This article was printed on March 28, 2011 in Complinet (Reuters). It is reprinted here with permission.
Enacted in response to financial crisis of 2008 and the bailout of Wall Street firms at taxpayer expense, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act) represents the most extensive change in the regulation of financial institutions since the Great Depression. Below are brief descriptions of the key points of the Act that may have a significant impact on the world of public finance.
At the outset, it should be noted that how the Act is implemented will be overseen by the new Republican majority in the House of Representatives. Many members of the Republican caucus were hostile to the Act's passage in the first place, and it is not clear how they will now oversee its implementation. Further, on January 18, 2011, President Obama signed executive order No. 13563, pursuant to which all executive agencies are required to quantify, to the extent possible, and weigh the costs and benefits of a proposed rule or regulation before it is issued, which ultimately may lessen the impact of some proposed regulations deemed to be too burdensome.
One of the most significant aspects of the Act are those regarding municipal advisors. With certain exceptions, the Act makes it unlawful for a "municipal advisor" to provide advice to or on behalf of a "municipal entity or obligated person" with respect to municipal financial products or the issuance of municipal securities, or to undertake a solicitation of a municipal entity or obligated person unless that municipal advisor is registered in accordance with the Act.
The universe of persons potentially affected is broad. Pursuant to the Act, those persons or entities falling within the definition of "municipal advisor" are required to register first with the SEC and then with the Municipal Securities Rulemaking Board (MSRB). The requirement that "municipal advisors" register with the MSRB means that such persons or entities must comply with other requirements of MSRB registration and membership. In doing so, municipal advisors must comply with the MSRB's rules regarding, among other things, assessments, fair dealing, "pay-to-play" rules and any continuing education requirements implemented pursuant to the requirements of the Act.
Additionally, the Act provides that municipal advisors and any person associated therewith are "deemed to have a fiduciary duty to any municipal entity for whom such municipal advisor acts as a municipal advisor, and no municipal advisor may engage in any act, practice, or course of business which is not consistent with a municipal advisor's fiduciary duty or that is in contravention of any rule of the [MSRB]." As a consequence, municipal advisors need to be aware of the changes to the MSRB's authority under the Act. Pursuant to the Act, the MSRB is now authorized, among other things, to work with the SEC and FINRA in enforcing its own rules and authorizes it to regulate advice provided to or on behalf of municipal entities or other so-called "obligated persons," which includes any guarantors of municipal securities.
An additional issue concerning municipal advisors under the Act is the breadth of the definition itself. As currently proposed, those falling under the label "municipal advisor" could conceivably include: appointed board members of municipal entities (other than ex-officio members); and attorneys acting as counsel to municipal entities. The current proposed definition of "municipal advisor" exempts attorneys from registering with the SEC and MSRB only when they give advice "of a traditional legal nature." The MSRB and other groups have provided to the SEC comments encouraging it to clarify the proposed rule and enable bond counsel and other professionals to work with municipal entities without being deemed to be municipal advisors. Resolution of this issue will not be reached until the SEC adopts its final rules. Comments to the proposed rules were due to the SEC by February 22, 2011, and the timeline for the issuance of final rules related to municipal advisors is yet to be determined.
Changes to the SEC
The Act authorizes the creation by the SEC of an Office of Municipal Securities. This new office will administer the rules related to municipal securities brokers and dealers, municipal securities advisors, municipal securities investors, and municipal securities issuers and coordinate with the MSRB with regard to rulemaking and enforcement actions as required by law. The date for when the Office of Municipal Securities is due to be staffed and operational is yet to be determined.
Changes Related to the Credit-Rating Agencies
The Act creates an Office of Credit Ratings within the SEC. Pursuant to the Act, the SEC is required to examine Nationally Recognized Statistical Ratings Organizations (NRSROs) at least once a year and make key findings public. The Act requires disclosure of NRSROs methodologies, reliance on third parties for due diligence efforts and ratings track record. A third-party provider must also provide a certification to the NRSRO, which then must be disclosed by the NRSRO.
Further, the Act requires NRSROs to address conflicts of interest. The Act requires NRSROs to conduct a one-year, look-back review when an NRSRO employee goes to work for an obligor or underwriter of a security or money market instrument subject to a rating by that NRSRO. Provisions of the Act provide for enhanced oversight of NRSROs. It creates a private right of action against NRSROs for "knowingly or recklessly" failing to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. Additionally, the Act authorizes the SEC to deregister an NRSRO for providing bad ratings over time, requires ratings analysts to pass qualifying exams and mandates continuing education. The Act provides that final rules related to NRSROs are to be implemented on or before July 21, 2011.
In addition, the Act provides that enforcement and penalty provisions of the Securities Exchange Act of 1934 (Exchange Act) apply to statements made by a credit-rating agency in the same manner and to the same extent as such provisions apply to statements made by a registered public accounting firm or a securities analyst. However, the SEC has issued a "no-action" letter saying that it will not bring enforcement actions against a NRSRO that does not disclose its ratings in disclosure documents. While there have been calls for the SEC to reconsider this position, as of now there will not being any enforcement action against a NRSRO under the expert liability provisions of the Act.
Effects of the Act on Securitizations
Section 941 of the Act defines an "asset-backed security" as "a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset."
The Act also requires issuers of asset-backed securities to refrain from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain with respect to an asset and to retain not less than five percent of the credit risk for any asset, subject to certain exceptions related to qualified residential mortgages. Although the Act directs the SEC to provide total or partial exemptions for certain asset-backed securities issued by municipalities, the extent of such exemption will remain unknown until the SEC issues its rules implementing these parts of the Act. Such rules are due to be implemented on or before April 15, 2011.
Orderly Liquidation Authority Under the Act
Title II of the Act provides for Orderly Liquidation Authority (OLA) for "Covered Financial Companies." Under the Act, entities deemed to be covered financial companies are subject to OLA. Such entities subject to OLA include any failing financial company deemed to pose significant risk to the financial stability of the United States. This determination is based upon recommendations made by federal regulatory authorities to the Secretary of the Treasury. The Secretary would then consult with the President and determine whether an entity is a covered financial company and should be subject to OLA.
Should the Secretary of the Treasury determine that an entity is subject to OLA authority, and absent a court finding such determination to be arbitrary and capricious, under the Act, the Federal Deposit Insurance Corporation (FDIC) will be appoint as receiver for the entity in question. Pursuant to OLA, the FDIC succeeds to "…all rights, titles, powers, and privileges of the covered financial company and its assets, and of any stockholder, member, officer, or director of such company." For issuers of municipal securities, swap counterparties, providers of letters of credit, other liquidity facilities, bond insurance or swap insurance may be subject to OLA under the Act, whereby the FDIC succeeds such provider as a receiver.
The significance here is this new ability that regulators have to rewrite certain terms of any agreement a bond participant may have with a troubled entity, particularly a credit enhancer. Such authority could lead bond counsel to consider changes in their enforceability opinions.
Effects of the Act on Derivatives and Swaps
The Act divides jurisdiction over derivatives and rulemaking into three categories: security-based swaps regulated by the SEC, swaps regulated by the CFTC, and mixed swaps subject to joint regulation by both the SEC and CFTC. Although the existing exemption for state and municipal obligations contained in the Commodity Exchange Act are expected to continue to be applicable to state and municipal swaps, the new provisions requiring reporting of municipal swap transactions will apply, as will the new rules regarding the business conduct standards for swap providers and swaps advisors providing services to municipal entities. Such rules are required pursuant to the Act to be implemented on or before July 15, 2011.
Frank A. Mayer III, Timothy B. Anderson and Andrew C. Maher
More Resources on the Dodd-Frank Act
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The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.