networks and two unaffiliated PIN-based networks. In the end, the Board determined such an interpretation was beyond its statutory mandate.
[28] The law also allows merchants to establish minimum dollar amounts in the case of credit card sales.
[29] See e.g., Fee Plans Take Shape at Wells Fargo, Regions In Case Durbin Deadline Sticks, American Banker, May 24, 2011; U.S. Bancorp Ends Waiting Game with Durbin Debit Rule, American Banker, January 20, 2011.
[30] The Consumer Financial Protection Bureau suggested in a recent proposed rulemaking that it is considering regulating prepaid cards. Proposed Rule, Defining Larger Participants in Certain Consumer Financial Products and Services Markets, 76 Fed. Reg. 38,059 (June 29, 2011).
[31] During deliberations on the final rule, Federal Reserve staff expressed a view that the final rule could have a negative impact on payments innovation.
[32] See Mark D. Manuszak, Senior Economist, Division of Research and Statistics, Federal Reserve, Remarks at the Open Board Meeting of the Board of Governors of the Federal Reserve System (June 29, 2011), video available at http://bcove.me/hud5ew6j.
[33] In October, 2010, TCF National Bank sued the Board in the U.S. District Court for the District of South Dakota to prevent implementation of the Durbin Amendment, claiming that the Amendment unconstitutionally deprived the bank of substantive due process and equal protection. See Complaint at 47-51, TCF Nat’l Bank v. Bernanke, No. CIV 10-4149, 2010 WL 3960576 (D.S.D. Oct. 12, 2010). The District Court denied a preliminary injunction to TCF, ruling that the bank was unlikely to prevail on the merits of its constitutional challenges. See TCF Nat’l Bank v. Bernanke, No. CIV 10-4149, 2011 WL 1578535 (D.S.D. Apr. 25, 2011) (order denying motion to dismiss and denying preliminary injunction). After the Eighth Circuit Court of Appeals affirmed, TCF Nat’l Bank v. Bernanke, No. 11-1805, 2011 WL 2555696 (8th Cir. June 29, 2011), and the Board issued its final rule, TCF requested voluntary dismissal of the lawsuit. In a press release, TCF Chairman and CEO William Cooper said “While we continue to believe that the Durbin Amendment is unconstitutional because it requires below-cost pricing and exempts 99% of all U.S. banks, we believe our lawsuit has served its purpose in demonstrating the unfairness of the Durbin Amendment and that it is time for us to move on. The Federal Reserve’s final rule is an improvement from its initial proposal and recognizes many of the points we made in our case.”
[34] George Zornick, The Nation: You Swipe Card, Banks Swipe Cash, National Public Radio (July 1, 2011) (quoting Mallory Duncan, Chair of the Merchants Payments Coalition), available at http://www.npr.org/2011/07/01/137547730/the-nation-you-swipe-card-banks-swipe-cash.
Preferred citation: Stacie E. McGinn and Mark Chorazak, Debit Interchange Regulation: Another Battle or the End of the War?, 2 Harv. Bus. L. Rev. Online 18 (2011), https://journals.law.harvard.edu/hblr//?p=1536.
The SEC’s Whistleblower Program: What the SEC Has Learned from the False Claims Act about Avoiding Whistleblower Abuses
Douglas W. Baruch* and Nancy N. Barr**
Introduction
The Dodd-Frank Wall Street Reform and Consumer Protection Act’s (“Dodd-Frank Act”) sweeping overhaul of the financial system now requires the SEC to pay substantial monetary awards to whistleblowers who disclose wrongdoing by publicly traded companies, financial services institutions, and other covered entities, and it prohibits employers from retaliating against SEC whistleblowers.[1] On May 25, 2011, the SEC adopted final rules implementing these new mandates.[2] Although the rules become effective 60 days after publication in the Federal Register, they apply retroactively to tips provided on or after July 21, 2010, Dodd-Frank’s enactment date. The SEC’s new whistleblower program borrows heavily from the whistleblower provisions of the civil False Claims Act (“FCA”), albeit with important distinctions that reflect an attempt by the SEC to distance itself from some of the problems plaguing FCA enforcement.
The concept behind the SEC’s whistleblower program, initially proposed by University of Alabama Law School Professor Pamela (Bucy) Pierson in a seminal article published nine years ago, is based on the view that so-called “qui tam enforcement” had worked so well in enforcing the FCA that it should be imported to enforce the securities laws.[3] Indeed, although a 2006 revision to the IRS whistleblower program served as a model for the award levels and appeals process under the SEC’s program,[4] a number of elements in the SEC’s whistleblower provisions derive from the FCA. For example, the 10–30% whistleblowers’ share levels, the “original information” requirement, and the “voluntarily provided” requirement are similar to FCA requirements. In its proposed whistleblower rules, the Commission noted that the FCA provided “helpful guidance” on whistleblower legal standards, and the SEC’s adopting release relied on a number of FCA decisions in defining the standards for the program.[5] However, the overall balance struck between the competing interests of whistleblowers, companies, and the government in the SEC’s whistleblower program results in a program that differs from the FCA and enables the SEC to curtail some of the whistleblower abuses that have occurred under the FCA’s qui tam enforcement mechanism.
The SEC’s Whistleblower Program Has No Qui Tam Enforcement
The most significant distinction between the SEC’s whistleblower program and the FCA’s enforcement regime is that the SEC program does not allow qui tam enforcement. The FCA gives the federal government powerful enforcement resources, but it also empowers private plaintiffs, referred to as qui tam relators, to pursue claims on behalf of the United States even when the United States decides not to prosecute actions on its own. The term “qui tam” is derived from a Latin phrase, “qui tam pro domino rege quam pro se ipso,” or “who pursues this action on our Lord the King’s behalf as well as his own.”[6] As this phrase indicates, the qui tam action arose in early English common law as a device for permitting private individuals to litigate claims on the sovereign’s behalf. Like relators in modern FCA actions, early qui tam litigants not only gained standing to sue that they otherwise would lack, but they also received a share of any recovery obtained on the sovereign’s behalf as a result of the qui tam action.[7] Significant FCA amendments in 1986 strengthened relators’ rights and increased their potential bounties, thus dramatically increasing the incentives to filing suit. FCA amendments in 2009 and 2010 further enhanced relators’ ability to share in recoveries and added additional protections against retaliation.[8]
While the original purposes of the FCA qui tam enforcement mechanism included “setting a rogue to catch a rogue,”[9] the FCA actually prevents recovery of an award by a whistleblower convicted of criminal conduct related to the action. It also restricts the ability of a relator with unclean hands to collect a qui tam bounty.[10] However, while the FCA specifically provides that a prevailing relator’s attorneys’ fees are paid by the defendant, a prevailing defendant may recover reasonable attorneys’ fees only if the qui tam action was clearly frivolous, vexatious, or brought in bad faith under the FCA.[11] And, under FCA case law, qui tam defendants may not bring claims for indemnification against relators, even those who assisted in perpetrating the fraud.[12] Given these parameters, there is plenty of room for whistleblower abuses under the qui tam enforcement mechanism.[13]
The potential for similar abuses may be curtailed under the SEC’s program because it is an administrative process with limited circuit court review of the SEC’s discretionary decisions on awards.[14] SEC whistleblowers are afforded no special powers to investigate potential violations or to bring administrative or judicial enforcement actions based on violations. Thus, while the SEC’s program requires the SEC to pay whistleblowers for information from the proceeds of successful actions, the fact that the program is essentially an administrative enforcement process enables the SEC to maintain complete control of enforcement of the securities laws, including whether, when, and how to exercise its prosecutorial discretion in enforcement matters.
The decision to keep the SEC in charge reflects a legislative recognition that, while paying whistleblowers for information about violations may make economic sense, giving them Article II power to enforce the laws absent intervention or participation by the Department of Justice (“DOJ”) is a bad investment. Indeed, less than three percent of FCA recoveries and almost all adverse case law come from qui tam cases litigated without the DOJ’s involvement.[15] The SEC, on the other hand, is able to pursue its programmatic interests and enforcement goals with whistleblowers’ help, but without their interference.
As under the FCA, the SEC’s rules exclude any whistleblower convicted of a criminal violation related to the action from receiving an award,[16] and a whistleblower’s culpability or involvement in the underlying wrongful conduct is considered in determining the amount of an award.[17] The SEC’s rules also specifically bar awards to whistleblowers who obtained the information in a manner that violates federal or state criminal law,[18] and in instances where liability stems from conduct substantially directed by the whistleblower, that conduct cannot factor into the $1 million threshold for an award.[19] Like the text of the FCA, the SEC’s rules are silent on the issue of indemnification actions against whistleblowers, which leaves that issue open to interpretation.
Under the FCA, the entire qui tam complaint is kept under seal until DOJ either intervenes or seeks court approval to partially unseal the complaint to seek the defendant’s comments―a cumbersome process. Although the SEC’s rules permit a whistleblower to submit information anonymously,[20] these confidentiality provisions are focused on the whistleblower’s identity and thus their effect on litigation and settlement is more limited than the FCA’s broad seal requirements, which should allow for better communication between the SEC and target companies. Both the FCA and the SEC broadly protect whistleblowers from retaliation.[21]
The Commission’s rules do not include any provision for attorneys’ fees, which is an issue that is frequently disputed under the FCA’s fee-shifting provision. Instead, the SEC leaves the issue of attorneys’ fees to state bar authorities and to contractual arrangements between whistleblowers and their attorneys.[22]
Eligibility to Receive an Award under the SEC’s Whistleblower Program
The SEC’s rules require whistleblowers to follow certain procedures in order to qualify for an award. Specifically, to be eligible for an award under the SEC’s program, (1) a “whistleblower” (2) must “voluntarily provide” the Commission (3) with “original information” about possible violation of the securities laws (4) that “leads to a successful enforcement action” (5) resulting in “monetary sanctions” of more than $1 million. While the SEC program eligibility requirements differ from the FCA in a number of respects, it is worth noting at the outset that enforcement of the SEC’s eligibility requirements will be left to the SEC. Unlike the FCA, where defendants have the ability to contest the bona fides of a qui tam relator, there is no such vehicle for testing whistleblower eligibility under the SEC program.
1. “Whistleblower”
The SEC defines a “whistleblower” as an individual who, alone or jointly with others, provides the Commission with information relating to a “possible violation” of the securities laws.[23] Whereas virtually any person or entity (other than a former or present member of the Armed Forces)[24] can be a qui tam relator under the FCA, the SEC’s program expressly excludes a company or other entity from eligibility as a whistleblower.[25] A “possible violation” under the SEC’s rules broadly encompasses a violation that “has occurred, is ongoing, or is about to occur.”[26]
a. Summary of Eligibility Exclusions
Section 21F specifically excludes any whistleblower who acquired the information submitted to the SEC through employment at
- “an appropriate regulatory agency,”
- the DOJ,
- the Public Company Accounting Oversight Board (“PCAOB”),
- a self-regulatory organization, or
- a law enforcement organization.[27]
It also excludes anyone convicted of a criminal violation related to the action that would otherwise be the basis for an award,[28] or one who gained the information through an audit required under the securities laws.[29]
The SEC incorporates all of these exclusions into its eligibility rules, adding seven additional exclusions.[30] For example, the rules exclude a person―including close relatives―who acquired the information as an employee at the Commission.[31] They also exclude members, officers, or employees of a foreign government or a foreign regulatory authority,[32] and a person who makes or uses false or fraudulent statements with the intent to mislead or hinder the Commission.[33]
In addition, as further explained below, the rules exclude as not “voluntarily provided” whistleblower submissions that are made after a request by certain specific authorities (such as the SEC, Congress, federal authorities, state attorneys general, or state securities regulatory authorities).[34] They also exclude information that is not considered “original information” because of the individuals (e.g., attorneys, company principals, accountants) who acquired it and the circumstances under which it was gathered.[35]
b. Specific Exclusions for Submissions by Government Employees and Whistleblowers with a Preexisting Duty to Report Violations to the SEC
Under the FCA, there is no express prohibition against awards to government employees or those with a preexisting duty to report fraud, such as in-house counsel, auditors, and compliance officers.[36] Indeed, while the government has argued vigorously against awards to government employee whistleblowers, many courts have continued to allow recoveries to government employee relators.[37] In United States ex rel. Fine v. Chevron, U.S.A., Inc., the government argued that permitting employees of the Office of the Inspector General to act as relators created undesirable incentives:
To spend work time looking for personally remunerative cases . . . rather than doing their assigned work; to conceal information about fraud from superiors and government prosecutors so that they can capitalize on it for personal gain; to race the government to the courthouse to file ongoing audit and investigatory matters as qui tam actions before those cases have been sufficiently developed by the government to justify a lawsuit, thus prematurely tipping off the target, undermining the likely effectiveness of the case, and diverting unnecessarily up to 30% of the government’s recovery to the government employee; and to use the substantial powers of the federal government conferred upon public investigators . . . to advance their personal financial interests . . . . Public confidence in the integrity and impartiality of government audits and investigations will necessarily decrease.[38]
Rather than leaving this critical issue vague or unresolved, Section 21F of the Dodd-Frank Act expressly denies awards to anyone who was an employee of “an appropriate regulatory agency,” the DOJ, the PCAOB, a law enforcement organization, or a self-regulatory organization at the time the information was acquired. This reflects an effort to maintain the integrity of the government’s regulatory process by barring those in charge of that process from pursuing personal monetary gain or adopting conflicting roles.
While the SEC rules incorporate these exclusions, the SEC’s definition of an “appropriate regulatory agency” narrows them so that there is no blanket exclusion for all government employees engaged in doing their jobs. Specifically, the rules define an “appropriate regulatory agency” as:
the Commission, the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and any other agencies that may be defined as appropriate regulatory agencies under Section 3(a)(34) of the Exchange Act (15 U.S.C. 78c(a)(34)).[39]
This definition includes government employees in certain agencies who would be expected to investigate or report conduct that could violate the securities laws to the Commission, but it does not extend to all personnel who investigate underlying conduct that may give rise to violations. For example, the SEC’s program does not exclude employees at EPA or FDA, which regulate conduct that may give rise to or be relevant to a securities law violation.
2. A Submission Must Be “Voluntarily Provided”
In order to be eligible for an award, the SEC whistleblower’s submission must be “voluntarily provided,” meaning that it must be made before a request by certain authorities. Submissions by whistleblowers who are subject to certain preexisting legal duties are also excluded on this basis. The SEC’s “voluntarily provided” exclusion focuses on the person to whom a request was directed, the authorities making the request, the type of request made, the type of preexisting duty owed, and the authority to whom the preexisting duty is owed. Even so, these parameters may not be sufficient to avoid some of the conflicts that occur under the FCA.[40]
a. Before a Request
In order to be “voluntarily provided,” the whistleblower’s submission to the Commission must be made before a request, inquiry, or demand:
- by the Commission,
- in connection with an investigation, inspection, or examination by the PCAOB, a self-regulatory organization, or
- in connection with an investigation by Congress, any authority of the federal government, a state Attorney General or state securities regulatory authority.[41]
This exclusion is limited in several ways. First, it contains a narrow list of authorities whose requests require exclusion. Second, while a subpoena is not required for the exclusion to apply and any request or inquiry by the Commission triggers the exclusion, requests from the PCAOB and self-regulatory organizations are subject to a broader exclusion than other federal and state authorities, whose requests must be investigatory for the exclusion to apply. Third, rather than treating a request to an employer as directed to all employees, the request must be made to the whistleblower or a representative.[42] Importantly, an employee contacted for information during the course of an internal investigation is not automatically excluded from voluntarily providing the information to the Commission.
b. Preexisting Legal Duties
Submissions by individuals under certain preexisting legal duties are not considered “voluntary” under the rules.[43] Again, this list of excluded duties is narrow, covering a duty to report to the Commission, but not a duty to report information to an authority other than the Commission. Instead, where other authorities are concerned, the exclusion issue is governed by the whistleblower’s contractual duty to those authorities.[44]
3. “Original Information”―Requirements, Exclusions, and Exceptions
The whistleblower must provide factual “original information” to be eligible for an award, meaning that the information must:
- come from the whistleblower’s “independent knowledge” or “independent analysis,”
- not already be known to the Commission (unless the whistleblower is the “original source” of the information), and
- not be “exclusively derived from an allegation made in a judicial or administrative hearing, in a governmental report, hearing, audit, or investigation, or from the news media, unless the whistleblower is a source of the information.”[45]
This information must be provided after July 21, 2010 (the date that the Dodd-Frank Act became law).[46]
a. “Independent Knowledge” and “Independent Analysis”
The SEC defines “independent knowledge” as factual information gained from the whistleblower’s experiences, communications, and observations that is not derived from publicly available sources.[47] “Independent analysis” is defined as the “examination and evaluation of information that may be publicly available, but which reveals information that is not generally known or available to the public.”[48] These requirements focus on the type of knowledge and analysis that would be valuable to the Commission, rather than unduly restricting the sources of publicly available information as the 2010 amendments to the FCA’s public disclosure provision have done. They differ from the FCA (prior to its amendment in 2010) in that the FCA required an “original source” to have both “direct and independent knowledge” of the information, and courts generally defined “direct” as first-hand. There is no such direct, first-hand knowledge requirement under the SEC’s definition of “original information,” which allows for information that is based on the whistleblower’s experience or analysis.[49]
Whistleblowers whose information derives from allegations in hearings, government reports, and the news media are specifically excluded under the SEC’s rules, but only if their information was “exclusively derived” from those sources. The SEC does not limit this bar to federal sources, as the FCA’s public disclosure bar now provides.[50] However, the SEC’s “exclusively derived” test may be easier for whistleblowers to skirt than the “substantially the same allegations or transactions” language that triggers the FCA’s public disclosure bar and the claim-by-claim assessment required under it.
b. Attorneys
While the FCA has no express prohibition against qui tam suits brought by attorneys, at least one court has dismissed a qui tam action based on attorney-client privileged information in an FCA case.[51] The SEC’s rules specifically exclude attorneys who obtain their information through legal representation of a client[52] or through attorney-client privileged communications,[53] unless disclosure is permitted under the Commission’s attorney conduct rules, state bar rules, or otherwise.[54] The purpose of these exclusions is to
send a clear, important signal to attorneys, clients, and others that there will be no prospect of financial benefit for submitting information in violation of an attorney’s ethical obligations.[55]
These exclusions apply to both attorneys and non-attorneys (if the non-attorney learns the information through a confidential attorney-client communication),[56] and they apply to all counsel―whether retained or working in-house.[57] The exclusions do not apply, however, if disclosure of the information is permitted under SEC Rule 205.3,[58] state statutes or state bar rules, or if disclosure is permitted through a waiver of the attorney-client privilege.
c. Other Exclusions
While the SEC excludes information gathered in violation of federal or state criminal law,[59] the FCA has no provision that protects the information gathering process from criminal conduct. Nor does the FCA exclude company principals, employees, or those retained by the company to investigate violations from bringing a qui tam suit. The SEC specifically excludes―from the definition of “original information” that derives from “independent knowledge or independent analysis”―information gathered by certain individuals:
- officers, directors, trustees, or partners who receive the information through the company’s internal compliance process,[60]
- employees whose principal duties involve compliance or internal audit responsibilities,[61]
- those retained to investigate possible violations of law,[62] and
- employees and persons associated with a public accounting firm who learn the information through an engagement required under the securities laws.[63]
An exception to these exclusions threatens to swallow the rule―that is, an excluded individual is able to become a whistleblower if at least 120 days have passed since the individual either provided the information through the company’s internal reporting system or received it in circumstances indicating that the company was aware of it.[64] In that case, the 120-day period is a beginning point for the whistleblower rather than a time limit. A second exception allows an excluded individual to become a whistleblower if he has a reasonable basis to believe that disclosure is necessary to prevent conduct likely to cause substantial injury to the financial interest or property of the entity or investors.[65] Finally, the individual may be a whistleblower if he has a reasonable basis to believe that the entity is engaging in conduct that will impede an investigation.[66]
4. Information That Leads to Successful Enforcement
The SEC’s rules lower the standards that were originally proposed for assessing the requirement that the whistleblower’s original information “leads to successful enforcement.” Under the standards adopted in the final rules, the Commission will consider this requirement to be met where: (1) “sufficiently specific, credible, and timely” original information caused the staff to commence an investigation, reopen a closed investigation, or inquire into different conduct in a current examination or investigation; or (2) original information “significantly contributed” to the success of an action already under examination by the Commission, Congress, a federal government authority, state Attorney General or securities regulatory authority, self-regulatory organization, or the PCAOB.
While the “sufficiently specific, credible, and timely” standard in (1) and the “significantly contributed” standard in (2) are lower than the standards originally proposed,[67] they nevertheless prevent whistleblowers from sharing in the government’s recovery when they provide no valuable or new information on allegations or transactions that the government is already investigating. That is far different from the FCA regime, where, under the First Circuit’s interpretation of the “original source” standard in United States ex rel. Duxbury v. Ortho Biotech Products, L.P., despite the government’s vigorous arguments to the contrary, a qui tam relator would face no such bar.[68] The SEC’s “significantly contributed” and “specific, credible and timely” standards are more direct and effective than the FCA’s “materially adds” standard in preventing parasitic suits while encouraging whistleblowers to provide their information about fraud to the government prior to the government’s initiation of an investigation.
5. Monetary Sanctions of Over $1 Million in an Action
The whistleblower’s award is based on the SEC’s collection of monetary sanctions of over one million dollars in an enforcement action. Monetary sanctions are defined under the SEC’s rules as money, penalties, disgorgement, and interest ordered to be paid as a result of the action, including money deposited into a disgorgement fund as a result of a Commission action or pursuant to Section 308(b) of the Sarbanes-Oxley Act.[69] The rules define “action” as a single captioned judicial or administrative proceeding brought by the Commission.[70] The SEC revised its proposed rules to provide that the Commission will treat additional proceedings as an “action” if they arise out of “the same nucleus of operative facts.”[71] Thus, the award could cover allegations that were not included in a whistleblower’s original disclosure under the SEC’s program.[72] The $1 million dollar threshold may also create some interesting incentives for the SEC, particularly for cases valued at approximately that amount. For instance, if the SEC had the opportunity to settle an action for $950,000 rather than $1 million, the argument could be made that the SEC would be “better off” opting for the $950,000 settlement which it would not have to share with the whistleblower, rather a $1 million settlement that could result in lower net recovery to the SEC after accounting for the whistleblower award.
SEC Whistleblowers Are Encouraged to Report Misconduct Internally
The issue of whether whistleblowers should be required to exhaust internal reporting procedures before reporting possible violations to the SEC was hotly contested prior to the final rules, with business interests in favor of the requirement and whistleblower advocates opposed.[73] Although the SEC decided not to require whistleblowers to report internally, the rules provide incentives for doing so. For example, the whistleblower’s use of internal reporting processes is one of the factors considered in determining the amount of an award.[74] Also, a whistleblower may establish his “place in line” in the SEC’s whistleblower program as the date he reported the conduct internally (provided he also notified the Commission of the conduct within 120 days of the internal report).[75] And, if the company self-reported violations to the SEC after the whistleblower reported them internally, the whistleblower is given credit for the self-reported information in addition to his own submission.[76]
Appeal and Review
Under Section 3730(d) of the FCA, neither the determination of whether to pay an award to the relator nor the amount of the award is a discretionary decision by DOJ, and contentious disputes between DOJ and relators have arisen in relators’ share determinations.[77] In contrast, the potential for such disputes under the SEC’s program is limited because of the broad SEC discretion in making awards, and because the whistleblower’s right to appeal the SEC’s decisions is limited.
Section 21F gives the SEC discretion to make any determination under its program, including whether to make an award, to whom, and in what amount.[78] Although the statute establishes the range for an award as from 10 to 30 percent and provides criteria for determining the amount of an award, Section 21F also expressly states that the Commission’s decision on the amount of an award may not be appealed if the award falls within the statutory mandate,[79] effectively creating a “safe harbor” in which awards within the statutory range are unreviewable.[80] If the SEC exercises its discretion to provide no award under the program, that determination is subject to U.S. Circuit Court review.[81]
Conclusion
The SEC has reported that it “successfully resolved” 92 percent of the 681 enforcement cases it brought in 2010.[82] The Commission estimates that it will receive 30,000 tips each year as a result of its whistleblower program.[83] Time will tell whether the anticipated volume of tips will actually occur and whether the SEC’s past success rate will keep pace. If so, the SEC’s whistleblower program could continue unchanged. However, Section 21F also requires the SEC’s Inspector General to assess a number of aspects of the program, including whether Congress should consider allowing whistleblowers who use the SEC’s program to bring suit on behalf of the government and themselves.[84] In other words, Congress could still authorize qui tam enforcement of the securities laws, and the SEC’s efforts to eliminate the abuses seen under the FCA’s qui tam enforcement mechanism could still be thwarted. The SEC Inspector General’s report is due in January 2013.
Meanwhile, the SEC is in the process of establishing and staffing its Whistleblower Office in anticipation of a large number of quality tips. Companies should be prepared for a dramatic increase in internal investigations, and should ensure that their compliance programs are ready to receive and promptly react to internal reports of misconduct.
* Douglas W. Baruch is a litigation partner resident in the Washington, D.C. office of Fried, Frank, Harris, Shriver & Jacobson LLP. Mr. Baruch specializes in defending companies and individuals accused of violations of the civil False Claims Act. Mr. Baruch also regularly represents companies in internal investigations of allegations which raise the prospect of civil False Claims Act liability or disclosure obligations under the FAR Mandatory Disclosure rules.
** Nancy N. Barr is a litigation staff attorney at Fried, Frank, Harris, Shriver & Jacobson LLP. Ms. Barr also contributes to the treatise of John T. Boese, Civil False Claims and Qui Tam Actions (Wolters Kluwer Law & Business) (4th ed. 2011).
[1] The SEC promulgated its whistleblower program under Section 21F of the Securities Exchange Act of 1934, 15 U.S.C. 78u-6 (“Section 21F”), which was added by Section 922 of the Dodd-Frank Act. See Dodd-Frank Act, Pub. L. No. 111-203, 124 Stat. 1376, §921 (2010).
[2] The SEC’s final rules (“SEC Rules”) are to be codified in 17 C.F.R. Parts 240 and 249. Prior to codification, the rules can be found in the SEC’s adopting release. See Securities Whistleblower Incentives and Protections, 76 Fed. Reg. 34300 (June 13, 2011) (“SEC Adopting Release”).
[4] See S. Rep. No. 111-176, at 111 (2010); Tax Relief and Health Care Act of 2006, Pub. L. No. 109-432, §406, 120 Stat. 2958 (2006).
[5] The SEC issued proposed rules to implement its whistleblower program on November 3, 2010. See Proposed Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, SEC Release No. 34-63237 (Nov. 3, 2010); 75 Fed. Reg. 70488 (Nov. 17, 2010) (“SEC Proposing Release”).
[7] See John T. Boese, Civil False Claims and Qui Tam Actions (Wolters Kluwer Law & Business) (4th ed. 2011) § 1.01[A] (hereinafter “BOESE”).
[12] See, e.g., Mortgages, Inc. v. U.S. Dist. Court of Nev., 934 F.2d 209 (9th Cir. 1991) (dismissing defendants’ counterclaims against relators and finding no right of action under the FCA for indemnification to “ameliorate the liability of wrongdoers by providing defendants with a remedy against a qui tam plaintiff with ‘unclean hands’”).
[13] See, e.g., United States ex rel. Cafasso v. General Dynamics C4 Sys., Inc., No. CV06-1381-PHX-NVW, 2009 WL 3723087, at 6 (D. Ariz. Nov. 4, 2009) (finding that “every principle of substantive and procedural law cut against Cafasso’s self-help discovery tactic”); United States ex rel. Rigsby v. State Farm Ins. Co., No. 1:06-CV-0433 LTS-RHW, 2008 WL 2130314 (S.D. Miss. May 19, 2008) (finding that relators had “purloined” documents from the employer’s files, that the consulting arrangement between the relators and their attorney was a sham, and ruling that stolen documents could not be introduced into evidence unless produced in discovery). Some relators have been shown to be untrustworthy even by their own counsel. See United States v. Resnick, No. 05CR9-1 (N.D. Ill. July 2, 2010) (order requiring MFCU to turn over relator’s share of qui tam award to relator’s counsel pursuant to stipulation in garnishment proceeding).
[15] See Boese, § 1.04[H] n. 99 (“The vast majority of qui tam recoveries . . . came from cases with federal government intervention”).
[20] SEC Rule 21F-7(b). Under Rule 21F-7(a), disclosure of the whistleblower’s identity and submission is allowed in certain circumstances, including disclosure to a defendant as required in a federal court or administrative action, or, when the Commission determines it is necessary, disclosure to DOJ or other regulatory authorities.
[21] For a discussion of how the SEC’s retaliation provisions compare to the FCA’s provisions, see FraudMail Alert No. 11-06-27 available at http://friedlive.icvmgroup.net/siteFiles/Publications/Fried%20Frank%20FraudMail%20Alert®%20No.%2011-06-27.pdf.; FraudMail Alert No. 11-06-30, available at http://friedlive.icvmgroup.net/siteFiles/Publications/Fried%20Frank%20FraudMail%20Alert%20No.11-06-30.pdf.
[36] See, e.g., X Corp. v. Doe, 805 F. Supp. 1298 (E.D. Va. 1992), aff’d sub nom. Under Seal v. Under Seal, 17 F.3d 1435 (4th Cir. 1994) (in-house corporate counsel allowed to use privileged information to bring qui tam case against his client).
[37] See, e.g., United States ex rel. Maxwell v. Kerr-McGee Oil & Gas Corp., 540 F.3d 1180 (10th Cir. 2008) (government auditor allowed to bring qui tam case); United States ex rel. Williams v. NEC Corp, 931 F.2d 1493 (11th Cir. 1991) (Air Force attorney allowed to bring qui tam case); United States ex rel. Hagood v. Sonoma County Water Agency, 929 F.2d 1416 (9th Cir. 1991) (government attorney who was counsel to Corps of Engineers brought qui tam suit). Other courts have used the “original source” bar to dismiss qui tam cases brought by government employees. See, e.g., United States ex rel. Biddle v. Board of Trs. of the Leland Stanford, Jr. Univ., 161 F.3d 533 (9th Cir. 1998) (government employee obliged to alert superiors to wrongdoing by contractor could not “voluntarily” provide information to the government for purposes of bringing a qui tam suit); United States ex rel. Schwedt v. Planning Research Corp., 39 F. Supp. 2d 28 (D.D.C. 1999) (same).
[39] SEC Rule 21F-4(f). The SEC’s rules define “an appropriate regulatory authority” more broadly as a regulatory agency other than the Commission in connection with other exclusions (a preexisting duty or a prior request for information) under the “voluntarily provided” requirement. See SEC Rule 21F-4(g).
[40] See, e.g., United States ex rel. Maxwell v. Kerr-McGee Chem. Worldwide, LLC, No. 04CV01224-PSF-CBS, 2006 WL 1660538, at *3, 6–7 (D. Colo. June 9, 2006) (government employee who obtains information about fraud in scope of employment and is required to report it is a “person” under FCA), rev’d on reconsideration, 486 F. Supp. 2d 1217 (D. Colo. 2007) (government employee relator’s disclosure to government was not “voluntary”), rev’d and remanded, 540 F.3d 1180, 1184 (10th Cir. 2008) (“1986 amendments allow suits based on…information [already known to the United States] as long as it is not publicly disclosed, and therefore do not prevent federal employees from acting as relators”).
[43] SEC Rule 21F-4(a)(3) excludes those who:
are required to report [their] original information to the Commission as a result of a preexisting legal duty, a contractual duty that is owed to the Commission or to one of the listed other authorities set forth in paragraph (1) of this section, or a duty that arises out of a judicial or administrative order.
[44] For example, disclosures by a person under a cooperation or similar agreement with DOJ which requires the person to report to the Commission are excluded. SEC Adopting Release, 76 Fed. Reg. 34309. The Commission specifically noted that, although Congress expressly declared certain categories of whistleblowers to be ineligible as a result of preexisting duties, the definition of the term “voluntarily” was left up to the Commission. Id. at 34309 & n. 85. By defining the term “voluntarily” narrowly, the rules narrow the statute.
[49] See SEC Rule 21F-4(b)(3). See also SEC Adopting Release, 76 Fed. Reg. 34312 & n. 104 (citing 31 U.S.C. §3730(e)(4), United States ex rel. Fried v. West Indep. School Dist., 527 F.3d 439 (5th Cir. 2008), and United States ex rel. Paranich v. Sorgnard, 396 F.3d 326 (3d Cir. 2005)). The Commission’s proposing release described a Freedom of Information Act (“FOIA”) response as “generally available to the public” and therefore not a basis for “independent knowledge.” See SEC Proposing Release, 75 Fed. Reg. 70492. This view is consistent with the Supreme Court’s recent decision interpreting the word “report” in the FCA’s public disclosure provision to include responses to FOIA requests. See Schindler Elevator Corp. v. United States ex rel. Kirk, 131 S. Ct. 1885 (2011).
[50] See Patient Protection and Affordable Care Act, Pub. L. No. 111-148, § 10104(j), 124 Stat. 119, 901-02 (2010) (amending 31 U.S.C. § 3730(e)(4)) (“PPACA”).
[51] See United States ex rel. Fair Lab. Practices Assocs. v. Quest Diagnostics, Inc., 2011 Wl 1330542 (S.D.N.Y. Apr. 5, 2011).
[58] SEC Rule 205.3 permits attorneys to disclose confidential information to the Commission (1) to prevent the issuer from committing a material violation likely to cause substantial injury to financial or property interests of the issuer or investors, (2) to prevent perjury in a Commission investigation or proceeding, or (3) to correct a material violation by the issuer that caused or may cause substantial injury to financial or property interests of the issuer or investors. See SEC Adopting Release, 76 Fed. Reg. 34314 & n. 119.
[68] 579 F.3d 13 (1st Cir. 2009) (holding that, despite the government’s long-standing investigation of fraud allegations and multiple public disclosures about it, the timing of relator’s qui tam filing was not a factor to be considered under the FCA’s “original source” standard). See FraudMail Alert No. 10-02-23, available at http://friedlive.icvmgroup.net/siteFiles/Publications/4828E492A22CA9C8657B60F8366AF296.pdf; FraudMail Alert No. 09-08-19, available at http://friedlive.icvmgroup.net/siteFiles/Publications/7C08F71E1BFBB2C1F7FC02728F4F6F2F.pdf. The PPACA amendments to Section 3730(e)(4) do not fix this problem in the FCA’s public disclosure bar because they continue to allow the relator this option in addition to the option of reporting the fraud prior to a public disclosure.
[72] Cf. Rockwell Int’l Corp. v. United States ex rel. Stone, 549 U.S. 457 (2005) (barring claims by relator who was not an “original source” of publicly disclosed allegations because he did not have direct and independent knowledge of the allegations in the government’s amended complaint).
[73] See FriedFrank SECMail No. 11-06-21, Living with the SEC’s Whistleblower Rules, at 3 (issued June 21, 2011) (“SECMail No. 11-06-21”), available at http://www.friedfrank.com/index.cfm?pageID=25&itemID=6386.
[75] SEC Rule 21F-4(c)(3). The 120-day “grace period” for whistleblowers is not intended to be a deadline for companies to self-report to the Commission. In his statement in support of the Staff’s recommendation on this issue, Director of Enforcement Robert Khuzami explained that
the 120-day grace period applies only to whistleblowers, and that the final rules do not change the fact-based analysis that each entity should conduct when considering whether and when to report potential securities violations to the Commission. We will continue to expect companies to self-report on a timely and responsible basis.
In practice, this 120-day period could dramatically limit the window of time that companies have in which to complete the process of conducting thorough internal investigations into the alleged conduct and considering whether to self-report it to the SEC. See SECMail No. 11-06-21, at 5–6.
[77] See, e.g., United States ex rel. Marchese v. Cell Therapeutics, Inc., No. CV06-0168MJP, 2007 WL 4410255 (W.D. Wash. Dec. 14, 2007); United States ex rel. Merena v. SmithKline Beecham Corp., 52 F. Supp. 2d 420 (E.D. Pa. 1998).
[79] Section 21(c)(1)(A). The SEC’s rules also include factors that may be considered in increasing or decreasing the amount of an award. See SEC Rule 21F-6(a)(1)–(4); SEC Rule 21F-6(b)(1)–(3). One of these factors is whether the whistleblower reported the violation through an internal compliance system―an issue of major concern to companies that commented on the proposed rules. The SEC responded to this concern not by requiring whistleblowers to report internally before reporting to the Commission, but by making such internal reports a basis for increasing awards. In addition, whistleblowers’ interference with an internal compliance system to prevent or delay detection is a basis for decreasing awards.
Preferred citation: Douglas W. Baruch and Nancy N. Barr, The SEC’s Whistleblower Program: What the SEC Has Learned from the False Claims Act about Avoiding Whistleblower Abuses, 2 Harv. Bus. L. Rev. Online 28 (2011), https://journals.law.harvard.edu/hblr//?p=1566.
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