DODD-FRANK: TOO MANY REGULATIONS TOO FAST?

The Dodd-Frank Act is considered by many to be the most significant piece of financial reform legislation since the securities laws were written in the 1930s. It also may well contain more directives to agencies to write new rules and conduct studies than most legislative acts. To date the SEC, CFTC and other agencies have been moving forward with a host of rule making projects. Is it to many regulations to fast?

The answer is “yes” according to The Committee on Capital Markets Regulation. The Committee has requested in a letter addressed to Senate and House leaders that each chamber hold hearings on the implementation of the Act through rule making. Essentially, the letter argues that critical new rules are being written to fast with inordinately short comment periods and, perhaps more importantly, in a somewhat piece meal fashion with an inadequate prospective on the overall issues.

The Committee on Capital Markets Regulation is a non-partisan group co-chaired by Glenn Hubbard, Dean of Columbia Business School, and John L. Tornton, Chairman of the Brookings Institute. Its Director is Hal S. Scott, the Normura Professor and Director of the Program on International Financial Systems at Harvard Law School. The letter is signed by each of these gentlemen and addressed to Senators Christopher Dodd and Richard Shelby and Representatives Barney Frank and Spencer Bachus. A copy, dated December 15, 2010, is available here

The letter begins by emphasizing the unique challenges presented by the Dodd-Frank Act. Not only does the legislation require that a large number of rules and studies be undertaken but, more importantly, the regulations to be written represent “almost a complete rewrite of the rules governing the country’s financial markets.” At the current pace of rule drafting there is simply inadequate time for businesses and individuals who will be impacted by the regulations to consider the proposals or for the agencies to frame and consider appropriate measures.

The letter goes on to make the following key points:

• Reforms: Sweeping reforms are being made through new regulations using a process which is “seriously flawed” because there is insufficient time for a meaningful dialogue.

• Number of rules per year: The average annual rate of rulemaking per year prior to Dodd-Frank for the SEC was 9.5, the CFTC 5.5, the FDIC 8 and the Federal Reserve 4.5 Post Dodd-Frank the average for the SEC is 59, the CFTC 37, the FDIC 6, and the Federal Reserve 17.

• Speed: Major rule makings traditionally have not been undertaken until the agency has extensively surveyed the landscape and gave careful consideration to the issues. During 2005 and 2006 the SEC, CFTC, Federal reserve and FDIC on average allowed more than 60 days for public comment following such a deliberative process and often 90 or 120 days. In contrast in the first three months after the passage of Dodd-Frank those same agencies and the new Financial Stability Oversight Counsel gave on average just over 30 days for comment. That period has now been expanded to an average of about 40 days. The period is to short, particularly in view of the fact that in November alone the financial regulators issued nearly 40 proposed rules.

• Drafting: The new proposals are being created essentially in bits and pieces rather than to solve a problem. Thus the letter notes that “instead of regulating in order to solve a particular problem and pursue a coordinated policy objective, regulators have been proceeding rule by rule. By treating each rule somewhat independently, and in no particular order, the results may be haphazard.”

The letter concludes by noting that while “a long period of implementation creates uncertainty, with a possible drag on the economy . . . “ what may be far worse is a bad process which produces rules that might “interfere with the proper functioning of the financial system for years to come . . .”

SEC ENFORCEMENT TRENDS 2011: MARKET REFORM

This is the second in a series of articles that will be published periodically analyzing the direction of SEC enforcement.

In recent testimony before Congress, SEC Chairman Mary Schapiro listed eight different areas in which rules had recently been adopted. They cover a variety of topics including custody and control of assets for investment advisers, proxy enhancements, short selling and failure to deliver, money market funds, central clearing for credit default swaps, credit rating agencies, pay-to-play and municipal securities disclosures. Other rules have been proposed relating topics which include asset backed securities, proxy access, large trader reporting, flash orders, sponsored access, dark pools, target date funds and an audit trail system for trading orders according to the Chairman’s testimony.

Under Dodd-Frank the SEC is required to write even more rules. That Act contains 95 provisions under which the SEC will issue rules. Those areas include swaps, investment advisers, securities lending, arbitration, credit rating agencies, securitization and corporate governance. The Act also requires the SEC to prepare seventeen reports presumably as the possible predicate for even more rules.

While many of these rules do not directly impact the enforcement division and its program, other provisions of Dodd-Frank add to its authority. Those include provisions: 1) an enhancement of the antifraud provisions under Exchange Act Sections 9, 10(1), and 15; 2) an expansion of the extraterritorial jurisdiction of the antifraud provisions; 3) extending aiding and abetting authority for the Commission under the Securities Act, the Investment Company Act and the Investment Advisers Act; 4) clarifying the SEC’s authority over formerly associated persons of regulated entities; 5) imposing joint and several liability on control persons in SEC actions; 6) authorizing nationwide service of subpoenas in SEC district court enforcement actions; 7) authorizing the SEC to impose collateral bars; and 8 ) expanding the Commission’s authority to impose penalties to all cease and desist proceedings.

While these provisions expand the authority of the enforcement division, there actual impact on its program is at present unclear. Provisions which many expect to have a far reaching impact on that program are the new whistleblower sections of the Act. Those provisions permit the Commission to pay potentially large bounties for tips which lead to successful enforcement actions. The provisions could spark a wave of tips and leads from corporate insiders on topics which range from FCPA violations to financial fraud.

While rules for the whistleblower program have been issued for comment, the vitality of the sections is in doubt. The program was to be administered by a new Associate Director of Enforcement. At present funding for that program, like others under Dodd-Frank, is in doubt. If insufficient funding is provided it could significantly impinge on its development.

Another important question is the impact of what may be a preference for rule writing by the Commission. To be sure many of the rules proposed and issued by the Commission will be beneficial. At the same time new rules are not always necessary. In some instances enforcement of those on the books is more than sufficient. The recent “window dressing” rules are an example. These arose out of reports from the Lehman Brothers bankruptcy proceedings that short term borrowings called Repo 105 were repeatedly used by the now collapsed investment bank at period end for reporting purposes. The transactions deceived investors by making it appear that the firm was far less leverage than was true. The Commission conducted a survey on the practice of “window dressing” last spring. Later in the year new disclosure rules were written.

In contrast the New York Attorney General recently brought an enforcement action against Lehman’s outside auditors centered on those transactions. The complaint charges securities fraud. It alleges that the auditors helped the firm defraud creditors by making it appear that it was far less leveraged than was true. At the heart of the case is a critical question about substance versus form in financial reporting. Lehman relied on the form of the transactions, according to the complaint, to defraud investors about the substance of its financial position.

To date the Commission has not brought such an action. Whether it will in view of the new “window dressing” rules appears doubtful. While the Commission has authorized controversial enforcement actions such as the case against Goldman Sachs, frequently this has been by a split vote of the Commissioners. The emphasis on rule writing, and in particular the new window dressing regulations, suggest that perhaps going forward the “tone at the top” may tend toward more rule writing.

Next: The reorganization of enforcement