HedgeCo.net - On July 21, 2010, after a legislative process that included intensive lobbying by influential interest groups and a partisan minority, President Obama signed into law H.R. 4173, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). With this legislation, Congress approved the most sweeping overhaul of U. S. financial regulation since the Great Depression.
The U.S. Chamber of Commerce says the Act will require federal agencies to develop 520 rules, conduct 81 studies, and issue 93 reports. As a result of the legislation, the U.S. Treasury Department will create a Federal Insurance Office and the Federal Reserve Board will create a Consumer Financial Protection Agency, which will have an Office of Financial Protection for Older Americans and an Office of Financial Literacy. The topics the Financial Literacy Office will address include retirement planning. Other sections of the Act will revamp bank and hedge fund regulation and create a Financial Stability Oversight Council.
Investor Protection Provisions of the Act
General Purposes & Approach
While further regulations and studies are yet to be developed under the Act, the Investor Protection Provisions aim generally to protect investors, foster efficient and competitive markets, and enable the best services to investors. A fundamental purpose is to address areas identified as adversely impacting investors during the 2008 and 2009 credit and financial crisis. To better protect investors, the Act focuses primarily on enhanced SEC regulatory authority and penalty imposition with respect to financial institutions, securities brokers and dealers, and investment advisers.
With respect specifically to investment advisers, the Investor Protection Provisions generally first empower the SEC to gather and monitor from such advisers additional information regarding financial products sold, trading strategies, fee and commission structures and related matters. Second, they authorize expanded SEC examinations of, and enforcement protocols against, investment advisers, including imposition of civil penalties. Additional provisions include prohibitions against improper credit (margin) extension to investors.
A. Disclosure & Oversight Provisions
The Act amends the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940 and establishes an Investor Advisory Committee to advise and consult with the SEC on (1) regulatory priorities and issues regarding new products, trading strategies, fee structures, and the effectiveness of disclosures; (2) initiatives to protect investor interests; and (3) initiatives to promote investor confidence in the integrity of the financial marketplace.
Observation: To enforce the new disclosure rules, the SEC is authorized to gather information, communicate with investors or other members of the public, and engage in temporary or experimental programs in the public interest or for the protection of investors.
The SEC is also directed to establish a standard of conduct or fiduciary duty for brokers, dealers, and investment advisers to act, without regard to their own financial or other interests, in the best interests of the customer when providing personalized investment advice about securities to a retail customer.
Additionally, the SEC is required to:
- Publish a study that examines the nature of “retail customers,” the range of products and services sold to them, the sellers or providers, and information such customers should receive before their purchase of investment products or services; and, following completion of this study, promulgate rules requiring that the appropriate persons or entities provide designated documents or information to retail customers prior to the purchase of identified investment products or services.
- Report to Congress on the need for enhanced examination and enforcement resources for investment advisers, and regarding the regulation and oversight of financial planning.
B. Enforcement and Remedies
The Act authorizes the SEC to restrict or prohibit mandatory dispute arbitration affecting customers or clients of brokers and dealers, including municipal securities dealers, and requires reporting to Congress on the costs of arbitration related to the Financial Industry Regulatory Authority as overseen by the SEC. The Act also expands incentives and protections for so-called whistleblowers and funding to the SEC to pay awards to whistleblowers as well as to provide investor education initiatives to help investors protect themselves against securities fraud or other violations of securities laws and regulations.
Observation: The Act also broadens the regulation of brokers, dealers, municipal securities dealers, transfer agents, and investment advisers, to revise requirements for collateral bars or suspensions in the case of persons associated, or seeking to be associated, with any who are subject to penalties for specified offenses. The Investment Advisers Act of 1940 is also broadened with regard to liability of, and prosecution and penalties for, persons who aid or abet violations of that act.
Enhanced SEC enforcement and remedies also include:
(1) Expanded deadlines and procedures for completing compliance examinations, inspections, and enforcement actions for violations of securities laws; (2) nationwide service of subpoenas; (3) imposition of civil penalties in cease and desist proceedings; (4) enforcement authority over any person who at the time of the alleged misconduct was a member or employee of specified bodies (formerly associated persons); (5) the sharing of privileged information with other authorities; (6) increased access to grand jury information; (7) recklessness as an element of the aiding and abetting standard of knowledge; and (8) SEC extraterritorial jurisdiction with respect to antifraud activities.
- Requirements for the fidelity bonding of registered management companies.
- Reasonable periodic, special or other information and document requests by SEC representatives conducting surveillance or risk assessments of all securities markets, national securities exchanges, their members, brokers or dealers who transact a business in securities through the medium of any such member, SEC-registered securities associations, registered brokers or dealers and municipal securities dealers, registered securities information processors, registered transfer agents, and other persons.
- Record-examination requirements for registered investment companies, and each underwriter, broker, dealer, or investment adviser that is a majority-owned subsidiary of such a company.
- Provision that any person who controls a person liable for a violation is also jointly and severally liable to the SEC in certain actions it may bring.
- Extension of SEC rulemaking authority to prescribe rules for proxy access by shareholders.
Observation: Section 413 of the Act excludes a primary residence from an investor’s net worth for purposes of determining “accredited investor” status under Rule 501(a)(5) of the SEC’s private placement safe harbor in Regulation D. This exclusion, immediately effective upon enactment without any further action by the SEC, will make it more difficult for natural persons to qualify as accredited investors. Issuers and other participants in private placement transactions should review their disclosure and subscription documents immediately and make necessary changes to conform to the new standard.
Also regarding Section 413, it has been reported that the staff of the SEC is expressing informally its view that, in determining an individual’s net worth for such purposes, the amount of mortgage or other indebtedness secured by the investor’s primary residence – to the extent such indebtedness does not exceed the value of the residence – does not need to be considered as a liability, but where the indebtedness secured by the primary residence exceeds the value of the residence and the lender has other recourse against the investor, the excess should be deducted from the investor’s net worth.
Observation: The Act addresses manipulative and deceptive devices, and (1) makes it unlawful for any person to effect, accept, or facilitate a transaction involving the loan or borrowing of securities in contravention of SEC rules and regulations; (2) imposes requirements for the reporting of lost and stolen securities to include canceled securities or any other category the SEC may prescribe; (3) requires fingerprinting of partners, directors, officers, and employees of registered securities information processors, national securities exchanges, and national securities associations; and (4) declares void any condition, stipulation or provision binding any person to waive compliance with the rules of a self-regulatory organization.
Further, the Act:
- Revises the prohibition against unlawful credit extension (margin lending) to customers.
- Extends the definition of “interested person” to any natural person who is a member of a class of persons the SEC determines are unlikely to exercise an appropriate degree of independence due to (1) a material business or professional relationship with a company or any affiliated person of such company or (2) a close familial relationship with any natural person who is an affiliated person of such company.
- Repeals two current requirements dealing with execution of portfolio transactions and the lending of money or other property.
- Authorizes the SEC to limit the extent to which a registered open-end investment company may own, hold, or invest in illiquid securities or other illiquid property.
- Subjects to domiciliary state registration requirements certain mid-sized investment advisers otherwise not exempt from federal registration requirements.
- Directs the SEC to adopt a rule making it unlawful for an SEC-registered investment adviser to have custody of funds or securities of a client the value of which exceeds $10 million, unless: (1) the funds and securities are maintained with a qualified custodian either in a separate account for each client under the client’s name, or in accounts that contain only client funds and securities under the name of the investment adviser as agent or trustee for the client; and (2) the qualified custodian does not directly or indirectly provide investment advice with respect to such funds or securities.
- Requires the SEC to revise recordkeeping requirements for each person with custody or use of a registered investment company’s securities, deposits, or credits.
- Requires the SEC to revise requirements for beneficial ownership and short-swing profit reporting.
- Requires every institutional investment manager who effects a short sale of an equity security to file daily with the SEC specified short sale disclosures and makes it unlawful to effect manipulative short sales of securities.
- Requires registered brokers or dealers to notify customers that (1) they may elect not to allow their fully paid securities to be used in connection with short sales and (2) the broker or dealer may receive compensation in connection with lending the customer’s securities.
C. SEC Funding and Organization and Additional Reforms
The Act directs the SEC to promulgate rules to collect fees annually from registered investment advisers, in order to recover the cost of inspections and examinations of such advisers. To implement this provision, the SEC is required to hire an independent consultant to examine and report to the SEC and Congress on SEC internal operations, structure, funding and the need for comprehensive reform, including the SEC’s reliance upon self-regulatory organizations for the regulation of securities matters and the protection of investors.
The SEC is also now required to report to certain congressional committees on the implementation of SEC reforms in the wake of the Madoff fraud.
Additionally, the Act directs the SEC, the Public Company Accounting Oversight Board (PCAOB), and a designated standard-setting body to provide oral testimony annually for five years to the Committee on Financial Services of the House of Representatives regarding efforts to reduce the complexity in financial reporting, in order to provide more accurate and clear financial information to investors.
On other procedural matters, the Act also:
- Directs the Comptroller General to study and report to Congress on SEC employees who leave the agency to work for financial institutions regulated by the SEC.
- Establishes a Financial Reporting Forum composed of certain senior federal agency personnel to report annually to Congress on immediate and long-term issues critical to financial reporting.
- Requires the SEC to (1) appoint an Ombudsman to act as a liaison between the SEC and any affected person who may have a problem dealing with the SEC as a result of its regulatory activities; and (2) revise its regulations to require due diligence on the part of brokers and dealers and other specified paying agents to search for lost security holders who have been sent checks for dividends, interest, and other valuable property which have not yet been negotiated.
- Revises requirements for SEC filing procedures with respect to proposed rule changes.
D. Securities Investor Protection Act Amendments
The Act amends the Securities Investor Protection Act of 1970 (SIPA) to increase: (1) the minimum assessment paid by Securities Investor Protection Corporation (SIPC) members; (2) the borrowing limit on Treasury loans; (3) the standard maximum cash advance for each customer (including an inflation adjustment); and (4) the fine for certain prohibited acts, including misrepresentation of SIPC membership or protection for investors.
Additionally, the Act:
- Amends SIPA with respect to (1) SIPC trusteeship in liquidation proceedings; (2) insider ineligibility for SIPC advances; and (3) futures held in a portfolio margin securities account.
- Revises requirements for determining whether a SIPC member qualifies for SIPC use of the direct payment procedure to satisfy customer claims without a liquidation proceeding; and increases from $250,000 to $850,000 the maximum aggregate amount of claims of all customers of a SIPC member that, among other criteria, allows SIPC to use the direct payment procedure.
- Directs the Comptroller General to study and report to Congress whether SIPC should be required to impose risk-based assessments on member brokers and dealers in order to maintain the SIPC Fund adequately and to provide additional levels of coverage on an optional basis.
E. Seniors’ Investment Protection
With regard to older investors, the Act directs the SEC to establish a program of grants to states to (1) investigate and prosecute misleading and fraudulent marketing practices and/or (2) develop educational materials and training to reduce misleading and fraudulent marketing of financial products.
F. Registration of Municipal Financial Advisors
The Act requires municipal financial advisers to register with the SEC.
Conclusion
The reports and regulations to implement the key Investor Protection Provisions of the Act will be developed over the next 6 to 18 months or longer, reflecting varying effective dates for different provisions and allowing in many cases a transition period for affected institutions to meet new requirements.
For more information, contact: swittner@eisnerllp.com
Editing by Alex Akesson
For HedgeCo.net
alex@hedgeco.net
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