In our last three newsletters, we explained the long awaited financial reform legislation Regulatory Reform 1, Regulatory Reform 2, Regulatory Reform 3. House and Senate compromises have resulted in a conference agreement early Friday morning reconciling many versions of the Restoring American Financial Stability Act (now known as the Dodd-Frank Bill). Negotiation has brought agreement on several key tenets of the act, including the proposed Consumer Protection Agency and SEC self-funding. Initially, both House and Senate versions of the bill called for a Consumer Protection Agency, but disagreement as to where to house the proposed agency ensued. In compromise, House democrats yielded to the Senate version, which houses the Consumer Protection Agency in the Federal Reserve and excludes the auto financing industry.

SEC funding is currently subject to a congressional appropriations process, allowing for political considerations to affect the size of the budget. Self-funding is accomplished by charging fees for various filings at the SEC, allowing for swift expansion in times of crisis. Originally, the Senate bill called for SEC self-funding, while the House version did not. Many were skeptical of the SEC self-funding provision surviving, including chairman of the House-Senate conference Barney Frank. Former SEC Chairman Arthur Levitt summed up the rationale: “The various oversight and appropriating committees simply don’t want to say good-bye to this honey pot.” The compromise allows the SEC to set up an emergency reserve fund for capital-improvement projects or for times of crisis. It would also allow the SEC to submit its budget directly to Congress without needing prior approval by the White House. "This approach ensures the SEC has the funding it needs while still ensuring it be accountable to Congress," said Sen. Richard Shelby, an Alabama Republican

There is also a broad-based push to standardize contracts and centralize derivative trading as much as possible. The Senate version of the bill was the most extreme, as it mandated banks spin-off their swap trading units. The compromise allows banks to engage in trades of contracts of traditional banking bets, such as on interest rates and the price of gold. But banks would have to two years to spin off affiliates if they want to make riskier trades, ranging from commodities to credit default swaps. The bill calls for international cooperation and information-sharing agreements. Furthermore, the bill calls for the trading of derivative contracts to be conducted through central clearinghouses.

The Volcker Rule, which would prohibit a bank from engaging in proprietary trading and from owning or investing in hedge funds or private equity, was originally a key point of contention between the original House and Senate versions of the bill. Underpinning this rule is the rationale that banks should not use guaranteed funds to speculate. However, there are subtle differences in facilitating client trades and speculating. The House version did not include the Volcker Rule, while the Senate version did. In compromise, lawmakers agreed to give regulators more specifics and less leeway when it comes to preventing banks from trading for themselves or owning hedge funds. But they also watered it down in several ways: It doesn't impact insurers. Additionally, the bill allows some proprietary trading in areas, such as government debt, for hedging purposes and small business investments. As for the ban on banks owning hedge funds, the provision allows Wall Street banks that take commercial deposits to sink as much as 3% of capital in hedge funds or private equity. It has been reported that is the current amount so that it’s not a reduction but a limit.

Another point of disagreement concerns fiduciary duty for broker/dealers. Many parties are concerned with the subjective nature of the “fiduciary duty” standard and its application to broker/dealers. The application of the duty would apply when a broker goes beyond its traditional role to act as an adviser but the dividing line has been very murky as new products and services come online. The House version creates a higher standard of fiduciary duty for brokers than does the Senate version. The House version would require brokers have a “fiduciary duty” to their clients, as currently brokers must at minimum only ensure a product is suitable for a client. Meanwhile, the original Senate version only called for a study to see if broker/dealers and investment advisers could be governed by an overarching standard of care. Lawmakers unanimously approved language that empowers the Securities and Exchange Commission to write a regulation requiring broker-dealers to act in the best interests of their clients and to reveal any conflicts of interest when providing investment advice to retail clients after the study is concluded.

Sarbanes-Oxley (SOX) continues to be a hot-button issue in the bill reconciliation process. On June 16, 2010, the conference committee reconciled the House and Senate versions of the federal financial reform bill by agreeing to exempt compliance with Sarbanes-Oxley Act (SOX) Section 404(b) for companies with less than $75 million in market capitalization. Under the provisions of SOX 404, publicly reporting companies and their independent auditors are each required to report on the effectiveness of internal controls over financial reporting. Section 404(a) requires all public companies to assess the effectiveness of their internal control over financial reporting, while Section 404(b) requires independent auditors to report on management’s assessment a large expense for small companies. In another related development the Supreme Court issued its long awaited PCAOB decision On June 28th and the chairman of the SEC explained as follows:

Washington, D.C., June 28, 2010 — Today the Supreme Court issued its decision in Free Enterprise Fund and Beckstead and Watts, LLP v. Public Company Accounting Oversight Board and United States of America. In its decision, the Supreme Court held that the restriction on removal of Board members under the Sarbanes-Oxley Act of 2002 violates separation of powers principles, but found that the provision was severable from the remainder of the Sarbanes-Oxley Act. The Court stated that the Act “remains fully operative as a law” with the for-cause restrictions excised, leaving the members of the PCAOB subject to removal by the Commission without restriction. The opinion does not call into question any action taken by the PCAOB since its inception.

Credit Ratings Agencies scored victories in Friday’s compromise, as language that originally would have allowed for investors to sue over faulty ratings was significantly softened (http://www.businessweek.com/news/2010-06-26/overhaul-of-financial-regulation-on-path-to-obama-s-desk.html). The bill allows the SEC to conduct studies and recommend procedures for the ratings of asset-backed securities.

The following changes are also included in the conference agreement:

• The cost of implementing Wall Street reform bills is around $19 billion and the conference initially decided to pay for it by taxing the largest financial firms, with firms taking the biggest risks paying the most. However on June 29th this provision was dropped to gain the support of Senator Scott Brown. http://www.washingtonpost.com/wp-dyn/content/article/2010/06/30/AR2010063001180.html
• A new council of federal regulators would try to monitor the entire financial services industry.
• Private equity and hedge funds with $100 million under management. would have to register with regulators and open their books to scrutiny. Not so for venture capital funds, which would be exempt
• The Treasury would monitor state insurance regulation.
• Banks would have to set aside more capital to ride out tough times, but will get several years to comply
• The Fed's emergency lending during the crisis would be reviewed, but not its decisions on interest rates
• Fees charged on debit card transactions would be reduced -
• FDIC insurance on deposits would be permanently raised to $250 million. http://www.washingtonpost.com/wp-dyn/content/article/2010/06/29/AR2010062904629.html

While important agreements have been made in recent weeks, the bill still faces several obstacles before it reaches the President’s desk including the death of Senator Byrd. Republicans are upset the bill essentially leaves Fannie and Freddie essentially untouched, and will likely make this a key point of debate. Even if agreements on key tenets are reached, the sustainability of the key provisions of the bill will be in question if the House and Senate change majorities in the mid-term elections.