First, can Dodd-Frank prevent another similar crisis? This is far from certain. The law depends too much on regulators to actually use the powers they have been granted. Past behavior suggests that they will not. And, even regulators who wish to act will have trouble completing the job of derisking and downscaling the banks to prevent collapse. Given the various advantages of being too bit to fail, we cannot expect the firms themselves to complete that task.
Second, what should we celebrate and where are the gaps? There is much to celebrate. Getting this first law enacted and to its first year, was a tremendous accomplishment. As noted yesterday, we just need more to follow in its footsteps to make up for its weaknesses. And, some parts of the statute, such as the consumer financial protection bureau deserve particular praise. However, even while the consumer protection measures are worth celebrating, it is shameful that the law fails to do more for troubled homeowners.
Let me provide an explanation for this skeptical view.Here goes. Dodd-Frank provides a number of tools to prevent banks and other financial firms from engaging in excessive borrowing and betting that result in taxpayer-funded bailouts. Some of these tools appear more effective than others. Without a doubt, many need to be strengthened. And, shadow banks that still remain outside of regulatory scrutiny need to be brought into the light. Similarly, Dodd-Frank provides strong tools to better protect consumers, but industry-funded politicians are trying to weaken this part of the law.
So what are the meltdown prevention tools? First, Dodd-Frank attempts to reduce leverage. Section 171, the “Collins Amendment,” establishes, for the first time, a cap on how much bank holding companies, thrift holding companies and nonbank financial firms (“nonbanks”) can borrow. However, the leverage cap is still too high. About $96 in borrowing for every $100 in total (non-risk-weighted) assets is allowed, and possibly as high as $97. Experts like Professor Anat Admati suggest a 15 to 20% equity cushion – or only $80 to $85 in borrowing should be permitted for every $100 in assets. Moreover, the limit does not apply to all. While banks are broadly covered, only a small number of nonbanks will be affected.Even though nonbanks include a variety of financial firms such as hedge funds, industrial loan firms and insurance companies, and though these have been prone to messy insolvencies and bailouts, they are not all covered. In fact, so far, none are. Only those nonbanks designated by the new Financial Stability Oversight Council (“FSCOC”) as systemically important financial institution (“SIFIs”) will be subject to this restriction. So far, the FSOC has not revealed the criteria by which nonbanks will be designated as SIFIs.
In addition, Dodd-Frank provides extra tools to control the borrowing and other risky activities of large bank holding companies (those with more than $50 billion in total consolidated assets) and nonbank SIFIs. Once again, only those nonbanks that get designated, and so far none have been. Under Section 165, the Federal Reserve is given the power to impose enhanced supervision and prudential standards on these companies. These “more stringent prudential standards” are supposed to “prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.”
While leverage is still too high, liquidity is barely even touched. A key weakness of the statute is the failure to deal with short-term debt. For example, it is unfortunate hat Dodd-Frank failed to roll back the special treatment in bankruptcy that repurchase agreements backed by mortgage-related collateral were granted in 2005. Policy makers and academics supported this rollback, including Florida Senator Bill Nelson, who attempted to get this into Dodd-Frank, yet his amendment never received a floor vote. There is continued support for such a roll back, including by Professor Stephen Lubben, Professor David Skeel and President of the Kansas City Federal Reserve Bank, Thomas Hoenig. Though under an FDIC “orderly resolution” there is a 24 hour hold on the safe harbors, this is not sufficient, as resolution, is hopefully rare. Many financial firms are only eligible or may otherwise end up in a Chapter 11 bankruptcy. So, this still needs fixing.
Another way the law tries to avoid another meltdown is through “early remediation.” Under Section 166, the Fed is required to take preemptive action, up to and including selling off assets of, (or breaking up) the giant bank holding companies and nonbank SIFIs. The Fed is supposed to take such action if the company experiences “increasing financial distress, in order to minimize the probability that the company will become insolvent and the potential harm of such insolvency to the financial stability of the United States.”
Dodd-Frank also attempts to limit public subsidies of private speculation through Sections 619 – 621 (the “Volcker Rule”). The Volcker Rule limits the ability of banking entities that have access to FDIC deposit insurance or the Federal Reserve discount window to also engage in certain high risk, speculative practices. This part of Dodd-Frank precludes them (subject to exceptions identified below) from owning or sponsoring hedge funds and private equity funds. It also forbids them from trading for their own accounts. Importantly, it also includes a prudential backstop, allowing regulators blanket authority to prohibit a whole host of activities if they create a threat to the financial system. This part of Dodd-Frank also prohibits firms from betting against their clients and other similar conflicts of interest.
There are notable gaps in Volcker, largely due to political expediency. In order to get 60 Senators on board and thus avoid a filibuster, it was necessary to provide a number of exemptions. One such exemption permits banks to operate or invest in hedge funds and private equity to start them up, so long as the amount of such investments does not exceed 3 percent of their Tier 1 capital. (Roughly, but not exactly, the amount left after subtracting the amount the bank owes from the value of its assets). Much of the details of this rule are unknown. Some complain that the line between permissible “market making” and impermissible “proprietary trading” will be difficult to draw. It is expected that the regulators will leave a lot of discretion to the internal compliance organizations at the covered banks to make those determinations.
And if prevention doesn’t work, Dodd-Frank sets out tools for intervention. Under Title II, the FDIC was given, subject to certain approvals, orderly liquidation authority. This encompasses the power to close down and sell off failing bank holding companies and nonbank SIFIs. Resolution authority is a third alternative – instead of the choice between a government-funded bailout (a la Bear Stearns) and a chaotic bankruptcy (such as Lehman). Whether resolution authority will be used or will be equally chaotic is a question many have raised. Some believe it will create even larger firms as they will buy up pieces of failed ones. And others express concern about whether this will work in a cross-boarder, complex financial firm.
Moreover, the funding for an FDIC resolution is first provided by the US Treasury. The taxpayers are fronting the funeral expenses. This means, if the sale of the failed firms assets are not enough to pay back Treasury, large financial firms may be asked to chip in after the fact, possibly when they are also weak. Of course, we remember that a bank-assessment to fill the orderly liquidation fund was strenuously opposed by Republicans in Congress who curiously called it a taxpayer-funded bailout.
So what to do? Prevention tools are not strong enough (and may not even be used by captured regulators) and intervention tools may be too discretionary and untested. Meanwhile, banks are still too big. The top five banks’ assets amount to 60 percent of GDP. In 1980, the top five held assets equal to only 16 percent of GDP. Perhaps we need a revival of the Brown-Kaufman “Safe Banking Act” amendment, which would have reduced bank size by limiting the total borrowing (liabilities) of any bank to no more than 3 percent of GDP. This would include amounts banks have on deposit from customers. And, it would have limited the non-deposit liabilities of any bank to no more than 2 percent of GDP. Or, better yet, perhaps we need a new Glass-Steagall, fully separating utility banking from securities operations, swaps trading and other high-risk, complex activities that are unrelated to deposit taking and credit extension.
On the consumer protection front, unmitigated praise is due for the creation and “standing up” of the Consumer Financial Protection Bureau. Though we hear repeated complaints about the weakness of Dodd-Frank, the CFPB is an example of a very strong and potentially very effective agency. That is why in the case of the CFPB, the financial services industry and sympathetic politicians in Congress are working hard to undermine it at every turn. This new agency has three major powers – rulemaking, supervision and enforcement. It will efficiently consolidate authority for numerous federal statutes related to consumer financial transactions. It also has “organic” rulemaking authority. This means it can prohibit a range of “unfair and deceptive acts or practices.” The CFPB is intended to create a level playing field and uniformity. For example, nonbanks such as payday lenders, mortgage brokers and private student lenders will now be subject to rules, oversight and enforcement.
While this part of Dodd-Frank has tremendous natural strengths, it is in a very tough environment. This is why the CFPB does not have a director. This week, the President bypassed Professor Elizabeth Warren (who initially conceived of the agency and stood it up before the transfer date) and nominated Richard Cordray, the former Ohio Attorney General. While this decision disappointed progressives, it did not mollify conservatives. A group of 44 Republican Senators have not budged. They recently vowed to block the appointment of any director of the CFPB unless the agency’s power and funding are substantially diminished.
The demands fit the acronym, “B.A.D.” Board. Appropriations. Diminished authority. They want a board and not a director to guide the agency. They want to subject the agency to the Congressional appropriations process. This would put the budget of the bureau in jeopardy based on Congressional whim. Even the expected $400 million budget is barely enough, given what industry lawyers estimate are 35,000 entities that might fall under its jurisdiction. Such lawyers have noted that the SEC has oversight over half as many firms with about three times that budget. And, the 44 wants to diminish the agency’s ability to make rules by giving the new Financial Services Oversight Counsel (FSOC) greater veto power.
Meanwhile, without a director, it may be that the Bureau is restricted from making rules in certain areas. And, some contend that the CFPB cannot supervise or bring enforcement actions against payday lenders, mortgage brokers and other nonbanks until a director is appointed. Unless the Republicans bend, there will not be enough votes in the Senate to block a filibuster. Thus, many believe that President Obama may resort to a recess appointment in August to assure that Cordray is appointed.
While Dodd-Frank via the CFPB and other provisions may help future homeowners, it does not do enough for existing homeowners who are drowning in debt. An individual who owes more on his mortgage than his home is worth is still not able to use the bankruptcy process to reduce the principal outstanding to the home’s value. Yet, a wealthier person with a vacation home can do so. And, a business with commercial real estate can as well. The bankruptcy code should have been amended long ago to fix this anomaly. The existence of the bankruptcy principal-reduction option would give all homeowners more bargaining power when they face foreclosure. Moreover helping consumers deleverage will be good for the economy and will discourage lenders in the future from using overvalued appraisals, risky mortgages, and poor underwriting standards, to extract too-big-to-pay commitments from borrowers.
In short, Dodd-Frank provides many tools for prevention and intervention. But it also has notable weaknesses. No surprise; the one-year-old law is not perfect. Yet, we should not throw the baby out with the birthday cake. We can and must do more to help this law succeed and to enact future legislation to compensate for its limitations. But, we had better act fast. As Professor Tom Ferguson notes ”the big banks are more dangerous and reckless than ever” and Admati warns that “the next crisis will happen sooner than later."
(This post and part i, initially appeared on The Pareto Commons)
]]>It is easy to point to places where Dodd-Frank falls short. Even at birth, gaps in the legislation were visible. At this young age, we can now also see gaps in how the numerous regulators are implementing the law. Yet instead of berating or abandoning this one-year-old, we should celebrate his strengths. And, we should find a way to fix the problems with strong implementing rules and additional legislation. In other words, add some siblings. It may take a family.
Previous reformers did more than lambast the limitations of a fledging statute. And, this approach paid off. For example, the New Deal era financial reforms kept us free from major panics and crashes for about fifty years. But this was not the result of a single statute. The Truth in Securities Act of 1933 was the first federal securities law. But it only covered initial offerings of securities. No problem. The following year, the Securities Exchange Act of 1934, was given life to focus on secondary market sales and the stock exchanges. Even Carter Glass had to push through two different banking laws, the Glass-Steagall Act of 1932 and The Glass-Steagall-Act of 1933, to ensure the FDIC was created and commercial banking was separated from securities operations. More securities law kin appeared in 1940 when the Investment Company Act and the Investment Advisers Act were added to address abuses in the investment trust industry and the provision of investment advice. These were concerns that arose before the Great Crash of 1929, but were not within the securities siblings’ DNA.
Back to the birthday boy. Dodd-Frank was supposed to be a doctor, created to provide bloated bank disease prevention and intervention. A challenging task. We faced a kind of debt dependency disease. While we all indulged, depending upon home prices to rise forever, when the hot air started to leak out of the $8 trillion housing bubble, the suffering began. Wall Street received trillions of dollars in bailouts, low interest loans and other “liquidity” supports when home prices reversed, but Main Street was left to suffer. Financiers gained bonuses, kept jobs and grew wealthier. The middle class lost savings, lost jobs, lost homes or saw home values plummet, and with reduced tax revenues and budgetary pressures, lost public services.
How did this happen? Many giant banks (and other financial firms) had borrowed more than $97 for every $100 of assets they owned. A 33 to 1 assets to equity leverage ratio. A decline of less than $3, or 3% percent in those assets spelled insolvency. What’s worse, a good deal of the money they borrowed was due in the very short term, sometimes overnight. But the assets they owned were very hard to sell. And, to make things even more shaky, it was not even clear that the mortgage-linked securities they loaded up on were worth the value they presented to shareholders, lender or regulators. The values of the mortgage-linked securities depended upon homeowners making their monthly mortgage payments in full and on time. And, the timely, full mortgage payments depended upon in part, the capacity of homeowners to pay, but more so, on the underlying home to increase in value.
This Ponzi scheme began to collapse after home prices began to stabilize and fall, and homeowners began to default in larger numbers. Then in the summer of 2007, many mortgage-linked securities were downgraded. This combination of extreme leverage, overvalued, illiquid assets, and maturity mismatch would put any individual borrower at risk of insolvency. When the borrowers were giant, interconnected banks and nonbank financial firms, a domino effect of failures ensued.
What ability does Dodd-Frank have to prevent another similar crisis? What should we celebrate and where are the gaps?
Answers provided in part 2.
(This post also appeared on July 21 on The Pareto Commons website).
]]>The Minority Report begins inauspiciously by noting that "[b]ubbles happen" as if the explanation is in part the inevitability of these things. Indeed, in describing bubbles, the Minority Report notes that "[t]he recent housing bubble was no different" than prior instances.
True enough that bubbles are recurring events but this particular "bubble" was anything other than ordinary. It was unique (at least since the Great Depression) in its severity and, having been particularly centered on housing, in its impact on ordinary people. The high tech boom in the late 1990s and early years of the new century also had the attributes of a bubble but one that was far less severe and painful than the current example. Had the Minority Report been describing the high tech bubble, the introduction would have been more fitting.
Much of the blame in the Minority Report for the current "bubble" is placed on Fannie Mae and Freddie Mac. See Report at 2 ("Through the GSEs [government-sponsored enterprises], FHA loans, VA loans, the Federal Home Loan Banks, and the Community Reinvestment Act, among other programs, the government subsidized and, in some cases, mandated the extension of credit to high-risk borrowers, propagating risks for financial firms, the mortgage market, taxpayers, and ultimately the financial system."). There is no doubt that Freddie and Fannie contributed to the crisis. But did they cause it? Not everyone thinks so. See Testimony of Thomas H. Stanton, Committee on Oversight and Government Reform U.S. House of Representatives, Dec. 9, 2008 ("That said, it is useful to note that Fannie Mae and Freddie Mac did not cause the housing bubble or the proliferation of subprime and other mortgages that borrowers could not afford to repay."). Pinning blame for the crisis on these pseudo-government agencies required far more thorough analysis than what appeared in the Minority Report.
As for the private sector participants, they mostly provided a positive service. See Report, at 3 ("However, important financial firms principally involved in pure credit intermediation—that is, providing the link between investors and borrowers—were exposed to the downturn as well, but did not understand the risks they were taking at the time."). Their failure? They ultimately, "did not understand the risks they were taking at the time." Report, at 4. As for credit rating agencies, they could be compared to ordinary investors and, as a result, "made many of the same mistakes as mortgage investors." As the Report sums up: "Put simply, the risk of a housing collapse was simply not appreciated. Not by homeowners, not by investors, not by banks, not by rating agencies, and not by regulators." Id. at 5.
As for the immediate cause of the crisis, here is the explanation:
Certainly the market was, by September 2008, edgy from many of the examples given in the prior paragraph. But the Minority Report more or less ignored the singular importance of the collapse of Lehman. Most of the examples mentioned in the paragraph above resulted in direct or indirect government bailouts. In other words, the crisis was largely averted as long as the government stood ready to intervene. The market was assured that despite the uncertainty, the government would step in and prevent large failures.
That belief went out the window when Lehman was allowed to fail. Only then did the financial system freeze, the interbank market effectively shut down, and commercial paper markets dried up. In other words, it was the absence of government intervention that set off the crisis. Yet the Report has little to say about this. Instead, it concludes:
There are differing views on the cause of the crisis. The debate can benefit from multiple viewpoints, as long as they are well reasoned. This Report, however, provides little insight into what actually happened and why. It provides little help to policy makers should similar circumstances arise again.
One can hope that when the Majority Report is issued in January it will provide more insightful analysis.
]]>The Act created a December 15, 2010 deadline for any report by the Commission. The deadline passed without a report by the entire Commission. This was not a surprise. A majority of the Commission had voted in November to delay the Report until sometime in January 2011.
Nonetheless, the 15th did not come and go without activity. The four Repulican members issued a Report titled "Financial Crisis Primer" presumably in an effort to meet the statutory time period. The Minority Report begins in an inauspicious manner, noting that "[b]ubbles happen."
The decision to issue the Minority Report apparently came as a surprise to the remaining members of the Commission. See FCIC Press Release, Dec. 15, 2010 (noting that "some members of the Commission made public their personal views on the financial crisis. The Commission had not previously seen or had an opportunity to review what was released today.").
The action and reaction reflect an obvious partisan divide on the FCIC. This is unfortunate. What is needed is serious reflection on the causes of the worst financial crisis since the Great Depression, not a forum for partisan discord. On the other hand, Congress gave to the majority/minority leaders in Congress the authority to appoint the members so perhaps it was to be expected that the partisan divide in Congress would likewise be reflected on the FCIC.
In the next post, we will take a look at the contents of the Minority Report.
]]>Most matters are heard by a panel of three arbitrators, two from the category of public arbitrators and one from the industry category. Some have contended that the system of arbitration is biased, although those complaints have been disputed. One recent study, however, suggests that customers continue to view the system in a more negative light. See JILL I. GROSS & Barbara Black, PERCEPTIONS OF FAIRNESS OF SECURITIES ARBITRATION: AN EMPIRICAL STUDY REPORT TO THE SECURITIES INDUSTRY CONFERENCE ON ARBITRATION, FEBRUARY 6, 2008, at 3 ("For almost every question in the survey, statistical analysis reveals that customers have a more negative perception of the process than non-customers,").
The Dodd-Frank Wall Street Reform Act addressed this issue by giving the SEC the authority to "prohibit, or impose conditions or limitations" on mandatory arbitration. While changes will have to await Commission rulemaking, reforms in the area could result in unintended consequences.
To the extent allowing securities firms to have some control over the selection of the forum, investors may find themselves unexpectedly in federal court, where the entire process can be far more expensive. Brokers confronting the possibility of significant liability would in at least some cases prefer the court system where the discovery process is far more robust (it allows, for example, the routine use of depositions). Presumably, Goldman Sachs would have preferred robust discovery in the case involving Bayou Hedge Fund where an arbitration panel ordered it to pay $20 million.
The devil will be in the details but its not automatic that investors will be better off.
The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online. Section 921 is reprinted below.
SEC. 921. AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.
(a) AMENDMENT TO SECURITIES EXCHANGE ACT OF 1934.-Section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 780), as amended by this title, is further amended by adding at the end the following new subsection:
( 0) AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.-The Commission, by rule, may
prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.
(b) AMENDMENT TO INVESTMENT ADVISERS ACT OF 1940.-Section 205 of the Investment Advisers Act of
1940 (15 U.S.C. 80b-5) is amended by adding at the end the following new subsection:
(f) AUTHORITY TO RESTRICT MANDATORY PREDISPUTE ARBITRATION.-The Commission, by rule, may
prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any investment adviser to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.
Under Regulation D, accredited investors were not entitled to any specific disclosure before purchasing their securities. Moreover, under Rules 506 and 505, securities could be marketed to an unlimited number of accredited investors (but no more than 35 non-accredited investors). Hedge funds and other risky investments could be marketed to accredited investors without needing to register the securities.
The term accredited investor applied to those making $200,000 a year or with over $1 million in assets. The definition was inserted into the securities laws in 1982, back when $1 million actually meant something. See Securities Act Release No. 6389 (March 8, 1982). The number of households with a net worth of a million dollars or more increased from 2.4 million in 1983 to 6.4 million in 2004. In short, that level of wealth can be the accumulated equity in a house, hardly the test of sophistication.
The feeble numbers have ceased, therefore, to be a good measure of sophistication, financial or otherwise. Over time, the numbers have looked increasingly feeble and not an accurate way of determining those investors who did not need the protections of the disclosure requirements of the securities laws. Nonetheless, for almost three decades, the numbers have remained unchanged.
In the absence of bureaucratic reform, Congress has stepped in, using Dodd-Frank to mandate an update of the financial standards used for accredited investors. Specifically, Section 413 requires the Commission to "adjust any net worth standard for an accredited investor" so that the net worth is at least $1 million, "excluding the value of the primary residence." This had been considered by the Commission back in 1982 but rejected. See Securities Act Release No. 6389 (March 8, 1982) ("Some commentators, however, recommended excluding certain assets such as principal residences and automobiles from the computation of net worth. For simplicity, the Commission has determined that it is appropriate to increase the level to $1,000,000 without exclusions.").
In addition, the provision encourages but does not require the Commission to immediately review the entire definition of accredited investors (for individuals). According to Section 413, the Commission may "undertake a review of the definition of the term 'accredited investor' . . . to determine whether the requirements of the definition, excluding the requirement relating to the net wolth standard . . . should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy." Such a review would presumably bring not only the net worth requirements but also the annual income tests under renewed scrutiny.
The Act does, however, require a review of the definition at least every four years to determine whether any adjustment is appropriate. While Congress stopped short of dictating standards (except for the $1 million net worth requirement, minus the primary residence, as a minimum), the mere fact that reviews take place on a regular basis is likely to result in higher net worth and income tests over time.
The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online. Section 413 is produced below.
SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.
(a) IN GENERAL.-The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net wolth of any natural person, or joint net wolth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that
begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.
(b) REVIEW AND ADJUSTMENT.-
(1) INITIAL REVIEW AND ADJUSTMENT.
(A) INITIAL REVIEW. The Commission may undeltake a review of the definition of the term "accredited investor", as such term applies to natural persons, to determine whether the requirements of the definition, excluding the requirement relating to the net wolth standard described in subsection (a), should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.
(B) ADJUSTMENT OR MODIli'ICATION. Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term "accredited investor", excluding adjusting or modifying the requirement relating to the net worth standard described in subsection (a), as such term applies to natural persons, as the Commission
may deem appropriate for the protection of investors, in the public interest, and in light of the economy.
(2) SUBSEQUENT REVIEWS AND ADJUSTMENTS
(A) SUBSEQUENT REVIEWS.-Not earlier than 4 years after the date of enactment of this Act, and not less frequently than once every 4 years thereafter, the Commission shall undertake a review of the definition, in its entirety, of the term "accredited investor", as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, to determine
whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.
(B) ADJUSTMENT OR MODIFICATION. Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term "accredited investor", as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.
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The provision was designed to ensure that the designated agencies had an office "responsible for all matters of the agency relating to diversity in management, employment, and business activities." Goals include increasing the "participation of minority-owned and women-owned businesses in the programs and contracts of the agency."
The SEC has issues with diversity, as we have noted, so an office that will be an internal advocate for increased diversity is a good idea.
The more significant impact, however, may be on industry. The SEC has already begun looking into board diversity. See Item 407(c)(2) of Regulation S-K ("Describe the nominating committee's process for identifying and evaluating nominees for director, including nominees recommended by security holders, and any differences in the manner in which the nominating committee evaluates nominees for director based on whether the nominee is recommended by a security holder, and whether, and if so how, the nominating committee (or the board) considers diversity in identifying nominees for director. If the nominating committee (or the board) has a policy with regard to the consideration of diversity in identifying director nominees, describe how this policy is implemented, as well as how the nominating committee (or the board) assesses the effectiveness of its policy").
The office has been given the responsibility for "assessing the diversity policies and practices of entities regulated by the agency." In other words, advisers and brokers, at a minimum, will have their diversity practices become subject to SEC review. To the extent that this evolves into anything other than information gathering, the results could be significant. Like boards of directors, the securities industry does not have a particularly good record when it comes to diversity. As the 2007 Report by the Securities Industry and Financial Markets Association on Workforce Diversity Reported that: "From the Associate level onward, representation of women and people of color decreases at each higher level across the survey organizations." More specifically, a recent GAO report concluded that "white males held 64 percent of senior positions [in the financial services industry] in 2008, African-Americans held 2.8 percent, Hispanics 3 percent, and Asians 3.5 percent." The report further noted that "overall diversity management-level positions did not change substantially from 1993 through 2004."
Given these numbers, it is possible that the SEC's Office of Minority and Women will provide some muscle behind increased diversity in both the Commission and the industries it supervises.
The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online. The provision creating the Office of Minority and Women is included below.
SEC. 342. OFFICE OF MINORITY AND WOMEN INCLUSION.
(a) OFFICE OF MINORITY AND WOMEN INCLUSION.-
(1) ESTABLISHMENT.-
(A) IN GENERAL.-Except as provided in subparagraph (B), not later than 6 months after the date of enactment of this Act, each agency shall establish an Office of Minority and Women Inclusion that shall be responsible for all matters of the agency relating to diversity in management, employment, and business activities. (B) BUREAU .-The Bureau shall establish an Office of Minority and Women Inclusion not later than 6 months after the designated transfer date established under section 1062.
(2) TRANSFER OF RESPONSIBILITIES.-Each agency that, on the day before the date of enactment of this Act, assigned the responsibilities described in paragraph (1) (or comparable responsibilities) to an other office of the agency shall ensure that such responsibilities are transferred to the Office.
(3) DUTIES WITH RESPECT TO CIVIL RIGHTS LAWS.-The responsibilities described in paragraph (1) do not include enforcement of statutes, regulations, or executive orders pertaining to civil rights, except each Director shall coordinate with the agency administrator, or the designee of the agency administrator, regarding the design and implementation of any remedies resulting from violations of such statutes, regulations, or executive orders.
(b) DIRECTOR.-
(1) IN GENERAL.-The Director of each Office shall be appointed by, and shall report to, the agency administrator. The position of Director shall be a career reserved position in the Senior Executive Service, as that position is defined in section 3132 of title 5, United States Code, or an equivalent designation.
(2) DUTIES.-Each Director shall develop standards for- (A) equal employment opportunity and the racial, ethnic, and gender diversity of the work-force and senior management of the agency;(B) increased participation of minority-owned and women-owned businesses in the programs and contracts of the agency, including standards for coordinating technical assistance to such businesses; and(C) assessing the diversity policies and practices of entities regulated by the agency.
(3) OTHER DUTIES.-Each Director shall advise the agency administrator on the impact of the policies and regulations of the agency on minority-owned and women-owned businesses.
(4) RULE OF CONSTRUCTION.-Nothing In paragraph (2)(0) may be construed to mandate any requirement on or otherwise affect the lending policies and practices of any regulated entity, or to re-
quire any specific action based on the findings of the assessment.
(c) INCLUSION IN ALL LEVELS OF BUSINESS ACTIVITIES.-
(1) IN GENERAL.-The Director of each Office shall develop and implement standards and procedures to ensure, to the maximum extent possible, the fair inclusion and utilization of minorities, women, and minority-owned and women-owned businesses in all business and activities of the agency at all levels, including in procurement, insurance, and all types of contracts.
(2) CONTRACTs.-The procedures established by each agency for review and evaluation of contract proposals and for hiring service providers shall include, to the extent consistent with applicable law, a component that gives consideration to the diversity of the applicant. Such procedure shall include a written statement, in a form and with such content as the Director shall prescribe, that a contractor shall ensure, to the maximum extent possible, the fair inclusion of women and minorities in the workforce of the contractor and, as applicable, subcontractors.
(3) TERMINATION.- (A) DETERMINATION .-The standards and procedures developed and implemented under this subsection shall include a procedure for the Director to make a determination whether an agency contractor, and, as applicable, a subcontractor has failed to make a good faith effort to include minorities and women in their work-force. (B) EFFECT OF DETERMINATION.- (i) RECOMMENDATION TO AGENCY ADMINISTRATOR.-UpOn a determination described in subparagraph (A), the Director shall make a recommendation to the agency administrator that the contract be terminated. (ii) ACTION BY AGENCY ADMINISTRATOR.-Upon receipt of a recommendation under clause (i), the agency administrator may--(I) terminate the contract; (II) make a referral to the Officeof Federal Contract Compliance Programs of the Department of Labor; or (III) take other appropriate action.
(d) APPLICABILITY.-This section shall apply to all contracts of an agency for services of any kind, including the services of financial institutions, investment banking firms, mortgage banking firms, asset management firms, brokers, dealers, financial services entities, underwriters, accountants, investment consultants, and providers of legal services. The contracts referred to in this subsection include all contracts for all business and activities of an agency, at all levels, including contracts for the issuance
or guarantee of any debt, equity, or security, the sale of assets, the management of the assets of the agency, the making of equity investments by the agency, and the implementation by the agency of programs to address economic recovery.
(e) REPORTS.-Each Office shall submit to Congress an annual report regarding the actions taken by the agency and the Office pursuant to this section, which shall include -
(1) a statement of the total amounts paid by the agency to contractors since the previous report;
(2) the percentage of the amounts described in paragraph (1) that were paid to contractors described in subsection (c)(I);
(3) the successes achieved and challenges faced by the agency in operating minority and women outreach programs;
(4) the challenges the agency may face in hiring qualified minority and women employees and contracting with qualified minority-owned and women-owned businesses; and
(5) any other information, findings, conclusions, and recommendations for legislative or agency action, as the Director determines appropriate.
(f) DIVERSITY IN AGENCY WORKFORCE.-Each agency shall take affirmative steps to seek diversity in the workforce of the agency at all levels of the agency in a manner consistent with applicable law. Such steps shall include--
(1) recruiting at historically black colleges and universities, Hispanic-serving institutions, women's colleges, and colleges that typically serve majority minority populations;
(2) sponsormg and recruiting at job fairs in urban communities;
(3) placing employment advertisements in newspapers and magazines oriented toward minorities and women;
(4) partnering with organizations that are focused on developing opportunities for minorities and women to place talented young minorities and women in industry internships, summer employment, and full-time positions;
(5) where feasible, partnering with inner-city high schools, girls' high schools, and high schools with majority minority populations to establish or enhance financial literacy programs and provide mentoring; and
(6) any other mass media communications that the Office determines necessary.
(g) DEFINITIONS.-For purposes of this section, the following definitions shall apply:
(1) AGENCY.-The term "agency" means-
(A) the Departmental Offices of the Department of the Treasury;
(B) the Corporation;
(C) the Federal Housing Finance Agency;
(D) each of the Federal reserve banks;
(E) the Board;
(F) the National Credit Union Administration;
(G) the Office of the Comptroller of the Currency;
(H) the Commission; and
(I) the Bureau.
It is important to note that many of the provisions are subject to future rule making, although some, such as the definition of “accredited investor” and many of the SEC enforcement provisions are also effective immediately upon enactment and effective immediately notwithstanding the fact that rule making is also required.99 The most significant provisions of the Act require studies by the SEC or the Comptroller General and the General Accounting Office (the “GAO”). In the few provisions discussed in this article, there are at least twenty provisions that require studies within the next two years or less.
Some of these studies are narrowly defined, and others will be far-reaching. In any event, there will be a significant amount of SEC and GAO staff time devoted to these studies and the anticipated rulemaking activities. As a result, the enactment of the Act should be viewed not as the end, but rather as the beginning of a significant amount of regulatory and administrative activity which will come to fruition over the next two to three years.99 Section 413 of the Act provides as follows:
Note that in mandating this definition, the Congress did not address § 2(a)(15) of the 1933 Act which contains a definition of the term “accredited investor.”
Herrick K. Lidstone, Jr., Burns Figa & Will, PC
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]]>Instead, Congress strengthened the SEC's authority to bring actions for aiding and abetting. Section 20 of the Exchange Act allows the SEC to bring an aiding and abetting claim against "any person that knowingly provides substantial assistance" to a primary violator. The requirement of actual knowledge of the violation provides a serious limit on efforts to bring actions against lower level participants in the fraud. They may have provided substantial assistance but did not actually know about the fraud.
Congress has softened this requirement in the Dodd-Frank Act by allowing actions to be brought on the basis of reckless behavior. The change will make it much easier for the Commission to bring actions against those who assist in the fraud without having actual knowledge of the scheme. Think salespeople.
Pressure for aiding and abetting liability in private actions may arise once the Supreme Court decides Janus Capital Group v. First Derivative Traders, another case that will plumb the destinction between primary and secondary liabilty. The Court recently took cert on whether an investment adviser can be liable under the antifraud provisions for participating in the drafting of the allegedly false statement where the statement was not attributed directly to the adviser. To the extent that the Supreme Court finds that those drafting false statements are not liable as primary violators, the attention will shift to Congress to address the gap in the securities laws.
SEC. 929M. AIDING AND ABETTING AUTHORITY UNDER THE SECURITIES ACT AND THE INVESTMENT COMPANY ACT. (a) UNDER THE SECURITIES ACT OF 1933.-
Section 15 of the Securities Act of 1933 (15 U.S.C. 770) is amended-
(1) by striking "Every person who" and inserting "(a) CONTROLLING PERSONS.-Every person who" and (2) by adding at the end the following:
(b) PROSECUTION OF PERSONS WHO AID AND ABET VIOLATIONS.-For purposes of any action brought by the Commission under subparagraph (b) or (d) of section 20, any person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this Act, or of any rule or regulation issued under this Act, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided."
(b) UNDER THE INVESTMENT COMPANY ACT OF 1940.-Section 48 of the Investment Company Act of
1940 (15 U.S.C. 80a-48) is amended by redesignating subsection (b) as subsection (c) and inserting after sub-section (a) the following:
(b) For purposes of any action brought by the Commission under subsection (d) or (e) of section 42, any person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this Act, or of any rule or regulation issued under this Act, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.".
SEC. 929N. AUTHORITY TO IMPOSE PENALTmS FOR AIDING AND ABETTING VIOLATIONS OF THE INVESTMENT ADVISERS ACT. Section 209 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-9) is amended by inserting at the end the following new subsection:
(f) AIDING AND ABETTING.-For purposes of any action brought by the Commission under subsection (e),
any person that knowingly or recklessly has aided, abetted, counseled, commanded, induced, or procured a violation of any provision of this Act, or of any rule, regulation, or order hereunder, shall be deemed to be in violation of such provision, rule, regulation, or order to the same extent as the person that committed such violation."
SEC. 9290. AIDING AND ABETTING STANDARD OF KNOWLEDGE SATISFIED BY RECKLESSNESS.
Section 20(e) of the Securities Exchange Act of 1934 (15 U.S.C. 78t(e)) is amended by inserting "or recklessly" after "knowingly"