RULE MAKING AND REPORTS BY THE SEC UNDER DODD-FRANK

By most accounts, the Dodd-Frank Wall Street Reform and Consumer Protection Act is poised for passage. The bill is being hailed as the most significant regulatory overhaul since the great depression – clearly appropriate to address the most significant economic crisis since the 1930s.

The potential impact of the 2000 page piece of legislation is difficult to discern, however. Dodd-Frank is not the end, but the beginning. In many respects, it is a blackboard on which the regulators may or will write as the bill directs. Reportedly, the bill has over 240 rule making provisions, requires 67 one time reports or studies and directs the preparation of an additional 22 periodic reports. More than perhaps any piece of legislation in recent years, Dodd-Frank is a work in progress whose impact will not be known for years.

The big winner in the rule making sweepstakes is the SEC. There are 95 provisions in Dodd-Frank concerning SEC rule making. The GAO is the winner in the report drafting department. The office will prepare 23 different reports. In second place is the SEC. The agency will prepare 17 reports.

A review of examples of the rules and studies the SEC is required to complete provides an insight into the legislation. Rules which the Commission is required to write include:

Swaps

• Along with the CFTC, rules for real time public data reporting of swaps transactions, including price and volume;

• Along with the CFTC, business conduct standards for swap dealers and major swap participants

• For non-banking entities, along with the CFTC, rules regarding the capital and uncleared swap margin requirements;

• Rules to establish limits, including related hedge exemption provisions, on the size of positions in any security-based swap that may be held by any person;

• Along with the CFTC, final rules providing for the reporting of uncleared swaps entered into before the date of enactment within 90 days of the date of enactment;

• Not later than one year after enactment of the legislation, rules providing for the registration of security-based swap dealers and major security-swap participants;

Investment advisers

• Not later than one year after enactment of the bill, final rules defining the term “venture capital fund” to effectuate an exemption from SEC registration for investment advisers that solely advise one or more venture capital funds;

• Rules to provide an exemption from registration for any investment adviser that acts solely as an adviser to private funds and has assets under management in the U.S. of less than $150 million;

• Rules requiring each investment adviser to a private fund to file reports containing such information as the Commission deems necessary and in the public interest for the protection of investors or for the assessment of systemic risk;

• Along with the CFTC, and after consultation with the Council, within 1 year, rules regarding the form and content of reports required to be filed with both agencies by dually registered advisers;

Securities lending

• Within two years of enactment of the legislation, rules designed to increase the transparency of information available regarding securities lending;

Arbitration

• Rules making, prohibiting or limiting the use of mandatory arbitration pre-dispute agreements between broker-dealers and investment advisers;

Credit rating agencies

• For credit rating agencies, rules to prevent sales and marketing considerations from influencing the production of ratings;

• Rules with respect to the procedures and methodologies used by credit rating agencies;

• Rules that require each credit rating agency to establish, maintain and enforce policies and procedures that clearly define and disclose the meaning of any ratings symbol and that apply that symbol consistently for all instruments for which it is used;

• Rules to ensure that persons employed to perform ratings are tested for knowledge of the rating process and meet standards of training, experience and competence necessary to produce accurate ratings;

• Remove the current exemption from Reg FD for credit rating agencies;

Securitization

• In conjunction with the federal banking agencies, regulations that require securitizers of asset-backed securities, by default, to maintain 5% of the credit risk in assets transferred, sold or conveyed through the issuance of asset-backed securities (with certain exemptions for qualified residential mortgages);

• Within nine months of enactment, rules to implement a prohibition against any underwriter, placement agent, initial purchaser, or sponsor of an asset backed security from engaging in any transaction for one year after the first closing of the sale of the asset backed security that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity;

• Rules requiring issuers of asset backed securities to disclose information on the assets backing each tranche or class of security;

Corporate governance

• Rules requiring companies to disclose whether employees and directors are allowed to hedge the value of any equity securities;

• Within one year, rules directing national securities exchanges and associations to require all members of a listed company’s compensation committee to be independent;

• Within one year of enactment, rules directing national securities exchanges and associations to require the compensation committee of a listed company to consider the independence of an adviser when selecting a consultant, legal counsel or other adviser;

• Rules requiring companies to disclose the relationship between executive compensation actually paid and its financial performance, including any change in the value of the company’s shares, dividends and distributions; and

• Rules requiring the disclosure of the median annual total compensation of all employees except the CEO, the annual total compensation of the CEO and the ratio of the median employee annual total compensation to that of the CEO.

Under the bill the SEC will also required to prepare reports on a variety of topics including:

• Within two years of enactment to conclude a study on the state of short selling after the recent rule changes and the incidence of failures to deliver shares sold short and the delivery of shares on the fourth day following a short sale transaction;

• Within six months of enactment to complete a study which includes public comment on any shortcomings in the standard of conduct and supervision of broker-dealers and investment advisers providing personalized investment advice about securities to retail customers;

• Within two years of enactment to complete a study of ways to improve the financial literacy of retail investors and the most effective means of communicating costs and conflicts of interest involving investments in securities;

• Within six months of enactment to complete a study on ways to improve access of investors to registration information about investment advisers, broker-dealers and their associated persons and implement any recommendation of the study;

• Within 180 days after enactment to complete a study of ways to enhance examinations for investment advisers including whether Congress should authorize the SEC to designate one or more SROs to aid the Commission’s examination efforts;

• Complete a study on the impact of applying a new test which would extend the reach of the antifraud provisions in SEC and DOJ actions and which would prevent any extension of the holding of the Supreme Court in Morrison (discussed here) in those actions to private actions;

• Within twenty-four months of enactment to complete a study of the credit rating process for structured finance products and the conflicts of interest associated with issuer-pay and subscriber- pay models and include the feasibility of establishing an independent utility or self-regulatory organization to assign NRSROs to determine credit ratings of structured finance products;

• Within three years of enactment to complete a study of the independence of NRSROs and how this affects ratings;

• Within one year to complete a study of the feasibility and desirability of standardizing credit ratings terminology; and

• Complete a study to determine how to reduce the burden of complying with SOX Section 404(b) for companies whose market capitalization is between $75,000,000 and $250,000,000.

Dozens of other sections in the bill give the SEC the authority to write rules to define and fill in the legislation.

THE IMPACT OF DELEGATING AUTHORITY TO ISSUE A FORMAL ORDER

Efforts to rejuvenate the Enforcement program have focused in part on speed and efficiency. In view of this emphasis, the Commission delegated to the Director of the Division of Enforcement and his senior staff the authority to issue formal orders of investigation as discussed here. That delegation eliminated any Commission consideration of the circumstances under which a formal investigation is initiated. Some may argue that Commission consideration of such requests had become perfunctory. At a minimum however, it meant that the staff had to prepare a memorandum justifying the request and the Commission or the duty officer had to review it. Thus, there was some independent barrier between those advocating that an investigation be conducted and those who might become entwined in it.

The loss of that independent barrier has the potential to compromise efforts to rejuvenate the enforcement program and restore its battered reputation. This is well illustrated by a July 12, 2010 order entered in In the Matter of Morgan Asset Management, Inc., Admin. Proc. File No. 3-13847. That order, entered at the request of Respondents who discovered the Division was supplementing its evidence by using a parallel investigation, creates a wall between Division personnel conducting the proceeding and those conducting the parallel formal investigation.

The Order for proceedings in Morgan Asset Management, issued on April 7, 2010, centers on claimed misconduct by the directors of Morgan Keegan & Company’s Funds as discussed here. It was issued after a two year investigation, A-3042. The hearing in Morgan Asset Management is scheduled to begin on September 13, 2010.

Eight days after the Order for Proceedings was issued, the Division began conducting a parallel investigation under a formal order of investigation, A-3211, authorized by the Associate Regional Director of the Atlanta Office. That order permits the Division to investigate potential misconduct by the directors of Morgan Keegan & Company’s Funds. While the Division informed the ALJ and Respondents about the new formal order approximately a month after it was issued, no notice was provided that investigative subpoenas were being issued. Respondent’s counsel discovered that fact.

Respondents filed a motion arguing that Division personnel conducting the proceeding should be precluded from participating further based largely on Rule 230(g). That rule provides in part that “The Division of Enforcement shall promptly inform the hearing officer and each party if investigatory subpoenas are issued under the same investigation file number or pursuant to the same order directing private investigation (“formal order”) under which the investigation leading to the institution of proceedings was conducted.”

The Division argued that the motion should be denied, claiming that the rule is inapplicable since the current investigation is being conducted under a different formal order. It also claimed the subject matter differed, while admitting there was some overlap.

The ALJ rejected the claims of the Division. While the current inquiry is in fact being conducted under a different formal order, in substance the two investigations focus on the same conduct. Indeed, five days after the Order for Proceedings was issued an internal e-mail was captioned “Morgan Asset—Continuing investigation after institution of proceeding.” Although the Division did not take the testimony of the directors during A-3211 as it now intends to do or obtain certain evidence it now seeks for its experts, it chose to commence this proceeding, the ALJ noted. In essence the two investigations are the same ALJ Kelly concluded: “I agree with Respondents that A-3211 is the continuation of A-3042, the investigation leading to the institution of the present proceeding. I further find that the Division’s efforts to camouflage this fact are unpersuasive. Any other reading of the two formal orders would exalt form over substance.”

To remedy this situation, the hearing officer ordered that the Division personnel involved in the proceeding not participate in the new investigation. Likewise, the Division will be precluded from using any evidence gathered in the investigation at the hearing. The Division personnel conducting the new investigation are permitted to share documents and transcripts with the persons on the hearing team, but only if those materials are made available to the Respondents at the same time.

As ALJ Kelly concluded in his order, to sustain the position adopted by the Division would “require me to turn a blind eye to the Commission’s concern that ‘[e]ven the appearance of a lack of integrity could undermine the public confidence in the administrative process upon which our authority ultimately depends,’ quoting Clarke T. Blizzard, 77 SEC Docket 1515, 14518 (Apr. 24, 2002). Indeed, the appearance of fairness and integrity is critical not just to administrative hearings, but all of the Commission’s processes. If the Commission is going to rejuvenate the Enforcement Division and craft an effective program the bedrock on which it is built must be fairness and integrity. The risks from abolishing the barrier between the investigators and the investigated by delegating the authority to issue a formal orders can undercut that bedrock as this case well illustrates.