financial services reform client alert series · senator scott brown (r-ma), who had previously...

Financial Services Reform Client Alert Series

Published July – August 2010

July 2010 Authors: Daniel F. C. Crowley [email protected] +1.202.778.9447 Bruce J. Heiman [email protected] +1.202.661.3935 Karishma Shah Page [email protected] +1.202.778.9128 Collins R. Clark [email protected] +1.202.778.9114 Margo A. Dey [email protected] +1.202.778.9322 Akilah Green [email protected] +1.202.661.3752 Justin D. Holman [email protected] +1.202.778.9317 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Financial Regulatory Reform - The Next Chapter: Unprecedented Rulemaking and Congressional Activity K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. On June 30, 2010, the House adopted the conference report on H.R. 4173, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Bill” or “Bill”). The Senate is expected to follow suit when it returns from recess later in July. This alert provides a high-level summary and analysis of the significant aspects of the Bill. In the days ahead, K&L Gates will be issuing alerts addressing in detail the various provisions of the Bill.

Background The conference committee proceedings began on June 10. The conferees worked arduously over a two-week period and, after working through the night, approved the conference report early in the morning of June 24. However, early last week, it became clear that the Senate did not have the 60 votes necessary to adopt the conference report. Senator Robert Byrd’s (D-WV) death resulted in the loss of a vote. Additionally, Senator Scott Brown (R-MA), who had previously voted for the measure, came out in opposition due to the financial crisis assessment that was added toward the end of the conference in order to comply with statutory pay-as-you-go requirements. The conference committee reconvened on June 29 in order to substitute that provision by raising the deposit insurance fund’s minimum reserve ratio from 1.15 percent to 1.35 percent and by ending the Troubled Asset Relief Program early in an effort to address Senator Brown’s concerns and garner his vote. Additionally, memorial services for Senator Byrd resulted in a truncated work week, deferring further action by the Senate until after the July 4th Recess. Please see K&L Gates alerts Approaching the Home Stretch: Senate Passes “Restoring American Financial Stability Act of 2010” and House Passes Financial Regulatory Reform Legislation for additional information.

Systemic Risk The Bill establishes a regulatory framework for monitoring the nation’s financial stability and managing systemic risks. The Bill creates a Financial Stability Oversight Council (“FSOC”), consisting of ten voting members who will be the heads of the federal financial regulators, charged with identifying and monitoring systemic risks to financial markets. The FSOC has the authority to require, by a 2/3 vote, that nonbank financial companies (including foreign nonbank financial companies) whose failure would pose systemic risk be placed under the supervision of the Board of Governors of the Federal Reserve System (“Federal Reserve”).

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Financial Services Reform Alert

Among the factors the FSOC must consider in making this determination are: the company’s leverage; the extent and nature of off-balance sheet exposures; relationships with other significant nonbank financial companies and significant bank holding companies; the nature, scope, size, and scale; concentration, interconnectedness and mix of the company’s activities; and any other risk-related factors the FSOC deems appropriate. The FSOC’s authority to subject nonbank financial companies to heightened regulation by the Federal Reserve is limited to nonbank financial companies that are “predominantly engaged in financial activities.” A company is “predominantly engaged in financial activities” if at least 85 percent of its consolidated annual gross revenues or 85 percent of its consolidated assets are related to activities that are financial in nature. Under the Bill’s provisions, the FSOC has the authority to recommend that the Federal Reserve adopt more stringent prudential standards and reporting and disclosure requirements for nonbank financial companies supervised by the Federal Reserve and “large interconnected bank holding companies” (those with assets greater than $50 billion). The standards may be increased in stringency depending on a variety of factors, including the company’s size and total liabilities. The bill also authorizes the FSOC to make recommendations to the Federal Reserve on various other matters, including requiring such firms to submit resolution plans, mandating credit exposure reports, establishing concentration limits, and limiting short-term debt. Further, FSOC may also recommend that other Federal financial regulators impose more stringent regulation upon, or ban altogether, financial activities of any financial firm that poses significant risks to the financial system. Enhanced Federal Reserve Authority As discussed above, the Bill requires that nonbank financial institutions designated as systemically significant by the FSOC, and large bank holding companies, be regulated by the Federal Reserve. Once these entities are designated, the Bill requires the Federal Reserve to impose more stringent prudential standards and reporting and disclosure requirements, taking into consideration differences among them. Notably, given the Bill’s significant expansion of the Federal Reserve’s oversight of

nonbank financial companies, the Bill also allows the Federal Reserve, in conjunction with the FSOC, to create a safe harbor exempting certain types of nonbank financial companies from its supervision. Minimum Leverage and Risk-Based Capital Requirements (Collins Amendment) One of the Bill’s most significant reforms, and a source of significant debate, is the establishment of minimum capital requirements advocated by Senator Susan Collins (R-ME). The Bill establishes minimum leverage and risk-based capital requirements determined on a consolidated basis for insured depository institutions, depository institution holding companies (including U.S. holding companies owned by foreign companies), and nonbank financial companies supervised by the Federal Reserve. Thus, bank holding companies and large nonbank financial companies supervised by the Federal Reserve will face the same capital and risk requirements that apply to banks. Further, in order to mitigate any threat posed by such an institution that engages in risky financial activities as determined by FSOC, the Bill directs Federal banking agencies to impose additional capital requirements. Trust-preferred securities (“TRuPS”) will no longer count as Tier 1 capital and will be phased out. The Bill provides an exemption, however, for depository institution holding companies with less than $15 billion of assets, allowing them to grandfather existing TRuPS as Tier 1 capital. Larger depository institution holding companies and systemically significant nonbank financial firms have three years to phase out existing TRuPS beginning on January 1, 2013 and to replace them with common stock or other securities.

Resolution Liquidation Authority The Bill establishes a Liquidation Authority for winding down “covered financial companies.” Under the provisions, the Treasury Secretary, upon a written recommendation approved by 2/3 votes of the boards of both the Federal Reserve and the Federal Deposit Insurance Corporation (“FDIC”), may decide to appoint the FDIC as a receiver for a financial company that is in danger of default and such default would have a systemically significant

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impact. Covered financial companies that may be subject to the Liquidation Authority include (1) bank holding companies, (2) nonbank financial companies supervised by the Federal Reserve, and (3) companies that are “predominantly engaged” in activities that are financial in nature under section 4(k) of the Bank Holding Company Act. Orderly Liquidation Fund The Bill would create an Orderly Liquidation Fund (“Fund”) to fund future liquidations. Instead of being pre-funded, the Fund would be financed through the FDIC’s issuance of debt securities to the Treasury Department, up to a maximum amount, subsequent to the FDIC’s appointment as receiver. Further, the FDIC must submit acceptable orderly liquidation and repayment plans to the Treasury before it can use any money from the Fund. In the event the FDIC is unable to repay the government within 60 months, the Bill requires the FDIC to impose assessments upon creditors who received payments from the government in excess of amounts they would have otherwise received in liquidation. If the FDIC cannot recoup its losses through assessments on creditors then, as a last resort, the FDIC can impose risk-based assessments on bank holding companies with consolidated assets over $50 billion, financial companies with consolidated assets over $50 billion, and nonbank financial companies supervised by the Federal Reserve. The FDIC will determine assessments based upon a risk matrix it has established, after taking into consideration recommendations from the FSOC.

Depository Institutions & Bank Holding Companies Under the Bill, depository institutions and their holding companies face new supervisory regulators, increased activities restrictions and capital requirements, and numerous other fundamental changes in how they are regulated. Changes to Supervisory Authority Within one year to 18 months after enactment, the Office of Thrift Supervision (“OTS”) will be abolished. Its authority over Federal thrifts will be transferred to the Office of the Comptroller of the Currency (“OCC”), where a Deputy Comptroller

will be appointed to oversee Federal thrifts. OTS authority over state thrifts will be transferred to the FDIC, and the Federal Reserve will gain supervisory authority over savings and loan holding companies. All existing OTS regulations and orders will remain in effect, but they will be enforceable by the agencies receiving the relevant authority. The Bill also increases the OCC’s autonomy, giving it the discretion to set fees and keep the resulting revenue, which is not subject to the appropriation process. The Federal Reserve will have increased authority over bank holding companies and savings and loan holding companies, including increased examination and reporting authority over subsidiaries. If the Federal Reserve fails to conduct examinations of a nonbank subsidiary, the relevant banking agency has back-up authority to examine and take enforcement action against the nonbank subsidiary. Financial holding companies will have to seek prior Federal Reserve approval for transactions involving the acquisition of assets worth $10 billion or more. In order to pay for its additional supervisory authority over holding companies, the Federal Reserve is authorized to assess fees from large bank holding companies, as well as systemically significant nonbank financial companies. Proprietary Trading and Hedge Fund Activities Another area of controversy during Congress’ deliberations has been the provisions known as the “Volcker Rule,” named after the provisions’ main advocate, former Federal Reserve Chairman Paul Volcker. The Volcker Rule generally prohibits banks from engaging in proprietary trading or sponsoring or owning an equity interest in a hedge or private equity fund. The FSOC has six months to conduct a study on implementing the Volcker Rule, after which the Federal banking agencies, the Securities and Exchange Commission (“SEC”), and the Commodity Futures Trading Commission (“CFTC”) will have nine months to coordinate the promulgation of regulations. The Volcker Rule applies to insured depository institutions, their holding companies, companies treated as bank holding companies, and any subsidiary of these companies. It would not apply to qualifying non-

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depository trust companies. Despite the broad, general prohibition, the Volcker Rule lists numerous activities that, subject to certain conditions, are nonetheless permitted. The Volcker Rule also imposes a general concentration limit on all financial companies, prohibiting any acquisition that would result in a financial company having more than 10 percent of the aggregate consolidated liabilities of all financial companies. The Bill imposes similar concentration limits with respect to insured deposits. Interstate merger transactions are generally prohibited if they would result in the applicant having more than 10 percent of all deposits held by insured institutions in the U.S. Deposit Insurance The Federal deposit insurance limit was temporarily increased to $250,000 in the fall of 2008, and the Bill makes that increase permanent. Unlimited insurance on all noninterest bearing transaction accounts has been extended only through the end of 2012, despite considerable efforts to make such insurance permanent. As part of the accommodation to Senator Brown with respect to the funding provisions discussed above, the Bill raises the deposit insurance fund’s minimum reserve ratio from 1.15 percent to 1.35 percent, but instructs the FDIC to “offset the effect” of the increase on institutions with assets of less than $10 billion.

Private Funds The Bill generally requires advisers to private funds, with certain exceptions, to register with the SEC if the adviser has assets under management of $100 million or more. The Bill subjects advisers to private funds to recordkeeping and reporting requirements related to the private funds they advise and subjects those advisers (with some exceptions) to SEC examination. As noted above, the Bill also places severe limitations on the ability of U.S. and certain non-U.S. financial institutions regulated by the Federal Reserve to sponsor or invest in a “hedge fund” or “private equity fund.”

Significant Carve-Outs The inclusion of carve-outs has been the most controversial portion of the private fund title. The significant carve-outs from SEC registration are advisers to venture capital funds, advisers to mid-sized private funds, advisers to family offices and foreign private advisers. Advisers who solely advise one or more venture capital funds (to be defined by rulemaking) will be exempt from SEC registration but are subject to the Bill’s recordkeeping and reporting requirements for advisers to private funds. Advisers to mid-sized private funds will be exempt from SEC registration, but will be subject to recordkeeping and reporting requirements if the adviser solely advises private funds and has assets under management of less than $150 million. Advisers to family offices (also to be defined by rulemaking) are excluded from the term “investment adviser” under the Investment Advisers Act of 1940 and, as a result, will not be required to register with the SEC or be subject to recordkeeping and reporting requirements, but, generally, will be subject to the anti-fraud provisions of the Advisers Act. Advisers that have no place of business in the United States and have in total fewer than 15 U.S. clients and investors in the funds they advise, if the total amount of assets managed by such advisers for their clients and funds is less than $25 million, are exempt from registration, provided that they do not hold themselves out as an investment adviser and do not advise a registered investment company or a business development company. Federal Registration Threshold The Bill raises the threshold for adviser registration with the SEC to $100 million for certain advisers. An adviser is prohibited from registering with the SEC if it: (1) is required to be registered as an adviser with a securities commissioner (or any agency or office performing like functions) of the State in which it maintains its principal office and place of business and, if registered, would be subject to examination as an adviser by the State’s commissioner, agency or office; and (2) has assets under management between $25 million and $100 million (or a higher amount if the SEC deems appropriate) unless it (a) is an adviser to an investment company or a business development company that has not withdrawn its election, or (b) would be required to register in 15 or more states.

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Investor Standards The Bill raises the financial threshold for a natural person to qualify as an “Accredited Investor,” as defined in Regulation D under the Securities Act of 1933, and requires subsequent reviews by the SEC of such definition and adjustments to this financial threshold. The Bill also requires the SEC to index for inflation the dollar amount measures in any test it establishes to determine who is a “qualified client” for purposes of permitting the assessment of a performance fee by a registered investment adviser and rounding such amount to the nearest $100,000 when making such determinations.

Over-the-Counter (“OTC”) Derivatives The Bill establishes a new regulatory regime for the OTC derivatives market. The CFTC and the SEC are authorized to write rules for the swaps and security-based swaps markets respectively and are required to coordinate to the extent possible. The CFTC and the SEC are both given the authority to ban abusive swaps if they believe the swaps or security-based swaps would be detrimental to the stability of a financial market or participants in a financial market. The Bill requires the clearing of swaps and security-based swaps that have been accepted to be cleared by a clearinghouse and approved by the CFTC and/or SEC. Swaps and security-based swaps that are currently listed for clearing by a derivatives clearing organization will be reviewed by the CFTC or the SEC to determine whether the swap or security-based swap should be required to be cleared. New swaps and security-based swaps will have to be approved by the CFTC or the SEC before the swap or security-based swap will be required to be cleared. If a swap or security-based swap cannot be cleared, then it must be reported to a swap data repository or security-based swap data repository, or, if there is no swap data repository or security-based swap data repository to accept the swap or security-based swap then it must be reported to the CFTC or the SEC. If a swap or security-based swap is required to be cleared, it must be exchange-traded if a designated contract market, swap execution facility, national securities exchange or security-based swap execution facility will accept it for trading. The Bill

also requires public reporting of swap and security-based swap transaction and pricing data. The Bill gives the CFTC, the SEC and banking regulators the authority to impose capital and initial and variation margin requirements on dealers and major participants with respect to uncleared swaps and security-based swaps. The Bill also authorizes regulators to establish position limits on certain contracts and prohibits market manipulation. Lincoln Rule During conference committee consideration, the most controversial aspect of the OTC derivatives title was section 716 (the “Lincoln Rule”). The conference committee report represents a significant departure from the original Lincoln Rule. Banks will now be able to retain swap trading desks involving interest rates or reference assets that are permissible for investment by a national bank or hedging and other similar risk mitigating activities with respect to the bank’s own risk. Riskier derivatives such as metals (excluding gold and silver) would have to be traded through a separate, capitalized affiliate. The new Lincoln Rule does not apply to (1) an insured depository institution containing a “swaps entity” affiliate, if the insured depository institution is part of a bank holding company or savings and loan holding company that is supervised by the Federal Reserve; or (2) an insured depository institution that limits its swap product activities to hedging and similar risk mitigating activities directly related to the insured depository institution activities. End-User Exemption The Bill’s end-user exemption is available if one of the counterparties to a swap or security-based swap (1) is not a financial entity (defined in the Bill); (2) is using swaps or security-based swaps to hedge or mitigate commercial risk; and (3) notifies the CFTC or SEC, in a manner set forth by the respective Commission, how it generally meets its financial obligations associated with entering into uncleared swaps or security-based swaps. Affiliates (including affiliated entities predominantly engaged in providing financing for the purchase of the merchandise or manufactured goods of the person) may take advantage of the exemption only if the affiliate, acting on behalf of the person and as an agent, uses the swap or security-based swap to hedge or mitigate the commercial risk of the person

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that is not a financial entity. Affiliates may not use the exemption if they are a prohibited entity (defined in the Bill). If the end-user is a publicly-traded company, its board must approve operating in accordance with the exemption. Retroactive Collateral Another controversial provision dealt with the potential retroactive imposition of initial and variation margin on pre-existing bilateral swap agreements. After the conference report was agreed to, Senate Banking Committee Chairman Chris Dodd (D-CT) and Senate Agriculture Committee Chairman Blanche Lincoln (D-AR) allayed this concern in a letter sent to House Financial Services Committee Chairman Barney Frank (D-MA) and House Agriculture Chairman Collin Peterson (D-MN) clarifying the legislative intent with respect to the derivatives title, particularly that it was not intended to apply retroactively or to close the forward contract exclusion from the swap definition.

Payment Clearing and Settlement Supervision The Bill also authorizes the Federal Reserve, in consultation with the FSOC and the Supervisory Agencies, to prescribe standards regulating (1) the risk management of systemically important financial market utilities (“FMU”), and (2) systemically important payment, clearing and settlement activities conducted by financial institutions. Supervisory Agency refers to the Federal agency that has primary jurisdiction over the FMU, including the Federal Reserve, the SEC, or the CFTC. The FSOC would determine which FMUs or activities are systemically important by a 2/3 vote.

Investor Protection The Bill contains numerous provisions designed to reform the SEC and to protect investors. Under the Bill, the SEC gains additional enforcement powers, including the ability to issue rules restricting or prohibiting mandatory pre-dispute arbitration clauses in agreements with customers. The Bill establishes whistleblower protections, including a whistleblower office, monetary awards for whistleblowers, and a prohibition against employer retaliation. The SEC is authorized to bar individuals from the entire securities industry, rather than just a particular segment of the industry, and the SEC is

required to issue rules barring felons and other bad actors from participating in Regulation D offerings. Subpoenas may be issued nationwide in proceedings initiated by the SEC. Liability under the securities laws is expanded to include anyone who “knowingly or recklessly provides substantial assistance” in violating the statute or regulation. The SEC may impose civil money penalties in cease-and-desist proceedings, and the U.S. courts have jurisdiction over any violation of the antifraud provisions of the securities laws, provided that a “significant step” in furtherance of the fraud took place in the U.S. The Bill does not create a private right of action against people who aid or abet violations of the securities laws, but it does call for a study of such an expansion. Broker-Dealer Fiduciary Duty One of the most controversial investor protection measures is the possibility of imposing a fiduciary duty on broker-dealers. In its final form, the Bill calls for a study by the SEC of the standards of care for brokers, dealers, and investment advisers for providing personalized investment advice to retail customers. The study will also examine the effectiveness of enforcement and compliance mechanisms and consider alternative means of imposing a fiduciary duty on broker-dealers. When the study is complete, the SEC is authorized to issue rules imposing a fiduciary-like duty on broker-dealers in providing advice to retail customers. The permissible standard of conduct is to act “in the best interest of the customer” without regard to the financial interest of the broker, dealer, or investment adviser.

Securitization The Bill requires securitizers to retain an economic interest in the credit risk for any asset that securitizers transfer, sell, or convey to a third party. Under these requirements, securitizers must retain not less than five percent of the credit risk for any asset that is not a qualified residential mortgage that is transferred, sold, or conveyed through the issuance of an asset-backed security. The risk retained may be less than five percent in the case that the originator of the asset meets certain underwriting standards, as established by the OCC,

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Federal Reserve, and FDIC. The regulations may provide for total or partial exemptions of any securitization that may be in the public interest and for the protection of investors, including an asset issued or guaranteed by the Federal government or subdivision thereof. The Bill also contains the “qualified residential mortgage carve-out,” based in part on a proposal by Senator Mary Landrieu (D-LA). Under this provision, the securitizer is not required to retain any risk in the case that all of the assets that collateralize the asset-backed security are qualified residential mortgages.

Credit Rating Agencies The Bill puts in place an entirely new framework to govern and regulate nationally recognized statistical rating organizations (“NRSROs”). The Bill establishes an Office of Credit Ratings (“OCR”) within the SEC. The OCR is required to examine NRSROs and make reports on key findings annually. Additionally, the Bill provides the SEC/OCR with broad rulemaking authority. The Bill provides OCR with the authority to deregister an NRSRO for providing bad ratings over time. Additionally, the Bill creates a private right of action against credit rating agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. Notably, the Bill removes several statutory references to credit ratings, credit rating agencies, and NRSROs. Additionally, there is a provision requiring all Federal agencies to review their regulations and modify them by striking these references.

Executive Compensation and Corporate Governance The Bill directs the SEC to promulgate several rules pertaining to the executive compensation practices of public companies. Significantly, the Bill directs the SEC to promulgate rules providing shareholders of public companies with an advisory vote on executive compensation (“say on pay”) and, in certain cases, golden parachute arrangements. Additionally, under this provision, institutional

investment managers must disclose their say on pay vote. The Bill also prohibits brokers who are not beneficial owners from voting by proxy unless the beneficial owner has instructed the broker to vote on the owner’s behalf. The Bill requires the SEC to promulgate rules prohibiting the listing of issuers that do not have independent compensation committees; however, the SEC will have the authority to exempt certain issuers, taking into account issuer size. Notably, the Bill directs the Federal Reserve, OCC, FDIC, OTS, National Credit Union Administration, SEC, and Federal Housing Finance Agency to promulgate and enforce rules requiring financial institutions to disclose the structure of incentive-based compensation arrangements and to prohibit any arrangement deemed to provide “excessive compensation, fees, or benefits” or that “could lead to material financial loss.” The Bill exempts financial institutions with assets less than $1 billion. The Bill authorizes the SEC to determine the terms and conditions of proxy access and to exempt certain issuers from the provisions.

Municipal Securities The Bill prohibits a municipal advisor from providing advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or, with respect to the issuance of municipal securities, or to undertake a solicitation of a municipal entity or obligated person, unless the municipal advisor is registered with the SEC. The Bill prohibits municipal advisors from providing advice, or from acting on behalf of an obligated person engaging in fraudulent, deceptive, or manipulative acts or practices. The Bill reconstitutes the Municipal Securities Rulemaking Board (“MSRB”) to give investors and public representatives a majority on the MSRB. The Bill imposes a fiduciary duty on advisors who advise a municipal entity and prohibit municipal advisors from engaging in any act, practice, or course of business which is not consistent with the municipal advisor’s fiduciary duty or that is in contravention of any rule of the MSRB. The Bill also establishes an Office of Municipal Securities at the SEC.

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Consumer Financial Protection One of the areas of contention during the development of the legislation has been the issue of consumer financial protection. The Bill addresses this issue by establishing a Bureau of Consumer Financial Protection (“CFPB”) that will be housed within the Federal Reserve. The CFPB will be headed by a Director who is nominated by the President, with the advice and consent of the Senate. Notably, the Bill explicitly states that no CFPB rule or order shall be subject to approval or review by the Federal Reserve. The CFPB will, however, be funded through a transfer from the Federal Reserve for amounts reasonable to carry out the CFPB’s authorities; in the case such sums are insufficient, the CFPB may request appropriations. The CFPB would have authority for consumer protection with respect to financial products and services offered by both banks and nonbanks. The CFPB has broad rulemaking authority, which it must exercise in consultation with appropriate Federal government entities. Notably, the CFPB’s rulemaking authority includes the ability to exempt classes of covered persons, providers, and financial products or services. Moreover, upon petition of a member agency of the FSOC and subject to a 2/3 vote of the FSOC, the FSOC may set aside a CFPB regulation. The Bill establishes the CFPB as the Federal agency with examination and enforcement authority over large depository institutions and nonbank financial institutions for compliance with the consumer protection laws. The prudential regulators will retain this authority for insured depository institutions and credit unions with assets of $10 billion or less. Notably, the Bill excludes from supervision and enforcement numerous financial service providers. These include: merchants, retailers, and sellers of nonfinancial goods or services; real estate brokerage activities; manufactured home retailers and modular home retailers; accountants and tax preparers; persons regulated by state insurance regulators; employee benefit and compensation plans; persons regulated by state securities commissions, the SEC, or the CFTC; activities related to charitable contributions; and auto dealers.

Preemption The Bill’s preemption provisions make clear that Federal consumer financial protection law is the floor and states have the authority to enact more stringent requirements. The Bill revises the standard the OCC will use to preempt state consumer protection laws. Specifically, the Bill allows for preemption of state consumer financial law, only if: (1) its application would have a discriminatory effect on national banks, in comparison with banks chartered by that State; (2) the preemption determination, made by OCC or a court on a case-by-case basis, is in accordance with the legal standard in Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner, et al., 517 U.S. 25 (1996); or (3) it is preempted by another Federal law. Interchange Fees Significant controversy occurred around the interchange fee debate. Surprisingly, the Senate adopted an amendment offered by Senator Dick Durbin (D-IL) regulating debit interchange fees. Although there has been a major lobbying effort against the controversial amendment, interchange fee provisions were included in the final version, though they were modified to ameliorate drafting and definitional issues. Among other things, the provision provides that the Federal Reserve cannot regulate network fees except to ensure that the fees are not used to circumvent interchange fee regulation and permits consideration of fraud prevention costs in the calculation of reasonable and proportional interchange rates.

Mortgage Reform and Anti-Predatory Lending Lax standards for mortgages and imprudent lending practices that led to the “housing market crash” are widely attributed as a primary contributor to the financial crisis that the reform Bill is intended to address. Most notably, the Bill establishes minimum national standards that are designed to require lenders to ensure that a borrower is able to repay a home loan at the time the loan is made. Under the Bill, a lender’s determination that a borrower is able to repay a loan must be based on verified and documented information, including the borrower’s income and credit history, current obligations, debt-to-income ratio, and employment

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status. A lender may presume that a borrower will be able to repay a loan if the loan has certain low-risk characteristics that meet the title’s definition of a “qualified mortgage.” Similarly, refinancings are exempted from the minimum mortgage standards if they exhibit certain low-risk characteristics. However, the Bill prescribes additional requirements for “nonstandard” loan products. Additionally, the Bill prohibits many of the practices perceived as “predatory” that lenders used to entice borrowers into taking out costly loans that they were ultimately unable to pay over the life of the loan. For instance, the Bill prohibits mortgage originators from receiving compensation that varies based on the terms of the loan. The Bill specifically prohibits “yield spread premiums,” which historically incentivized lenders and mortgage brokers to steer borrowers into risky mortgages. The Bill also establishes appraisal independence requirements that prohibit a person with an interest in the underlying mortgage transaction from compensating, coercing, bribing, or intimidating a person or entity conducting an appraisal with the purpose of influencing the appraisal value. Government Sponsored Enterprise (“GSE”) Reform This title includes a “Sense of the Congress” that expresses the importance of reforming Fannie Mae and Freddie Mac. Throughout consideration of the financial reform bill, Republican members of Congress repeatedly called for inclusion of reforms to these entities; however, the Obama Administration and Democratic leadership have insisted on keeping GSE reform separate – largely due to concern about disrupting the GSEs’ current role in propping up the fragile housing market. As a result, Congress is expected to address GSE reform next year.

Federal Insurance Office The Bill creates a new Federal Insurance Office (“FIO”) within the Treasury Department, ushering in a new era of Federal involvement in the U.S. insurance industry, which has historically been

dominated by the states. The FIO will: (1) monitor the U.S. insurance industry, (2) coordinate Federal efforts and policy relating to international insurance matters, (3) determine which state insurance measures are preempted by international agreements, (4) report to Congress annually on the state of the insurance industry, and (5) identify insurers that could pose a threat to financial stability. Health insurance, long-term care insurance, and crop insurance are excluded from the FIO’s authority. The FIO has authority over all other lines of insurance. Notably, the FIO Director will have the authority to determine when state insurance measures are inconsistent with international agreements relating to prudential measures for insurance or reinsurance. Additionally, the Bill contains reforms to nonadmitted insurance and reinsurance.

Next Steps At the time of this writing, it appears most likely that the conference report will be adopted in its current form by the Senate in mid-July and signed into law by the President shortly thereafter. It is important to note that enactment will mark the beginning of a process that will take months, if not years. The Bill contains rulemaking requirements and study provisions on a multitude of issues, and the Bill is the most far-reaching financial services law ever enacted. Congress necessarily left many of the most contentious policy decisions to rulemaking or study by various administrative agencies. Congress retains a vested interest in the outcome of those processes. Therefore, Congressional oversight of the implementation of the Dodd-Frank Bill is expected to be unprecedented in terms of scope and the impact it will have on the promulgation of rules. Additionally, there will inevitably be subsequent legislation, including technical corrections, substantive modifications, and issue areas that have yet to be addressed. Chairman Frank has already indicated there will be follow-up legislation. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.

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K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. K&L Gates is comprised of multiple affiliated entities: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), in Tokyo, and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong; a Polish limited partnership (K&L Gates Jamka sp. k.) maintaining an office in Warsaw; and a Delaware limited liability company (K&L Gates Holdings, LLC) maintaining an office in Moscow. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners or members in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. ©2010 K&L Gates LLP. All Rights Reserved.

July 1, 2010 Authors: Stephen J. Crimmins [email protected] +1.202.778.9440 – Washington, D.C. +1.212.536.3987 – New York Kay A. Gordon [email protected] +1.212.536.4038 Matt T. Morley [email protected] +1.202.778.9850 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Investor Protection Provisions of Dodd-Frank K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The investor protection provisions of Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. (2010) promise to make major changes in the world of securities enforcement and regulation. Thanks to Dodd-Frank, we will shortly see whistleblowers enticed by potentially lucrative bounties for reporting violations to a much larger and more powerful SEC. In addition to seeing its budget likely double over the next five years, the SEC will benefit from relaxed proof standards in pursuing secondary actors, expanded jurisdiction over foreign cases, the ability to obtain penalty awards in SEC administrative cases, industry-wide bars for securities professionals, and the ability to subpoena trial witnesses nationally. The SEC will also have the power to impose fiduciary standards on brokers, regulate short selling, restrict customer arbitration agreements, and engage in other extensive rulemaking. With further changes in this area unlikely as the bill moves towards final enactment over the next few days, this alert reviews key provisions that will soon begin to impact investors, public companies, securities professionals and their counsel. Whistleblower Provisions Dodd-Frank Section 922 provides powerful monetary incentives for individuals who know of a securities violation to contact the SEC and provide assistance in the investigation and prosecution of wrongdoing. At the same time, Section 922 creates significant new protections for such persons. Section 922 provides mandates that, where information provided by a whistleblower leads to an SEC enforcement action that results in monetary sanctions of more than $1 million, the SEC must pay that individual a bounty of between 10 and 30 percent of those amounts. The SEC must also pay a bounty where information provided by the whistleblower leads to enforcement action by the Justice Department, another federal agency, an SRO, or a state attorney general. Determination of the precise amount of the bounty is left to the discretion of the SEC, taking into consideration factors such as the importance of the information and the degree of assistance provided. To qualify for a bounty, the whistleblower must have voluntarily provided information that was “derived from the independent knowledge or analysis” of the whistleblower, that was not known to the SEC from any other source, and that “led to the successful enforcement of” the SEC or other proceeding. The program begins immediately, and whistleblowers can get bounties for information provided even before the SEC issues its implementing regulations. (§924) The SEC is expected to actively promote the whistleblowing program, and the Act tasks the SEC’s Inspector General with reporting to Congress whether the SEC does so. (§922)

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Bounties must be paid even to whistleblowers who are themselves violators, unless they are criminally convicted. (Whistleblowers may also be eligible for cooperation agreements limiting their civil liability under the SEC Enforcement Division’s new cooperation policy for individuals). The Act also provides that whistleblowers may remain anonymous (by acting through counsel) until prior to payment of the bounty. Whistleblowers who provide false information are not entitled to any award, and whistleblowers are not entitled to awards in connection with information acquired while they were employed by a regulator, law enforcement agency or SRO. The SEC will pay bounties from a newly-created “Investor Protection Fund,” funded with undistributed sanctions from other SEC cases, and it is anticipated that this will always be sufficient, even where the whistleblower’s tip in a particular case leads to a monetary sanction that is collected by a non-SEC enforcer such as a state attorney general. The Act also significantly enhances the protections available to these whistleblowers, providing for a private right of action by persons who provide information to the SEC or testify in or otherwise assist an SEC investigation or proceeding. An employer may not “discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against” such a person in the “terms and conditions of employment,” and a whistleblower can bring an action in federal court seeking double back pay, reinstatement with appropriate seniority, attorney and expert costs, and other relief. (§922) Expanded Secondary Liability Section 929-O of the Act provides for the SEC to impose aiding and abetting liability on persons who “recklessly” provide substantial assistance to someone who violates the Exchange Act. Previously, the SEC was generally required to show that such assistance was provided “knowingly.” In addition, the Act provides, for the first time, for aiding and abetting liability under the Securities Act, the Investment Company Act and the Investment Advisers Act. (§§929-M and 929-N)

The Act will not create a private right of action for aiding and abetting liability claims, but the Act directs the GAO to study whether private plaintiffs should also be allowed to sue aiders and abettors. (§929-Z) Private plaintiffs have been unable to bring such claims since the Supreme Court’s Central Bank decision in 1994, and the Court’s 2008 Stoneridge decision has blocked plaintiffs from bringing similar “scheme” liability claims. The Act also clarifies that the SEC may pursue enforcement actions against so-called “control” persons – those found to “directly or indirectly control” a violator – unless they acted in “good faith” and did not “directly or indirectly induce” the violative conduct. Previously the relevant Exchange Act provision (Section 20) could have been interpreted to restrict such “control person” claims to private plaintiffs. (§929-P(c)) Jurisdiction Over Foreign Securities Transactions In June 2010, the Supreme Court, in the National Australia Bank case, rejected the notion that the Exchange Act applies to private claims by foreign investors relating to transactions on foreign exchanges (so-called “f-cubed” claims). Dodd-Frank provides for U.S. jurisdiction over actions brought by the SEC under the antifraud provisions of the Exchange Act and Investment Advisers Act relating to securities transactions outside the U.S. where the defendant took “significant steps” in the U.S. to further the violation, or if the foreign misconduct had a “foreseeable substantial effect” within the U.S. Foreign plaintiffs have often preferred to file in U.S. courts, where pretrial discovery is extensive and where juries can award substantial amounts in damages. (§929-P(b)) Dodd-Frank directs the SEC to conduct a study on whether extraterritorial jurisdiction should to apply to private actions under the antifraud provisions. (§929-Y) Doubling the SEC’s Budget For most of the Senate-House conference on Dodd-Frank, it appeared that the SEC would finally achieve the so-called “self-funding” status used to fund most other financial services regulators. The

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SEC has actually generated enough to fund itself for years with relatively inconsequential transaction and registration fees Congress authorized long ago, but the self-funding proposal would have allowed the SEC to adopt the banking agency model of adjusting its own budget to cover its operational needs, subject to general Congressional oversight. Proponents, including prominent securities practitioners, argued that this would allow the SEC to respond quickly to market developments and to engage in long-term planning on technology and staffing. During the final days of the Senate-House conference, despite the absence of significant opposition, the self-funding provision was suddenly replaced by a compromise measure providing that, while the SEC will remain subject to the annual appropriations process, it will no longer be folded into a small corner of the Administration’s general budget request. Instead, for fiscal 2012 and after, the SEC will prepare its own budget that the President “shall” transmit to Congress “in unaltered form” and separate from the Administration’s budget. The SEC’s budget is to itemize amounts the SEC needs for its operations, designate additional “contingency funding” to be used to meet “unanticipated needs,” and designate particular activities for which “multi-year budget authority” would be suitable. Congress can then determine to provide the amount requested in the SEC’s budget or make adjustments. Dodd-Frank has preliminarily “authorized” a series of increases in SEC funding over the next five years from $1.3 billion in fiscal 2011 to $2.25 billion in 2015, effectively doubling the SEC’s budget over that period. If the SEC proposes annual budgets within these “authorized” amounts – and bearing in mind that SEC budgets are funded out of existing transaction and registration fees, not tax dollars – it is likely that Congress will “appropriate” these substantially increased amounts it has already “authorized.” In addition, the SEC will be able to tap a new $100 million SEC “Reserve Fund” to supplement its budget and facilitate long-range planning and commitments, and that fund will be replenished in $50 million annual increments out of SEC fee income. These increases should have a profound effect on the number and complexity of enforcement cases it files, and it should allow a

substantial expansion of the number and quality of its examinations. (§991) Penalties in Administrative Proceedings Since 1990, the SEC has been authorized to bring administrative cease-and-desist proceedings before its own administrative law judges as an alternative to bringing injunctive actions in federal court. Like court proceedings, these administrative proceedings could result in an order prohibiting future violations and requiring disgorgement of illegal profits – but only a federal court could award additional amounts (which have often been substantial) as a “penalty” to deter future misconduct. The Act provides for penalty awards to be made in administrative proceedings as well. As a result, the SEC may now bring more of its cases as administrative proceedings, where pretrial discovery is limited, where there is no right to a jury trial, and where the administrative law judge’s decision is reviewed de novo by the SEC commissioners who originally directed that the proceeding be filed. (§929-P(a)) Fiduciary Standard for Brokers The Act authorizes the SEC to issue rules to impose fiduciary duties on brokers and dealers when they provide “personalized investment advice about securities to a retail customer” after conducting a study. The SEC is empowered to “harmonize” the standard of conduct for such brokers and dealers with that presently imposed on investment advisers, requiring them to “act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice,” and to disclose “any material conflicts of interest.” (§913(g) and (h)) The SEC may also issue rules requiring brokers to provide particular information before purchase of an investment product or service by a retail investor, including information about investment objectives, strategies, costs and risks, as well as the compensation and other financial incentives of the broker and any intermediary. (§919)

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Securities Industry-Wide Bars The Act provides that when a securities professional is suspended or barred because of misconduct, the suspension or bar will extend to prohibit that person’s association with any “broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization.” Previously, such suspensions or bars could relate only to working in the capacity in which the person committed the violation – e.g. an investment adviser could only be suspended or barred from working as an investment adviser, but not also from working as a broker. (§925) SEC Authority to Restrict Customer Arbitration Agreements The Act authorizes the SEC to issue rules limiting, imposing conditions on, or even entirely prohibiting agreements that require arbitration by customers of brokers, dealers, municipal securities dealers and investment advisers. The SEC can issue such rules if it determines they are “in the public interest and for the protection of investors.” To the extent the SEC restricts the arbitration of customer disputes, customers will be free to litigate their claims in court, unrestrained by the confidentiality that applies to arbitration proceedings and where they can conduct pretrial discovery and have their cases decided by juries, with legal points ruled on by judges and decisions subject to judicial review. (§921) Nationwide SEC Trial Subpoenas The Act enables both the SEC and defendants in SEC federal court litigation to issue subpoenas requiring witnesses located anywhere in the United States to appear in person at trials and hearings. Previously, with a few technical exceptions, witnesses could only be required to appear if they were within a 100-mile radius of the courthouse, which often meant that juries heard much of the testimony by watching videotapes of pretrial depositions, sometimes taken months earlier before trial strategies had coalesced. The SEC has long had nationwide subpoena power for its administrative proceedings and investigations, and giving the SEC the same power for its federal court litigation puts

the SEC on the same footing as many other federal agencies. (§929-E) Deadlines for SEC Enforcement Actions, Inspections and Examinations Once the SEC’s enforcement staff notifies a target that they are considering enforcement action (the SEC’s so-called “Wells” notice), the staff will have 180 days to actually file their case. Similarly, once the SEC’s compliance inspections and examinations staff completes an on-site examination or inspection and obtains all requested records, the staff has 180 days to request corrective action or provide notice that the matter is concluded. Either of these deadlines can be extended for a second 180-day period on notice to the SEC Chairman and, with Commission approval, for any number of successive 180-day periods. This provision reflects an effort to address situations in which matters have gone unresolved, sometimes for years, although it will not address delays in investigations that have not yet advanced to the Wells notice stage. (§929-U) In a similar vein, Dodd-Frank requires SEC action to approve or disapprove proposed SRO rule changes within 180 days from publication or, subject to certain exceptions, the rule will be deemed to be approved. (§916) Investor Advocacy Dodd-Frank creates an “Investor Advocate,” who will report directly to the SEC Chairman and be responsible for identifying issues of concern to retail investors. (§915) The Investor Advocate will appoint an “Ombudsman” to act as a liaison between the Commission and retail investors. (§919-D) Additionally, a new “Investor Advisory Committee” composed of the Investor Advocate, state regulators and representatives of a broad cross-section of the investing public will meet at least twice a year to advise and consult with the SEC on investor protection issues. (§911) SEC Operational Improvements Dodd-Frank makes a number of additional technical improvements in the way the SEC executes its investor protection mission, including:

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• Hiring Market Specialists. The SEC will be able to use the streamlined hiring authority it already has in recruiting certain professionals to add staff with “specialized knowledge of financial and capital market formation or regulation, financial market structures or surveillance, or information technology.” This will assist the SEC’s ongoing efforts to build greater securities industry experience into an agency largely dominated by lawyers and accountants. (§929-G)

• Sharing Information with Other Agencies. The Act provides for the maintenance of any privileges that may apply to information that the SEC exchanges with other federal agencies, the PCAOB, any SRO, and any state or foreign securities or law enforcement authority. This will assure continued protection of information covered by the government law enforcement and deliberative privileges, the attorney-client privilege, the work product protection and other privileges. This provision is likely to facilitate greater coordination and cooperation among securities enforcement agencies, including the sharing of internal evidence and market data analyses and dialogues on possible prosecution theories. (§929-K)

• Paying Penalties to Victims. Regardless of whether it has collected any disgorgement in a particular case, the SEC may contribute all amounts collected as penalties to any fund established for the victims of the violation. Previously, due to a technicality in Sarbanes-Oxley, the SEC could only pay penalties to victims if the SEC had also collected disgorgement. (§929-B)

• Investor Testing. The SEC will be able to engage in “investor testing programs” and other initiatives to gather information from investors. The SEC may consult with “academics and consultants” in carrying out these programs. (§912)

• Self-Examination. Within 90 days, the SEC must hire an independent consultant to examine

its internal operations, structure, funding, and the need for comprehensive reform of the SEC, as well as the SEC’s relationship with and the reliance on SROs and other entities relevant to the regulation of securities and the protection of investors. The report of this consultant – due within six months after retention of the consultant – must be provided to the relevant Congressional committees.

Other Substantive Changes Additional Dodd-Frank measures designed to enhance investor protections include the following:

• SIPC Limits. The Act increases SIPC protection for investors, raising the “maximum cash advance amount” from $100,000 to $250,000, with the possibility of further increases for inflation. (§929-H)

• Foreign Accountants. The Act expands Sarbanes-Oxley provisions relating to foreign public accounting firms, placing them under the jurisdiction of U.S. courts and requiring them to produce to the SEC and PCAOB audit work papers “and all other documents of the firm related to” audits or interim reviews of any issuer. (§929-J)

• Market Manipulation. The Act extends to over-the-counter securities existing prohibitions on market manipulation of listed securities contained in Sections 9 and 10(a) of the Exchange Act. Previously, manipulations of OTC securities have been prosecuted under Section 10(b) and Rule 10b-5. (§929-L)

• Short Selling. The Act prohibits any “manipulative short sale of any security” and authorizes the SEC to issue rules to enforce this provision. The SEC must issue rules providing for public disclosure at least monthly of short sale activity in each security. Brokers must notify customers that they may elect not to allow their securities to be used in connection with short sales, and brokers must disclose that they may receive compensation for lending their customers’ securities. The SEC may by

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rule specify the “form, content, time, and manner of delivery” of such customer notifications. (§929-X)

• Reg D Disqualifications. The SEC must issue rules within one year to bar felons and various civil violators, among others, from participating in private placements under Regulation D. (§926)

• Asset-Backed and Municipal Securities, Credit Rating Agencies and Corporate Governance. Title IX of the Act includes various other important investor protections and securities regulatory improvements not specifically discussed above. These deal, among other things, with the regulation of credit rating agencies, the asset-backed securitization process, corporate accountability and executive compensation, strengthening corporate governance, and municipal securities. Most of these areas will be discussed in detail in separate K&L Gates alerts to be issued shortly.

Potential Areas for Future Changes In lieu of undertaking reforms in a number of controversial areas, Dodd-Frank instead directs the SEC to undertake a wide variety of studies – most due within six months – which may in turn lead to further legislation or rulemaking. These mandated SEC studies will include:

• the effectiveness of existing standards of care applicable to brokers, dealers and investment advisers in providing personalized investment advice and recommendations about securities to retail customers, and regulatory gaps relating to these issues;

• whether the SEC should engage the assistance of SROs in conducting examinations of investment advisers;

• the adequacy of examinations of investment advisory activities of dually registered broker-dealers and investment advisers and their affiliates;

• the level of financial literacy of retail investors, and what means might be most effective to further educate them;

• potential improvements in disclosures to investors regarding financial intermediaries, investment products, and investment services;

• methods to increase the transparency of expenses and conflicts of interests in transactions involving investment services and products, including shares of open-end companies; and

• how to better facilitate investor access to information regarding disciplinary actions; regulatory, judicial, and arbitration proceedings; and other information about registered investment advisers, brokers and dealers.

Additionally, the Act directs the Government Accounting Office to conduct studies – most due within eighteen months – regarding:

• mutual fund advertising;

• conflicts of interest that may result from having investment banking and securities analyst functions within the same firm;

• regulation of financial planners;

• employment of former SEC personnel by institutions regulated by the SEC;

• proprietary trading by and within insured depository institutions, bank holding companies, financial holding companies and certain of their affiliates and other entities;

• person-to-person lending; and

• the impact of the amendments made by the Act to the exemption for smaller issuers from the registered public accounting firm attestation requirements mandated by Sarbanes-Oxley Section 404(b).

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Finally, the Act requires the SEC’s Inspector General to conduct a study of the whistleblower protections established under the Act, to be completed within 30 months.

This client alert is part of a series of alerts focused on monitoring financial regulatory reform.



San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d’Alene Taipei Tokyo Warsaw Washington, D.C. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. K&L Gates is comprised of multiple affiliated entities: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), in Tokyo, and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong; a Polish limited partnership (K&L Gates Jamka sp. k.) maintaining an office in Warsaw; and a Delaware limited liability company (K&L Gates Holdings, LLC) maintaining an office in Moscow. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners or members in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. ©2010 K&L Gates LLP. All Rights Reserved.


July 7, 2010 Author: James E. Earle [email protected] +1.704.331.7530 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

New Executive Compensation and Governance Requirements in Financial Reform Legislation K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law.

Introduction The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), while delayed as the Senate leadership searches for votes, is almost certain nevertheless to be enacted in mid-July 2010. While the Act’s primary purpose is to broadly reform the regulation of the financial services industry, within the massive text of the Act lurk new requirements that may impact executive compensation and corporate governance practices at most public companies, not just banks. This alert highlights these key executive compensation and governance changes. In many cases, the Act directs the Securities and Exchange Commission (“SEC”) to implement the Act’s requirements by adopting rules or directing the national securities exchanges or associations (the “securities exchanges”) to adopt rules. The Act also authorizes the SEC or securities exchanges to exempt certain companies, such as smaller issuers, from some of the Act’s requirements.

Key Executive Compensation Changes 1. Say-on-Pay Section 951 of the Act includes two new requirements for public companies to obtain non-binding shareholder approval on executive compensation matters (frequently referred to as “say-on-pay” votes). First, shareholders must be given a vote on compensation to the company’s named executive officers as disclosed in the executive compensation sections of the annual proxy statement. These disclosures include the Compensation Discussion and Analysis, Summary Compensation Table and various supporting compensation tables and disclosures. Companies must hold this shareholder vote at least once every three years. The shareholders separately determine whether the vote must be obtained on a cycle of every one, two or three years. The shareholders must have a chance to separately vote on the approval cycle at least once every six years. Second, the so-called “golden parachute” say-on-pay rule requires companies to give shareholders a non-binding vote in connection with shareholder approval of certain mergers, acquisitions or dispositions over compensation to named executive officers based on or relating to the transaction. The compensation arrangements, including potential or contingent payments and the aggregate amount that may be paid to each officer, must be clearly disclosed in the proxy statement or other materials for the shareholder vote on the transaction. The shareholder vote on the compensation arrangements must be separate from the shareholder vote on the transaction.



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A transaction-related shareholder vote is not required, however, for an arrangement that was subject to a shareholder vote at an annual meeting under the first say-on-pay requirement described above. Shareholder votes under these requirements are not binding on the company. The Act also makes clear that the shareholder votes do not change or add fiduciary duties for the board and do not limit the ability of shareholders to submit proposals on executive compensation matters. Both requirements first apply to shareholder meetings occurring more than six months after enactment. This means that these requirements will apply for many companies for the first time in the spring 2011 proxy season, assuming a July 2010 enactment. One open question for the SEC to answer in its rulemaking is whether preliminary proxy statements will need to be filed because of the say-on-pay vote requirement.

Say-on-pay shareholder votes have become more common in the U.S. over the last several years. Banks that received financial assistance under the Troubled Asset Relief Program (“TARP”) were required to hold a say-on-pay vote. Dozens of other businesses across various industries have voluntarily included a shareholder vote on executive compensation. While three companies have failed to garner majority support in their say-on-pay votes during the 2010 proxy season, shareholders have, in most cases, shown high levels of support for the disclosed executive compensation. In addition, one of the main purposes of say-on-pay votes is to encourage better dialogue between companies and their key shareholders on executive compensation matters. To avoid an embarrassing (although non-binding) “no” vote, companies should focus on the quality of their executive compensation disclosures and proactively reach out to key shareholders in order to discuss any concerns about the company’s executive compensation programs. The Act does not specify the exact form of shareholder resolution to be voted on. Companies should consider alternative formulations for the resolution in order to best obtain meaningful information from the vote and to best facilitate dialogue with shareholders. In addition, many shareholders may look to voting recommendations

from proxy advisory firms, such as RiskMetrics and Glass Lewis. As a result, the influence of these proxy advisory firms may further expand. Public companies may need to closely follow the say-on-pay voting policies developed by these firms. For 2010, RiskMetrics has recommended votes against approximately 17% of say-on-pay voting proposals, including TARP companies, most often citing “disconnects” in pay-for-performance. 2. Compensation Committee Independence Section 952 of the Act requires that most public companies have compensation committees comprised exclusively of “independent” directors. The definition of “independence” for this purpose is to be developed by the securities exchanges, but at a minimum must take into account (i) consulting, advisory or other fees received by the director other than for service on the board and (ii) whether the director is an “affiliate” of the company or its subsidiaries. The Act requires the securities exchanges to publish rules regarding these requirements within 360 days after enactment. The formulation of the independence standard under the Act mirrors the independence standard that applies to audit committee members under Section 301 of the Sarbanes-Oxley Act. The extent to which this requirement imposes a greater independence standard than current listing rules will depend on how the securities exchanges develop the rules. One issue to monitor will be whether significant share ownership could potentially disqualify a director from service on the compensation committee under the new requirement. There will likely continue to be separate standards for determining whether compensation committee members are “non-employee directors” for purposes of Section 16 under the Securities Exchange Act or “outside directors” under Section 162(m) of the Internal Revenue Code. 3. Independence of Compensation Consultants and Other Advisers Section 952 of the Act also addresses Congress’s concerns about the independence of compensation consultants, legal counsel and other advisers to the compensation committee. While the Act does not mandate use of independent compensation

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consultants or other advisers, it does require the compensation committee to consider factors that could affect the independence of the consultant/adviser. These factors include (i) other services provided by the consultant’s/adviser’s firm, (ii) the amount of fees received by the consultant’s/adviser’s firm from the company relative to the firm’s total revenues, (iii) the consultant’s/adviser’s firm’s policies to limit conflicts of interest, (iv) business or personal relationships between the consultant/adviser and any member of the compensation committee, and (v) share ownership by the consultant/adviser. The compensation committee retains full authority to engage and oversee its own compensation consultants and other advisers, and the company must provide sufficient resources for the committee to pay those consultants/advisers. The Act clarifies that the compensation committee need not follow the advice of its consultants/advisers, nor does the retention of consultants/advisers relieve the compensation committee from the requirement to exercise its own judgment in fulfilling its duties. The company must disclose in its annual proxy statement whether the compensation committee has retained a compensation consultant, whether the work of the compensation consultant raises any conflict of interest concerns, and if so, how those concerns have been addressed. This disclosure requirement does not apply to other advisers. The Act directs rules to be published regarding these requirements within 360 days after enactment. The Act also commissions a study and report by the SEC on the use of compensation consultants, to be submitted to Congress within two years after enactment. Proxy statement rules already require disclosure regarding the use of compensation consultants, including the identity of the consultant, the types of services provided, and if other non-compensation services are also provided, details on those other services. The disclosures required under the Act do not appear any more comprehensive. Nevertheless, over the last several years there has been considerable pressure on compensation consulting firms retained by compensation committees not to provide broader services to the company, and some

management consulting firms have divested or spun off their compensation consulting units in order to avoid such potential conflicts. The Act will continue and increase this pressure. There has generally not been as much emphasis on compensation committees retaining independent legal counsel, but it is not clear how the Act might impact the delivery of legal services to compensation committees. 4. Additional Executive Compensation Disclosures Section 953 of the Act imposes two new disclosure requirements regarding executive compensation. First, under what is styled as “disclosure of pay versus performance,” the Act requires the SEC to establish rules regarding “clear disclosures” of executive compensation, including the relationship between amounts actually paid and the company’s financial performance, taking into account stock prices and dividends. The Act states that this disclosure may be provided graphically. Second, the Act requires disclosure of the ratio of the CEO’s total annual compensation compared to the median total annual compensation of all employees other than the CEO. “Total annual compensation” for this purpose means the total compensation amount reported in the Summary Compensation Table. The Act does not specify a date by which the SEC must adopt these rules. It is unclear exactly what additional disclosures will be required under the first rule. The current proxy disclosure rules require clear, plain English disclosures regarding the executive compensation policies and, particularly in the case of performance-based compensation, payment outcomes. The reference to a “graphic” disclosure may suggest disclosures similar to the “performance graph” that was previously required to be included in annual proxy statements. The second new rule raises potentially significant practical challenges. Determining the Summary Compensation Table total compensation amounts for a limited group of executive officers often presents difficulties, especially in identifying and quantifying perks, above-market earnings on deferred compensation, and changes in the present

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value of pension benefits. How these amounts can be determined for all employees in order to derive a median value may be extremely difficult for many companies. One can only hope that SEC rules will provide clear guidance and rules of convenience to reduce the potential burdens of this rule. 5. Enhanced Clawbacks Section 954 of the Act requires companies to adopt and implement policies that will require recovery of prior incentive compensation awards (including stock options) that were based on financial information later restated due to the company’s material non-compliance with any financial reporting requirements under the securities laws. These are often referred to as “clawback” policies. The clawback will apply to incentive compensation awarded to any current or former executive officers within three years before the date of the triggering financial restatement. No misconduct on the part of the executive officer will be required. The Act requires the SEC to direct the securities exchanges to prohibit the listing of any companies that do not meet this requirement. The Act, however, does not specify a date by which the SEC or the securities exchanges must adopt rules regarding this requirement.

This new rule significantly expands on the Sarbanes-Oxley Act’s clawback, which applies only to the CEO and CFO, has only a one-year lookback, and requires misconduct. However, the new rule is in some ways less expansive than the clawback requirement applicable to banks that received financial assistance under TARP. In particular, the TARP clawback could be triggered without regard to whether a financial restatement was required. For option awards, it is unclear if the clawback would apply only or primarily to (i) options granted based on erroneous financial results, (ii) performance-based options that vest and become exercisable based on such financial results, or (iii) any in-the-money option that is exercised during the prior three-year period regardless of when it was granted or how it became vested. Another uncertainty is how the clawback rules will deal with incentive compensation that is based on a number of factors in addition to financial performance.

One of the biggest legal challenges for any clawback policy is establishing an enforceable right against compensation previously paid. Companies will need to consider how to most effectively incorporate this new clawback requirement into incentive compensation awards. Given the three-year lookback, depending on how the rules are developed, the clawback requirement might attach to individuals who were not executive officers at the time the incentive compensation was awarded. 6. Disclosure of Hedging Policies Section 955 of the Act requires disclosure as to whether directors or employees of the company are permitted to hedge against stock price drops with respect to equity compensation awards. The Act does not specify a time by which the SEC must adopt rules regarding this disclosure. Although some companies have adopted anti-hedging policies for executives and directors, the requirement under the Act more broadly refers to all employees. 7. Excessive Compensation at “Covered Financial Institutions” Section 956 of the Act potentially creates new regulatory limits on compensation at “covered financial institutions.” For this purpose, a “covered financial institution” means any of the following entities that has $1 billion or more in assets — a depository institution, a holding company for a depository institution, a broker-dealer registered under the Securities Exchange Act, a credit union, an investment advisor under the Investment Advisers Act or any other financial institution that the applicable regulators determine should be covered. (Fannie Mae and Freddie Mac also are covered.) Unlike the other executive compensation provisions in the Act, the covered financial institutions subject to this rule include both public and private companies. The applicable regulators (which include the Federal Reserve, FDIC, OCC, SEC and others) have nine months after enactment to establish rules by which covered financial institutions must disclose to their applicable regulator all incentive compensation plans (i.e., not solely executive officer plans). This disclosure is intended to allow the applicable regulator to determine whether the covered financial institution’s incentive plans encourage

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“inappropriate risks” (i) through providing “excessive compensation, fees or benefits” to its executive officers, employees, directors or principal shareholder or (ii) that could lead to a material financial loss for the covered financial institution. The rules also will directly prohibit such “excessive compensation, fees or benefits.” The Act cross-references certain provisions of the Federal Deposit Insurance Act regarding the intended meaning of “excessive” compensation. It is not clear how the various regulators will coordinate their rulemaking or how expansive they will be in defining “excessive” compensation. Even the executive compensation limits under TARP did not impose substantive caps on compensation. It is worth noting that the Federal Reserve, FDIC, OCC and OTS recently issued their Guidance on Sound Incentive Compensation Policies (“the Guidance”). The Guidance largely focuses on key principles for ensuring that incentive compensation plans at financial institutions appropriately balance risks with financial performance and compensation rewards. Perhaps the Guidance will inform the rulemaking for this new “excessive compensation” requirement under the Act, especially given the Act’s focus on mitigating against “inappropriate risks.”

Key Governance Changes 1. Broker Non-Votes Section 957 of the Act prohibits discretionary voting by brokers on shares they do not beneficially own on the following matters — (i) election of directors, (ii) executive compensation matters, and (iii) any other “significant matter” as determined by the SEC. Presumably, the executive compensation matters include the new say-on-pay shareholder votes under Section 951 of the Act. Section 957 of the Act does not prohibit a broker from voting shares if they received voting instructions from the beneficial owner. This new requirement will codify the NYSE rules approved by the SEC in 2009 that preclude discretionary broker votes on director elections, and it will potentially broaden those rules as applied to executive compensation matters. 2. Proxy Access Section 971 of the Act authorizes (but does not require) the SEC to adopt rules allowing shareholders to nominate candidates for directors,

using the company’s proxy statement. There were substantial debates in Congress over whether the Act should include requirements on the level or duration of shareholder ownership. However, due to powerful opposition from shareholder activist groups, these eligibility requirements, if any, were left up to the discretion of the SEC. Proxy access has been a controversial subject for a number of years. Last summer, the SEC published proposed new rules that would have provided shareholders with an ability to nominate directors through the company’s proxy statement. The SEC expressed a view that this proxy access could make boards more responsive and accountable to shareholder interests. The SEC proposal included requests for comments on numerous issues, such as – (i) should proxy access be triggered only in case of certain events (such as a management-nominated director receiving a certain percentage of “no” or “withhold” votes), (ii) should proxy access not be required for companies that have adopted a “majority vote” requirement in uncontested elections, (iii) what ownership levels and holding periods should be required before a shareholder could nominate a director candidate through the company’s proxy statement, (iv) should the rules mandate proxy access to shareholders at all companies or simply allow shareholders to propose bylaw changes that would provide for proxy access on a company-by-company basis, (v) should a company be allowed to “opt out” of proxy access if approved by its shareholders, and (vi) how should federal proxy access rules coordinate with potentially conflicting state corporate law requirements? The SEC received over 500 comment letters on its proposal, expressing a wide range of views on the questions presented. Given the complexity of the issue and the divergence of views, the SEC has not yet adopted a final rule. Indeed, some of the commentary suggested that the SEC lacked authority to adopt proxy access rules, which arguably infringe on internal corporate affairs that are ordinarily the province of state corporate law. It is likely, though, that the authority provided by the Act will spur the SEC to action. It remains to be seen how the SEC will answer the many open questions about proxy access, including the

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establishment of any shareholder eligibility requirements. The answers to these questions could have potentially profound effects on the director nomination and election process for public companies. 3. Disclosures Regarding CEO/Chairman Leadership Structure Section 972 of the Act directs the SEC to issue rules requiring disclosure in the annual proxy statement as to why the company either has one person serving in the Chairman/CEO positions or separate people in those roles. The SEC proxy disclosure rules revised last December include a requirement to discuss the rationale for the company’s selected leadership structure. The Act seems to simply codify this

requirement and does not appear to add any additional disclosure requirements on this issue.

Conclusion Much detail for these new executive compensation and governance requirements will come from SEC, securities exchanges or other regulators to be developed over the coming months. Companies will need to monitor closely these developments and potentially consider commenting on proposed rules, if a comment period is made available. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.





July 7, 2010 Authors: Melanie Hibbs Brody [email protected] +1.202.778.9203 Stephanie C. Robinson [email protected] +1.202.778.9856 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Consumer Financial Services Industry, Meet Your New Regulator K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. While the 2,319-page, sixteen-title Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) imposes new regulatory requirements on virtually every sector of the financial industry, the centerpiece of the Dodd-Frank Act from a consumer protection standpoint is the creation of a consumer financial protection watchdog. The new agency will be called the Bureau of Consumer Financial Protection (“Bureau”) and will be created pursuant to Title X of the Dodd-Frank Act, entitled the Consumer Financial Protection Act of 2010 (“CFPA” or “Act”). Its main goal will be to protect consumers. Based on an idea advocated by Harvard Law School professor Elizabeth Warren,1 the Bureau will have exceptionally wide-reaching powers over providers of consumer financial products and services and vast implications for the financial industry. As we have reported in prior alerts, the creation of this new agency will fundamentally change how financial products and services are regulated in the United States.2 The majority of existing federal consumer financial laws will come under the purview of the Bureau, and the Bureau will have the authority to enforce those laws as well as issue its own rules to implement the CFPA. The Act transfers consumer financial protection functions and personnel from other federal agencies to the Bureau and purports to make one agency primarily accountable for protecting consumers in financial transactions. The Bureau will have to be a behemoth just to handle the single national consumer complaint hotline where consumers will report problems with financial products and services. Potential penalties for violations of the CFPA and existing federal consumer financial laws will be extensive. Possible liability for taking a wrong step under just about any law that touches on the provision of consumer financial products or services is enormous. The Bureau will have the power to order remedies such as rescinding or reforming contracts, civil money penalties of up to $1 million per day in some cases, disgorgement for unjust enrichment, and restitution. The Dodd-Frank Act, however, still is not law. The bill that emerged from a joint House-Senate conference committee on June 25 has already passed the House of Representatives. Senate Majority Leader Harry Reid says that the Senate will vote on the measure when the Senators return from recess on July 12. Although the vote is likely to be close—supporters may get exactly the 60 votes they need to avert a filibuster—Messrs. Dodd and Frank are publicly confident that the President will sign the bill by mid-month. After providing some background on the CFPA, this alert will address the following questions:




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• What Is the Bureau of Consumer Financial Protection? (Page 2)

• What Are the Bureau’s Objectives? (Page 3)

• What Are the Bureau’s Primary Functions? (Page 4)

• When Does the Act Become Effective? (Page 4)

• Whom and What Does the Act Cover? (Page 4)

• What Persons and Activities Are Not Covered? (Page 6)

• What Authority Will the Bureau Have Over “Very Large” Banks, Savings Associations, Credit Unions, and Their Affiliates? (Page 6)

• How Does the CFPA Affect Smaller Banks, Savings Associations, and Credit Unions? (Page 6)

• What Authority Will the Bureau Have Over Non-Depository Covered Persons? (Page 7)

• What About Service Providers? (Page 8)

• What Rulemaking Authority Will the Bureau Have? (Page 8)

• What Enforcement Powers Will the Bureau Have? (Page 9)

• What Acts Are Prohibited, and What Are the Penalties for Violating the CFPA? (Page 10)

• What Authorities Will Be Transferred to the Bureau? (Page 10)

Evolution of the CFPA Legislation The legislation has undergone a number of significant changes since House Financial Services Committee Chairman Barney Frank first introduced the bill in the House of Representatives in July 2009. Among the more notable changes are the (qualified) exemptions from the Act for insurers, auto dealers, and retailers, as well as the scaled back coverage of community banks. Some of the specific authorities that would have been granted to the Bureau under early drafts of the bill also have been eliminated. For example, at one point the legislation would have required providers of financial products and services to disclose to

consumers the risks and costs of such products and services in “reasonable proportion” to benefits. That vague language alarmed many readers last year but does not appear in the final bill. A provision requiring “fair dealing” regulations applicable to persons who communicate with consumers in the provision of a consumer financial product or service also did not survive in the final version of the bill. Provisions in the original bill that would have made it difficult for a covered person to offer “alternative” consumer financial products or services are not in the final bill; however, at least with respect to residential mortgages, only plain vanilla products are left under the Mortgage Reform and Anti-Predatory Lending Act. We discuss that Act in detail in a separate alert. The version of the legislation that the House of Representatives passed in December 2009 defined a covered person to include someone who “indirectly” engages in a financial activity in connection with the provision of a consumer financial product or service. Fortunately, that definition has evolved and the word “indirectly” has been removed. There are also no longer the words of “encouragement” to the states to prescribe operational standards to deter unfair, deceptive, or abusive practices.

What Is the Bureau of Consumer Financial Protection? The CFPA creates the Bureau, which will regulate the offering and provision of consumer financial products and services for the purpose of ensuring access to markets for consumer financial products and services that are fair, transparent, and competitive.3 The Bureau will be autonomous4—but housed within the Federal Reserve System.5 The Director of the Bureau will be appointed by the President with advice and consent of the Senate.6 The Bureau will be an executive agency7 with a dedicated budget paid by the Federal Reserve System.8 It will receive annually a fixed percentage of the total operating expenses of the Federal Reserve System. Congress also approved a mechanism for authorizing appropriations for the Bureau when the Director determines that the funding needs of the Bureau will exceed the amount that may be transferred from the Board of

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Governors. If the Director determines that more funds are needed and submits a required report to the President and the appropriations committees of the Senate and House of Representatives, the CFPA authorizes an additional $200 million in appropriations for each fiscal year through 2014. A Consumer Advisory Board will advise the Bureau by providing information on emerging practices in the consumer financial products or services industry.9 Members should include experts in consumer protection, financial services, community development, fair lending, and civil rights, among others.10 An earlier version of the bill would have created two new boards—an advisory board and an oversight board, both of which would advise the Director—but the final legislation eliminated that redundancy. A Financial Stability Oversight Council established in Title I of the Dodd-Frank Act will in a sense oversee the watchdog. The Council would have the power to set aside a final regulation promulgated by the Bureau under certain conditions.

What Are the Bureau’s Objectives? The CFPA outlines five primary objectives:11

• ensure consumers receive timely and understandable information;

• protect consumers from unfair, deceptive, or abusive acts or practices;

• address outdated, unnecessary, or unduly burdensome regulations;

• enforce federal consumer financial law consistently, without regard to status of a person as a depository institution; and

• ensure the transparent and efficient operation of markets for consumer financial products and services.

“Federal consumer financial law” means the CFPA, certain “enumerated consumer laws” (defined below), the laws for which authorities are transferred under subtitles F (transferring consumer financial protection functions and personnel) and H of the CFPA (making conforming amendments to 25 federal laws), and any rule or order that the Bureau issues under any of the foregoing.12 The

“enumerated consumer laws” encompass almost all federal laws that regulate the activities of consumer financial product and service providers, including:

• the Alternative Mortgage Transaction Parity Act;

• the Consumer Leasing Act;

• the Electronic Fund Transfer Act;

• the Equal Credit Opportunity Act;

• the Fair Credit Billing Act;

• the Fair Credit Reporting Act (portions);

• the Home Owners Protection Act;

• the Fair Debt Collection Practices Act;

• the Federal Deposit Insurance Act (portions);

• the Gramm-Leach-Bliley Act (portions);

• the Home Mortgage Disclosure Act;

• the Home Ownership and Equity Protection Act;

• the Real Estate Settlement Procedures Act;

• the S.A.F.E. Mortgage Licensing Act;

• the Truth in Lending Act;

• the Truth in Savings Act;

• section 626 of the Omnibus Appropriations Act; and

• the Interstate Land Sales Full Disclosure Act.13

New mortgage reform provisions in Title XIV of the Dodd-Frank Act also are transferred to the Bureau. The Federal Trade Commission Act, however, is not an “enumerated consumer law.” The Fair Housing Act also is conspicuously absent from the list of enumerated consumer laws, and the CFPA explicitly states that no provision of the CFPA “shall be construed as affecting any authority arising under the Fair Housing Act”.14 Administrative enforcement of the Fair Housing Act at the federal level will stay with the Department of Housing and Urban Development. This is significant because most allegations of discrimination by mortgage lenders support parallel claims under the Fair Housing Act and the Equal

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Credit Opportunity Act (which, as noted above, is an “enumerated consumer law”). The Bureau also will have the authority to issue regulations under another title of the Dodd-Frank Act—Title XIV, called the Mortgage Reform and Anti-Predatory Lending Act, discussed in more detail in a separate alert—to ban lending practices that “promote disparities among consumers of equal credit worthiness but of different race, ethnicity, gender, or age.”15 In short, fair lending enforcement in the mortgage industry will still be divided among multiple federal agencies. Conforming amendments to the Federal Deposit Insurance Act would require federal banking agencies to make referrals to the Bureau when the agency “has a reasonable belief that a violation of an enumerated consumer law…has been committed,”16 and the Bureau may engage in joint fair lending investigations with the Department of Justice, the Department of Housing and Urban Development, or both.17 The FTC would continue to have authority to enforce the Equal Credit Opportunity Act.18

What Are the Bureau’s Primary Functions? The primary functions of the Bureau are to:19

• conduct financial education programs;

• collect, investigate, and respond to consumer complaints;

• collect, research, monitor, and publish information relevant to the functioning of markets;

• supervise covered persons and enforce federal consumer financial law;

• issue rules, orders, and guidance implementing federal consumer financial law; and

• perform necessary and useful support activities.

When Does the Act Become Effective? The Bureau will come into existence as soon as the President signs the Dodd-Frank Act. But the Bureau will not immediately have the authorities and personnel that will be transferred to it from other agencies. That will not happen until a “designated transfer date” to be determined by the Treasury

Secretary.20 Most of the substantive provisions in the CFPA also do not become effective until the designated transfer date.21 The Treasury Secretary must decide on a designated transfer date within sixty days of the Dodd-Frank Act becoming law (in other words, by mid-September if the sponsors of the bill stick to the current schedule). When setting this date, he must consult with various federal agency heads.22 The designated transfer date cannot be sooner than six months after the bill is enacted (mid-January 2011, assuming a mid-July Presidential signing) and no later than 12 months after enactment.23 The Treasury Secretary can extend the designated transfer date beyond 12 months if he submits a report to Congress explaining, among other things, why it is not feasible to complete the transition within the statutory timeframe.24 It will be interesting to observe the existing federal agencies issuing regulations under and enforcing the “enumerated consumer laws” during this transition period, knowing that the entire decision making process soon could change.

Whom and What Does the Act Cover? In general, the Act applies to “covered persons.” Covered persons are persons or entities that engage in offering or providing a consumer financial product or service, and include their affiliates that act as service providers for them.25 A “consumer financial product or service” is any “financial product or service” defined in the Act when it is offered or provided for use by consumers primarily for personal, family, or household purposes. “Consumer” means an individual or an agent, trustee, or representative acting on behalf of an individual.26 Financial products and services include the following:27

• extending credit, which would include first- and subordinate-lien, open-end and closed-end, residential mortgage loans;*

* In addition to the above financial products and services that are “consumer financial products or services” when offered or provided for use by consumers primarily for personal, family, or household purposes, the Act also provides that a financial product or service that is described in one or more of the activities listed above with an asterisk beside them are also deemed to be consumer financial products or services—even if they are not provided for use by consumers primarily for


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• acquiring, purchasing, selling, brokering, or servicing loans or other extensions of credit (but not solely extending commercial credit to an originator of consumer credit);*

• leasing or brokering leases equivalent to purchase finance arrangements under certain conditions;

• providing real estate settlement services, other than insurance or electronic conduit services;28

• performing appraisals of real estate or personal property;

• deposit-taking, money transmitting, or money services;

• selling, providing, or issuing stored value in any electronic format if the seller exercises substantial control over terms and conditions of the stored value;

• check cashing, check collection, and check guaranty services;

• financial data processing and transmission services;

• providing financial advisory services, including providing credit counseling to consumers and providing services to assist a consumer with debt management or debt settlement, with modifying loans, or with avoiding foreclosure (but excluding persons regulated by the SEC or a state securities commission);

• collecting, analyzing, maintaining, or providing consumer report information or other account information for use in connection with any decision regarding the offering or provision of a consumer financial product or service, with certain exceptions;*

• debt collection related to a consumer financial product or service;* and

• such other product or service as defined by Bureau regulation if the Bureau finds the

personal, family, or household purposes—if they are delivered, offered, or provided in connection with a consumer financial product or service provided for such purposes.

product or service is entered into or conducted as a subterfuge or with a purpose to evade any federal consumer financial law, or if it is permissible for a bank or a financial holding company to offer or provide it under federal law or regulation and has or is likely to have a material impact on consumers; but

• does not include the business of insurance or electronic conduit services.

As noted above, the term “covered person” includes an affiliate of a person that provides a consumer financial product or service if the affiliate acts as a service provider to that person.29 The Act defines “service provider” as a person that provides a material service to a covered person in connection with the offering or provision by the covered person of a consumer financial product or service. Service providers include: (i) a person that participates in designing, operating, or maintaining the consumer financial product or service; and (ii) a person who processes related transactions (other than unknowingly or incidentally and in a manner in which the data is undifferentiated from other types of data the person transmits or processes).30 The term does not include a person who merely offers or provides ministerial support services or advertising space.31 “Related persons” also are “covered persons.” “Related persons” is defined, but only with respect to a covered person that is not a bank holding company, credit union, or depository institution, as:32

• directors, officers, employees with managerial responsibility, controlling shareholders of, or agents for, the covered person;

• shareholders, consultants, joint venture partners, and any other person as determined by the Bureau who materially participates in the conduct of the affairs of the covered person; and

• independent contractors (including attorneys, appraisers, or accountants) who knowingly or recklessly participate in any violation of law or regulation, or breach of a fiduciary duty.33

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What Persons and Activities Are Not Covered? The CFPA specifically exempts certain entities to the extent they are not engaging in financial activities. Except to the extent that a person otherwise engages in offering or providing a consumer financial product or service, or is otherwise subject to any enumerated consumer law or any law for which authorities will be transferred to the Bureau, the following generally are not subject to the Act:34

• persons engaged in the business of insurance, which includes reinsurance;35

• providers of electronic conduit services;36

• merchants, retailers, and sellers of non-financial goods or services;37

• real estate licensees and registrants;38

• manufactured home retailers and modular home retailers;39

• accountants and tax preparers;40

• lawyers;41

• persons regulated by a state insurance regulator;42

• employee benefit and compensation plans and certain other arrangements under the Internal Revenue Code of 1986;43

• persons regulated by the SEC or a state securities commission;44

• persons regulated by the CFTC;45

• persons regulated by the Farm Credit Administration;46

• people engaged in the solicitation or making of charitable contributions; and47

• auto dealers predominantly engaged in the sale and servicing of motor vehicles, the leasing and servicing or motor vehicles, or both.48

What Authority Will the Bureau Have Over “Very Large” Banks, Savings Associations, Credit Unions, and Their Affiliates?

The Bureau will supervise covered persons that are insured depository institutions or credit unions with total assets of more than $10 billion, as well as any of their affiliates (collectively, “Very Large Banks”).49 To that end, the Bureau will require reports, conduct examinations, and coordinate its supervisory activities with those of prudential regulators and state bank regulatory authorities.50 A prudential regulator and the Bureau must conduct simultaneous examinations unless the supervised institution requests that examinations be conducted separately.51 If the proposed supervisory determinations of the Bureau and a prudential regulator are conflicting, then the Very Large Bank can ask the agencies to coordinate and present a joint statement of coordinated supervisory action within thirty days. If they fail to do so, the Very Large Bank can appeal to a governing panel.52 The Bureau will have primary enforcement authority over Very Large Banks with respect to a federal consumer financial law, although any federal agency other than the FTC that is authorized to enforce a federal consumer financial law may make a referral to the Bureau.53 If the Bureau does not initiate an enforcement proceeding within 120 days of the referral, the other agency may initiate an enforcement proceeding. The Very Large Bank subject to supervision under this section is required to provide to the Bureau and other agencies with jurisdiction timely responses concerning a consumer complaint or inquiry.54

How Does the CFPA Affect Smaller Banks, Savings Associations, and Credit Unions? As a result of much lobbying and negotiation, the CFPA’s application to community banks is not as extensive as it would have been under earlier versions of the bill. The Director could require reports from covered persons that are insured depository institutions and credit unions with total assets of $10 billion or less (collectively, “Smaller Banks”); however, to the extent possible the Bureau is supposed to rely on public information and reports that have been provided to a federal or state agency.55 The Bureau also could include its examiners “on a sampling basis” of the examinations performed by the prudential

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regulator.56 The prudential regulators will retain exclusive enforcement authority (relative to the Bureau) over Smaller Banks, but the Bureau could make a referral to the regulator to recommend action if the Bureau has reason to believe that the Smaller Bank has engaged in a material violation of federal consumer financial law.57 These provisions do not reference affiliates of Smaller Banks.

What Authority Will the Bureau Have Over Non-Depository Covered Persons? Supervisory Authority The Bureau must consult with the FTC in defining non-depository covered persons subject to Bureau supervision, and must issue its initial rule within one year of the designated transfer date.58 With respect to any covered person other than a Very Large Bank or Smaller Bank who:

(i) offers or provides origination, brokerage, or servicing of loans secured by real estate for use by consumers primarily for personal, family, or household purposes, or loan modification or foreclosure relief services in connection with such loans; (ii) is “a larger participant of a market for other consumer financial products or services,” as defined by rule by the Bureau; (iii) the Bureau has reasonable cause to determine is engaging or has engaged in conduct that poses risks to consumers; (iv) offers or provides to a consumer any private education loan; or (v) offers or provides to a consumer a payday loan,59

the Bureau can: conduct examinations and require reports; coordinate its supervisory activities with those of prudential regulators and state bank regulatory authorities; and require registration, among other things.60 The Bureau’s authority to prescribe rules regarding registration requirements applicable to a non-depository covered person appears to be permissive. That is, the Bureau may

prescribe such registration rules but the CFPA does not expressly require the Bureau to do so.61 Enforcement Authority If a federal law authorizes the Bureau and another federal agency to enforce federal consumer financial law against a non-depository covered person, the Bureau will have exclusive authority to enforce that law; however, the other federal agency may make a referral to the Bureau by recommending that the Bureau initiate an enforcement proceeding.62 Notwithstanding this, the FTC will retain its enforcement authority over non-depository covered persons or their service providers. Within six months after the designated transfer date, the Bureau and FTC must negotiate an agreement for coordinating their enforcement actions. The agreement must include procedures for notice to the other agency prior to initiating a civil action to enforce any federal law regarding the offering or provision of consumer financial products or services.63 State attorneys general are explicitly authorized to bring civil actions to enforce the CFPA and its implementing regulations against any covered persons except national banks and federal thrifts. Under the category of “dancing on the head of a pin,” a state attorney general may bring a civil action against a national bank or federal thrift to enforce a regulation that the Bureau has issued under the CFPA, but not to enforce a provision of the statute itself.64 In order to bring an action against a national bank or federal thrift, however, the state attorney general must first notify the Bureau and applicable prudential regulator, and the Bureau may intervene in the action as a party.65 Upon intervening, the Bureau could remove the action to the appropriate United States district court, be heard on all matters arising in the action, and appeal any order or judgment to the same extent as any other party in the proceeding may.66 The CFPA expressly does not alter the authority of state attorneys general to enforce federal consumer credit laws besides the CFPA: “No provision of this title shall be construed as modifying, limiting, or superseding the operation of any provision of an enumerated consumer law that relates to the authority of a State attorney general or State

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regulator to enforce such Federal law.”67 Thus, in enforcing federal consumer financial laws other than the CFPA, state attorneys general could not use the additional administrative authorities that are available to the Bureau for a violation of those laws. State consumer financial laws are preempted for national banks and federal savings associations only if: (i) their application would have a discriminatory effect on national banks or thrifts in comparison with the effect of the law on a bank chartered by that state; (ii) they meet the preemption standard set forth in Barnett Bank v. Nelson (i.e., the state law prevents or significantly interferes with the exercise by the national bank of its powers); or (iii) the state law is preempted by a provision of federal law other than the National Bank Act (for national banks) or Home Owners’ Loan Act (for federal thrifts).68 State laws will not be preempted as to non-depository subsidiaries and affiliates of national banks and thrifts.69 “State consumer financial law” is a precisely defined term for purposes of these preemption standards, and will not include many state laws that regulate consumer financial transactions, including arguably UDAP laws. We discuss in detail in a separate alert the CFPA’s implications for preemption of state law. Rulemaking and Examination Authority To the extent that federal law authorizes the Bureau and another federal agency to issue regulations or guidance, conduct examinations, or require reports from a non-depository covered person, the Bureau will have exclusive authority.70

What About Service Providers? Service providers to covered persons will likewise be subject to the authority of the Bureau, to the same extent as if they were engaged in a service relationship with a bank and the Bureau were an appropriate federal banking agency.71 But service providers to Smaller Banks are subject to Bureau authority only if they provide services to a “substantial number” of such persons.72 Presumably, a Smaller Bank that acts as a service provider to a Very Large Bank or non-depository covered person would be covered to the same extent as any other service provider. In conducting exams or requiring reports of service providers, the Bureau

will coordinate with the appropriate prudential regulator.73

What Rulemaking Authority Will the Bureau Have? The Bureau will have exclusive authority to prescribe rules under the federal consumer financial laws.74 In doing so, it must consider the potential costs and benefits to consumers and covered persons alike.75 It also must consult with appropriate prudential regulators or other federal agencies regarding consistency with prudential, market, or systemic objectives administered by such agencies.76 The Bureau must conduct an assessment of each significant rule or order it adopts and publish a report of its assessment within five years of the effective date of the subject rule or order.77 The Act authorizes—and in some cases requires—the Bureau to make rules or guidelines regarding the following:

• the definition of other financial products or services;78

• confidential treatment of information obtained from persons in connection with the exercise of its authorities under federal consumer financial law;79

• registration of non-bank covered persons;80

• restricting mandatory pre-dispute arbitration clauses in agreements between a covered person and consumer for a consumer financial product or service;81

• identifying prohibited unfair, deceptive, or abusive acts or practices, including with respect to mortgage loan modification and foreclosure rescue services;82

• mandating the form and content of disclosures to consumers, with a safe harbor for a covered person that uses a model form;83

• combining the disclosures required under TILA and RESPA into a single, integrated disclosure form;84

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• consumer rights to access information related to their consumer financial product or service transaction or account;85

• state attorney general enforcement actions (the Bureau must prescribe regulations to implement the requirements of the CFPA that preserve state enforcement powers, and must provide guidance from time to time to coordinate actions with the state attorneys general and other regulators);86

• capturing information about loans to women-owned, minority-owned, or small businesses;87

• standards for remittance transfer providers;88

• interchange transaction fees;89

• payment card network restrictions and network fees;90

• conditions or limitations on reverse mortgages;91

• minimum net worth or surety bond requirements under S.A.F.E. Mortgage Licensing Act for residential mortgage loan originators and minimum requirements for recovery funds paid into by loan originators;92 and

• the accuracy and integrity of information furnished to consumer reporting agencies, and regulations requiring persons that furnish information to credit reporting agencies to establish reasonable policies and procedures for implementing those guidelines.93

In connection with its authority to impose requirements regarding consumer disclosures, the Bureau could include in any final rule a model form, which must be validated through consumer testing.94 The Bureau could also allow a covered person to conduct a trial disclosure program for the purpose of improving upon any model form.95 Any new disclosure regulations the Bureau might propose have the potential to require consumer financial product and service providers to overhaul their existing disclosure systems. Fair Lending Conforming amendments to the Equal Credit Opportunity Act require the Bureau to make regulations to carry out the purposes of ECOA with respect to auto dealers (even though the Bureau does

not have general enforcement jurisdiction over auto dealers).96 State Request for Regulation Additionally, the Bureau has to respond to state calls for regulation. It must issue a notice of proposed rulemaking whenever a majority of the states has enacted a resolution in support of the establishment or modification of a consumer protection regulation by the Bureau.97 This would not require the Bureau to issue rules that comport with the states’ resolution, but the Bureau at least must initiate a rulemaking proceeding to consider such an action. Review of Bureau Regulations A member agency of the Financial Stability Oversight Council may petition the Council to set aside all or part of a final regulation prescribed by the Bureau, regardless of whether the regulation implements other federal consumer financial laws or falls under the Bureau’s independent rulemaking authority.98 The Council may set the regulation or provision aside if it finds that it would put the safety and soundness of the United States banking system or the stability of the financial system at risk.99 This is an extremely high standard of review. It seems unlikely that the Bureau would promulgate any regulations that put the entire national financial system in jeopardy; nevertheless, this is at least a check on the Bureau’s authority. The Council’s decision to set aside a Bureau regulation would be subject to judicial review.100 The CFPA directs the Council to prescribe procedural rules to implement these provisions.

What Enforcement Powers Will the Bureau Have? The Bureau will have the power to:

• issue civil investigative demands and file a petition to a court for their enforcement;101

• conduct joint investigations, including joint fair lending investigations with HUD and/or DOJ;102

• issue subpoenas;103

• conduct hearings and adjudication proceedings and issue cease-and-desist orders; and104

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• commence civil actions.105

The statute of limitations for bringing an action under the CFPA is three years from the date of discovery of the violation to which the action relates. Actions arising under the enumerated consumer laws or laws for which authorities are transferred under the Act may be brought in accordance with the statute of limitations requirements of those laws, as applicable.106 The CFPA is silent with respect to private rights of action. An earlier version of the legislation that was approved in the House of Representatives on December 11, 2009 had included specific language stating that the CFPA does not create a private right of action, but also does not negate any private right of action arising under the enumerated consumer laws or authorities transferred under subtitles F or H of the Act.107 Presumably, the availability of private rights of action under the enumerated consumer laws remains unchanged, and no new private right of action is created under CFPA.

What Acts Are Prohibited, and What Are the Penalties for Violating the CFPA? The CFPA expressly prohibits a covered person or service provider from: (i) engaging in unfair, deceptive, or abusive acts or practices, or knowingly or recklessly providing substantial assistance to a covered person or service provider in violation of the CFPA’s UDAP provisions or rules; (ii) offering or providing to a consumer a financial product or service not in conformity with federal consumer financial law; or (iii) failing to permit access to or copying of records, establishing or maintaining records, or making reports or providing information to the Bureau.108 Penalties for violations of federal consumer financial laws, including rule or order violations, include:

• rescission or reformation of contracts;

• refunds of money or return of real property;

• restitution;

• disgorgement of compensation for unjust enrichment;

• monetary damages;

• limits on activities or functions of the person;

• public notification of the violation, including costs for notification; and

• civil money penalties of up to $5,000 per day, up to $25,000 per day for a reckless violation, or up to $1 million per day for a knowing violation.109 Mitigating factors are to be considered, and the Bureau could reduce the penalty accordingly.

These remedies in large measure are patterned after the rights afforded to federal banking agencies under section 8 of the Federal Deposit Insurance Act. In several respects, however, the Bureau has fewer statutory hurdles it must scale before it can invoke certain of these remedies. The CFPA states that in an administrative proceeding or court action brought under federal consumer financial law, the court or Bureau may grant any of the above relief without limitation.110 Litigation costs also may be recovered in actions brought by the Bureau, a state attorney general, or a state regulator to enforce any federal consumer financial law.111 Thus, the CFPA’s penalty provisions effectively amend each federal consumer financial law by providing an entirely new set of remedies. The Bureau also must refer any person to the Attorney General of the United States if the Bureau obtains evidence that the person has engaged in criminal conduct.112 The Act also contains whistleblower protection provisions.113

What Authorities Will Be Transferred to the Bureau? All consumer financial protection functions of the Board of Governors, FDIC, NCUA, OCC, and OTS will be transferred to the Bureau, except as discussed above.114 All consumer protection functions of HUD relating to RESPA and the S.A.F.E. Mortgage Licensing Act are transferred to the Bureau.115 The authority of the FTC under an enumerated consumer law to prescribe rules, issue guidelines, or conduct a study or issue a report mandated under

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such law will be transferred to the Bureau.116 The Bureau also will have the authority to enforce a rule prescribed under the FTC Act with respect to an unfair or deceptive act or practice to the extent that the rule applies to a covered person or service provider with respect to the offering or provision of a consumer financial product or service as if it were a rule prescribed by the Bureau under its own authority.117 Similarly, the FTC will have the authority to enforce under the FTC Act any CFPA rule with respect to a covered person who is subject to FTC jurisdiction.118 The CFPA directs the FTC and Bureau to negotiate an agreement to coordinate rulemaking by each agency to avoid duplication or conflict between rules.119 As noted above, the two agencies must negotiate a similar agreement to coordinate enforcement. Whenever one agency files a civil action against a covered person, the other agency may not file its own action against the person, but may intervene as a party.120

These transfers of functions do not affect the authority of these agencies from conducting examinations or initiating and maintaining enforcement proceedings in accordance with the provisions described above.121 Personnel will be transferred from these agencies to the Bureau.122

Conclusion Even the most cynical observers of gridlock in our nation’s capital have to stand back in awe at the creation and empowerment of the Bureau. The transfer of functions and personnel from various federal agencies previously charged with supervising consumer credit laws, and the broad authorization of new rulemaking powers, will result in an extraordinarily strong advocate for consumers. Whether it will use those powers and authorities in an evenhanded way will be determined over time. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.





1 See, e.g., E. Warren, A Clear-Cut Case for Regulatory Reform, The Hill (2009), http://thehill.com/special-reports/finance-july-2009/51569-a-clear-cut-case-for-regulatory-reform. Professor Warren has been serving as chair of the Congressional Oversight Panel mandated by TARP. 2 See, e.g., Stephanie C. Robinson, Analysis of Consumer Financial Protection Agency Legislation: Top Ten Issues, Mortgage Banking & Consumer Financial Products Alert (Oct. 26, 2009) (available at http://www.klgates.com/newsstand/Detail.aspx?publication=5986); Melanie H. Brody, Steven M. Kaplan, David L.

Beam & Stephanie C. Robinson, Million Dollar Baby: The Consumer Financial Protection Agency Act of 2009, Mortgage Banking & Consumer Financial Products Alert (July 27, 2009) (available at http://www.klgates.com/newsstand/Detail.aspx?publication=5816); Melanie H. Brody & Stephanie C. Robinson, Singularity of Purpose: Is Looking Out for Consumers Too Narrow a Mission?, Mortgage Banking Alert (June 25, 2009) (available at http://www.klgates.com/newsstand/Detail.aspx?publication=5735); Melanie H. Brody & Stephanie C. Robinson, Fifty Ways to Need a Lawyer: Congress Proposes to Establish Financial Services Watchdog Agency, Mortgage Banking & Consumer Credit Alert (Apr. 15, 2009) (available at


http://thehill.com/special-reports/finance-july-2009/51569-a-clear-cut-case-for-regulatory-reform





http://www.klgates.com/newsstand/Detail.aspx?publication



July 7, 2010 12


http://www.klgates.com/newsstand/Detail.aspx?publication=5547). 3 Consumer Financial Protection Act of 2010, Title X of the Dodd-Frank Wall Street Reform and Consumer Protection Act , H.R. 4173, 111th Cong. § 1021(a) (2010) [hereinafter CFPA]. 4 Id. § 1012(c). 5 Id. § 1011(a). 6 Id. § 1011(b). 7 Id. § 1011(a). 8 Id. § 1017(a). An earlier version of the bill that was approved by the House last December would also have assessed fees on covered entities to fund the Bureau, but those assessments were eliminated from the final bill. 9 Id. § 1014(a). 10 Id. § 1014(b). 11 Id. § 1021(b). 12 Id. § 1002(14). 13 See id. § 1002(12). 14 Id. § 1027(s). 15 Mortgage Reform and Anti-Predatory Lending Act, Title XIV of the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. § 1403 (2010). 16 CFPA § 1090. 17 Id. § 1052(a)(2). 18 See id. § 1085. 19 Id. § 1021(c). 20 Id. § 1062. 21 Id. §§ 1018, 1029A, 1037, 1048, 1058, & 1100G. 22 Id. § 1062. 23 Id. § 1062(c)(1). 24 Id. § 1062(c)(2). 25 Id. § 1002(6). 26 Id. § 1002(4). 27 Id. § 1002(5), (15). 28 Electronic conduit services means the provision of electronic data transmission, routing, intermediate or transient storage, or connections to a telecommunications system or network, except where the person: (i) selects or modifies the content of the electronic data; (ii) transmits, routes, stores, or provides connections for electronic data, including financial data, in a manner that such financial data is differentiated from other types of data of the same form that such person transmits, routes or stores, or with respect to which, provides connections; or is a payee, payor, correspondent, or similar party to a payment transaction with a consumer. Id. § 1002(11). 29 Id. § 1002(6). 30 Id. § 1002(26)(A). 31 Id. § 1002(26)(B). 32 Id. § 1002(25)(A), (B). 33 Id. § 1002(25)(C). 34 See id. § 1027 for specific exclusionary language and limitations. 35 Id. §§ 1002(3), 1002(15)(C), 1027(m). 36 Id. § 1002(15)(C). 37 Id. § 1027(a). The vast majority of retail sales would not be covered by CFPA. Merchants, retailers, and sellers of non-financial goods or services that offer or provide

consumer financial products or services in connection with the sale or brokerage of non-financial goods or services are covered if certain conditions apply, but there are some exceptions for small businesses. See id. § 1027(a)(2). 38 Id. § 1027(b). 39 Id. § 1027(c). 40 Id. § 1027(d). 41 Id. § 1027(e). The exclusion for the activity of an attorney engaged in the practice of law does not apply where a financial product or service: (i) is not offered or provided as part of or incidental to the practice of law, occurring exclusively within the scope of the attorney-client relationship; or (ii) is otherwise offered or provided by the attorney in question with respect to any consumer who is not receiving legal advice or services from the attorney in connection with the financial product or service. Id. § 1027(e)(2). 42 Id. § 1027(f). 43 Id. § 1027(g). 44 Id. § 1027(h), (i). 45 Id. § 1027(j). 46 Id. § 1027(k). 47 Id. § 1027(l). 48 Id. § 1029(a). This exclusion for auto dealers will not apply to a person that (i) provides consumers with any services related to residential or commercial mortgages or self-financing transactions involving real property; (ii) operates a line of business that involves the extension of retail credit or retail leases involving motor vehicles, and in which (a) the extension of retail credit or retail leases is provided directly to consumers; and (b) the contract governing such extension of retail credit or retail leases is not routinely assigned to an unaffiliated third party finance or leasing source; or (iii) offers or provides a consumer financial product or service not involving or related to the sale, financing, leasing, rental, repair, refurbishment, maintenance, or other servicing of motor vehicles, motor vehicle parts, or any related or ancillary product or service. Id. § 1029(b). Furthermore, the Federal Trade Commission is authorized to prescribe rules under sections 5 and 18(a)(1)(B) of the Federal Trade Commission Act with respect to an auto dealer, and the Act preserves the authorities of other agencies over motor vehicle dealers. Id. § 1029(c), (d). 49 Id. § 1025(a), (b). 50 Id. § 1025(b), (e). 51 Id. § 1025(e). 52 Id. § 1025(e). 53 Id. § 1025(c). 54 Id. § 1034(b). 55 Id. § 1026(a), (b). 56 Id. § 1026(c)(1). 57 Id. § 1026(d). 58 Id. § 1024(a)(2). 59 Id. § 1024(a). 60 Id. § 1024(b). 61 See id. §§ 1022(c)(7) & 1024(b)(7). 62 Id. § 1024(c). 63 Id. 64 Id. § 1042(a). 65 Id. § 1042(b). 66 Id. § 1042(b)(2). 67 Id. § 1042(a)(3).


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68 Id. §§ 1044, 1046. 69 Id. § 1045. 70 Id. § 1024(d). 71 See id. §§ 1024(e), 1025(d), & 1026(e). 72 Id. § 1026(e). 73 See id. §§ 1024(e), 1025(d), & 1026(e). 74 Id. § 1022(b)(4), but see § 1061(b)(5) relating to Federal Trade Commission authority. 75 Id. § 1022(b)(2)(A). 76 Id. § 1022(b)(2)(B). 77 Id. § 1022(d). 78 Id. § 1002(15)(A)(xi). 79 Id. § 1022(c)(6). 80 Id. § 1022(c)(7). 81 Id. § 1028(b). If the Bureau prescribes such a regulation restricting mandatory pre-dispute arbitration, the regulation will apply to agreements entered into after the end of the 180-day period beginning on the effective date of the regulation. Id. § 1028(d). 82 Id. §§ 1031(b), 1097. The Bureau will have to consult with other agencies for consistency, and cannot declare an act or practice to be “unfair” unless the Bureau has a reasonable basis to conclude that the act or practice causes or is likely to cause substantial injury to consumers that is not reasonably avoidable by consumers and the injury is not outweighed by countervailing benefits to consumers or to competition. Id. §§ 1031(c)(1), (e). The Bureau similarly cannot declare an act or practice to be “abusive” unless the act or practice materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service or takes unreasonable advantage of: (i) the consumer’s lack of understanding of material risks, costs, or conditions; (ii) the consumer’s inability to protect his or her own interests in selecting or using the product or service; or (iii) the consumer’s reasonable reliance on the covered person to act in his or her interests. Id. § 1031(d). The Bureau’s UDAP rules must provide that a mortgage lender may consider the seasonality and irregularity of a borrower’s income in the underwriting of and scheduling of payments for residential mortgage loans. Id. § 1031(f). 83 Id. § 1032. 84 Id. § 1032(f). The Bureau must propose such model disclosure form within one year of the designated transfer date. 85 Id. § 1033(a). 86 Id. § 1042(c). 87 Id. § 1071(a). 88 Id. § 1073(a). 89 Id. § 1075(a). 90 Id. 91 Id. § 1077. 92 Id. § 1100. 93 Id. § 1088(a)(11). 94 Id. § 1032(b). 95 Id. § 1032(e). 96 Id. § 1085. 97 Id. § 1041(c). 98 Id. § 1023(a).

99 Id. 100 Id. § 1023(c)(8). 101 Id. § 1052(c), (e). 102 Id. § 1052(a). 103 Id. § 1052(b). 104 Id. § 1053. 105 Id. § 1054. 106 Id. § 1054(g). 107 See Consumer Financial Protection Agency Act of 2009, Title X of the Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Cong. § 4508 (2009). 108 CFPA § 1036. 109 Id. § 1055(a)-(c). 110 Id.§ 1055(a). 111 Id. § 1055(b). 112 Id. § 1056. 113 See id. § 1057. 114 See id. § 1061. 115 Id. § 1061(b)(7). 116 Id. § 1061(b)(5)(A). 117 Id. § 1061(b)(5)(B). 118 Id. § 1061(b)(5)(C)(ii). 119 Id. § 1061(b)(5)(D). 120 Id. § 1024(c)(3)(B). 121 Id. § 1061(c). 122 See id. § 1064.

July 8, 2010 Authors: Kristie D. Kully [email protected] +1.202. 778.9301 Laurence E. Platt [email protected] +1.202.778.9034 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Hope You Like Plain Vanilla! Mortgage Reform and Anti-Predatory Lending Act (Title XIV) K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. Like the Saturday Night Live lunch counter from the late 1970s that, regardless of what the customers reasonably requested, offered only cheeseburgers, chips, and Pepsi, the Mortgage Reform and Anti-Predatory Lending Act (the Mortgage Reform Act) would essentially mandate that all flavors of mortgage loans besides “plain vanilla” will disappear from the menu. And what about those consumers who want strawberry ice cream instead? Sorry, the government has determined that it may be hazardous to your health. Capitol Hill watchers in the industry have long expected many of the provisions in the new Mortgage Reform Act, passed by the House of Representatives on June 30 as part of the comprehensive financial reform package called the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The Mortgage Reform Act will, if and when enacted, change the way creditors offer, and consumers receive and pay for, residential mortgage loans in the future. What still comes as a surprise, however, is the extent to which makers and holders of non-plain vanilla mortgages are targeted for punishment through enhanced monetary damages, defenses to foreclosure, and risk retention requirements. Only time will tell whether the mortgage finance industry will assume the risks and expand the menu of mortgage options. In this client alert, we summarize the many provisions in the Mortgage Reform Act that will regulate the origination process.1 First, we summarize the Mortgage Reform Act’s extension of the Truth in Lending Act (TILA) to control the actions and compensation of, and to impose liability on, mortgage loan originators; the requirement for creditors to consider a borrower’s ability to repay based on verified and documented information; the designation of plain vanilla “qualified” mortgage loans that escape that amorphous ability-to-repay scrutiny; and other expansions to TILA’s requirements and liability. We then summarize the new consumer disclosures the Dodd-Frank Act will impose, many of which are confusingly duplicative (ironic when considering the efforts to consolidate consumer protection and to reform the mortgage process). We also describe the Mortgage Reform Act’s amendments to the Real Estate Settlement Procedures Act (RESPA), the Fair Credit Reporting Act (FCRA), the Home Mortgage Disclosure Act (HMDA), and the Secure and Fair Enforcement for Mortgage Licensing Act (the S.A.F.E. Act).




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Other K&L Gates client alerts describe the abundant other provisions in the Mortgage Reform Act and the larger Dodd-Frank Act relating to residential mortgage lending, including the creation of the new gargantuan Consumer Financial Protection Bureau (the Bureau) within the Federal Reserve, the imposition of new mortgage loan servicing requirements, the dilution of federal preemption of state laws for national banks (and the remaining few entities with federal thrift charters) and their operating subsidiaries, the impact of the amendments to the Alternative Mortgage Transactions Parity Act, and the consequences of the new “skin in the game” requirements under the new risk retention rules. In addition, other alerts from K&L Gates will address other aspects of financial reform in the Dodd-Frank Act. Additional information is available on the K&L Gates website specially dedicated to Financial Services Reform. These mortgage reform efforts have been under construction for over two years, and K&L Gates has issued several clients alert discussing the efforts of the House and Senate (as well as the Federal Reserve Board) to finalize new policies, and comparing those bills and rules as they progressed.2 In many, but not all, respects the Mortgage Reform Act within the Dodd-Frank Act is based on the provisions in the House bill with respect to mortgage loan originator anti-steering, but it reflects the Senate version in that it deleted the anti-flipping/net tangible benefit requirements and narrowed the remedies of monetary damages rather than rescission against assignees and securitizers. We note that the provisions we describe below would not affect the preemptive effect (or lack thereof) of any of the founding statutes we discuss (TILA, RESPA, FCRA, HMDA). While the Dodd-Frank Act will affect the preemption that federally chartered depository institutions and their subsidiaries enjoy, the Mortgage Reform Act itself would not affect the impact of those particular federal statutes on the applicability of state law. Effective Date First, as with a whole host of other federal consumer protection laws, the Mortgage Reform Act would (if enacted in its current form) be deemed an “enumerated consumer law” (along with the federal TILA, which it amends). Thus, the authority for

implementing its provisions would be assigned to (or transferred to) the new Bureau. The regulations required in the Mortgage Reform Act would have to be finalized within 18 months of the designated date of transfer of authority and functions to the Bureau. Those regulations then would become effective not later than 12 months after the regulations are issued in final form. Based on the enormous quantity and substantive importance of the issues to be prescribed in regulations (by a brand new agency with a huge mandate, but without a director, an organization, office space, telephone system, etc.), it is clear that we will continue discussing many of these issues for many months/years. However, while certain provisions of the Mortgage Reform Act expressly require regulatory implementation and thus will become effective when the rulemaking process is complete, other provisions do not specifically require implementing regulations. The Act is less clear about the effective date of those provisions. On one hand, the Act says that any section of Title XIV “for which regulations have not been issued on the date that is 18 months after the designated transfer date shall take effect on such date.” This would seem to say that those provisions of Title XIV that do not specifically require the Board to adopt implementing regulations do not become effective until 18 months after the designated transfer date (which would be sometime between two years and two-and-one-half years after the President signs the bill), unless the Board or Bureau (as applicable) decides to adopt regulations to implement the provisions anyway, and specifies an earlier effective date in those regulations. On the other hand, others have asserted that the foregoing effective date applies only to those provisions of Title XIV for which the Bureau is required to issue regulations. This would mean that the provisions for which the Bureau is not required to issue regulations would be subject to the Dodd-Frank Act’s default effective date--which is the day after the President signs the bill. This would be a shocking result given the time it would take to implement the many statutory requirements in an orderly manner. We hope that the Board immediately clarifies this ambiguity in a way that would permit the changes to be carefully implemented.

http://www.klgates.com/practices/ServiceDetail.aspx?service=139

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Definition of “Mortgage Originator” The Mortgage Reform Act would begin by expanding TILA to apply to mortgage originators, in addition to those persons that actually extend credit to consumers. Federal law already has attempted to define a concept of a “mortgage originator” under the S.A.F.E. Act (which provides a federal standard for licensing and/or registration of mortgage originators). The Mortgage Reform Act would not, however, adopt the S.A.F.E. Act definition. Instead, for purposes of the prohibitions described in this client alert, and for other provisions of TILA, as amended, the definition of a “mortgage originator” would be any person (an individual or an organization) that, for direct or indirect compensation or gain, or in the expectation of direct or indirect compensation or gain:

(i) Takes a “residential mortgage loan” application;

(ii) Assists a consumer in obtaining or applying to obtain a residential mortgage loan; or

(iii) Offers or negotiates terms of a residential mortgage loan.

Interestingly, an early version of the S.A.F.E. Act included the second prong, above (i.e., assisting a consumer), and a small number of states enacted that version. However, that prong was removed before the S.A.F.E. Act was finally enacted. Under the Mortgage Reform Act, a person “assists a consumer in obtaining or applying to obtain a residential mortgage loan” by, among other things, advising on residential mortgage loan terms (including rates, fees, and other costs), preparing residential mortgage loan packages, or collecting information on behalf of the consumer with regard to a residential mortgage loan. (This definition appears in the S.A.F.E. Act, but the phrase is not otherwise used in that Act. In fact, it becomes a struggle to differentiate this scope of “assisting” activities from the clerical or support activities that the S.A.F.E. Act – and the Mortgage Reform Act, and most state laws – otherwise exclude from mortgage loan originating.) Similar to the S.A.F.E. Act, the Mortgage Reform Act would specify that any person who represents to the public, through advertising or other means of communicating or providing information (including the use of business cards, stationery, brochures,

signs, rate lists, or other promotional items), that such person can or will provide any of the services or perform any of the activities described above, constitutes a mortgage originator and is subject to the applicable requirements and prohibitions of the Mortgage Reform Act. Although not fully clear on this point, the Mortgage Reform Act would appear to clarify that the definition of “mortgage originator” (and the new requirements and restrictions applicable to those individuals and organizations) does not generally include the creditor, but does include the creditor in a table-funded transaction for certain purposes. Specifically, the creditor in a table-funded transaction (i.e., the person whose name appears as the payee on the initial loan documents, although the funds for the transaction are simultaneously provided by the loan purchaser) would appear to be subject to the Mortgage Reform Act’s restrictions on mortgage originator compensation and related remedies for violations, summarized below. Contrary to the S.A.F.E. Act, however, the Mortgage Reform Act takes a welcome step by expressly excluding from the definition of “mortgage originator” servicers and their employees, agents and contractors, including those who offer or negotiate terms of a residential mortgage loan for purposes of renegotiating, modifying, replacing and subordinating principal of existing mortgages where borrowers are behind in their payments, in default, or have a reasonable likelihood of being in default or falling behind.3 The Mortgage Reform Act defines “servicer” consistently with RESPA, as the person responsible for the servicing of a loan. As we have indicated in past client alerts,4 the applicability of the S.A.F.E. Act’s licensing and/or registration requirements to servicing individuals is a topic of continuing controversy, ambiguity, and lack of uniformity. While requiring licensing of individuals who work for servicers to perform loan modifications and other loss mitigation activities presents a significant hurdle to the nationwide effort to prevent costly foreclosures and keep troubled borrowers in their homes, it appears those individuals will at least not be subject to the Mortgage Reform Act’s new requirements described herein for individuals and entities who actually originate mortgage loans. Perhaps the Bureau, which will assume the role of

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implementing the S.A.F.E. Act, will take a cue from this Mortgage Reform Act definition and clarify that the S.A.F.E. Act does not require servicing individuals to be licensed as originators. As indicated above, the definition of “mortgage originator” would be tied to, and limited by, the term “residential mortgage loan.” The Mortgage Reform Act would define “residential mortgage loan” more narrowly than the S.A.F.E. Act. The Mortgage Reform Act provides that a “residential mortgage loan” is any consumer credit transaction that is secured by a mortgage, deed of trust, or other equivalent consensual security interest on a dwelling or on residential real property that includes a dwelling. The definition excludes a consumer credit transaction under an open end credit plan. The definition also excludes, for purposes of many of the Mortgage Reform Act’s new requirements, an extension of credit relating to a timeshare plan. Thus, the requirements described in this client alert applicable to mortgage originators would apply only in the context of consumer credit transactions that are closed-end, dwelling secured mortgage loans. Mortgage Loan Originator Qualification and Unique Identifier Disclosure The Mortgage Reform Act would require that mortgage originators be qualified and registered/licensed in accordance with applicable state or federal law, including the S.A.F.E. Act. As indicated above, the S.A.F.E. Act applies only to individuals, but obviously many states impose licensing or other qualification requirements upon organizations that conduct mortgage loan origination activities as defined in the Mortgage Reform Act. This provision will now create a federal violation for failure to comply with those state laws. Additionally, the Nationwide Mortgage Licensing System and Registry (NMLS) and the S.A.F.E. Act have mandated the assignment of “unique identifiers” – a number assigned to licensees such as mortgage loan originators that identifies the originator and stays with him or her if (for example) an individual moves from one company to another. The Mortgage Reform Act (like many states5) requires that mortgage loan originators include on all loan documents any unique identifier of the mortgage originator provided by the NMLS. The

law does not define specifically which loan documents must include the originator’s identifying number, whether the documents must include the number of both an originating entity and an originating individual or individuals, or whether compliance with a similar state law may constitute compliance with the federal requirement. However, as with the qualification requirement described in the previous paragraph, failure to include the identifier on all loan documents is now a violation of the federal TILA and thus subject to the civil damages and other enforcement actions under that law (in addition to any sanctions, penalties, or licensing impairment available under state law). The Mortgage Reform Act states that these requirements are “subject to regulations.” Thus, it would appear that the effective date for these requirements may be down the road, once the Bureau is up-and-running, has issued final regulations, and those regulations have become effective. Prohibition on Steering Incentives – Mortgage Originator Compensation The law would prohibit mortgage originators from receiving from any person, and prohibits any person from paying to a mortgage originator, directly or indirectly, compensation that varies based on the terms of the loan (other than the amount of the principal). This prohibition applies in connection with a residential mortgage loan; while the provision itself refers to “any mortgage loan,” the definition of “mortgage originator” is, as explained above, limited to “residential mortgage loans,” i.e., a closed-end, dwelling secured mortgage loan. Further, based on the definition of “mortgage originator,” this compensation restriction would surprisingly apply both to payments by lenders to independent mortgage brokers and payments by lenders to their employee sales force. Additionally, in a subsection called “Restructuring of Financing Origination Fee,” the Mortgage Reform Act curiously might be read, subject to exceptions described below, to prohibit a mortgage originator from receiving compensation from any person besides the consumer, presumably even if the originator’s compensation is not based on the loan terms (e.g., it is a flat fee or a percentage of the loan amount). As mentioned above, since

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“mortgage originator” includes both retail loan officers and independent mortgage brokers, an overly aggressive reader might try to construe this provision to prohibit employer lenders from paying their employee loan officers, which obviously would be an absurd and unintended result; the exceptions to this prohibition reinforce the notion that this section is intended to address the payment by lenders of “back end fees,” like yield spread premiums, to independent mortgage brokers. While there are no exceptions to the prohibition against compensation that varies with the loan terms (other than the loan amount), there are two exceptions to the prohibition against receiving compensation from someone besides the consumer:

1. The originator may pass along bona fide third party charges that are not retained by the creditor, mortgage originator, or an affiliate of the creditor or mortgage originator;

2. The originator may receive an origination fee or charge other than from the consumer if the originator does not receive any compensation directly from the consumer; and the consumer does not make an upfront payment of discount points, origination points, or fees, however denominated (other than bona fide third party charges not retained by the mortgage originator, creditor, or an affiliate of the creditor or originator). The Board6 may provide an exception or waiver to these requirements in the interest of consumers and the public.

The law also prohibits any person from paying compensation to a mortgage originator, other than the consumer, or a person who does not know and has no reason to know that a consumer has directly compensated or will directly compensate a mortgage originator, unless one of the exceptions above applies. The Mortgage Reform Act stresses, however, that it is not intended to prohibit incentive payments to a mortgage originator based on the number of residential mortgage loans originated within a specified period of time (although, obviously, RESPA would still apply). Further, it is not

intended to restrict a consumer’s ability, at his or her option, to finance, through principal or rate, any permitted origination fees or costs, or the mortgage originator’s right to receive those fees or costs (including compensation) from any person, subject to the criteria and requirements described above, so long as those fees or costs do not vary based on the terms of the loan (other than the amount of the principal) or the consumer’s decision about whether to finance those amounts. On the other hand, it stresses that it must not be construed to permit any yield spread premium (YSP) or other similar compensation that would, for any mortgage loan, permit the total amount of direct and indirect compensation from all sources permitted to a mortgage originator to vary based on the terms of the loan (other than the amount of the principal). Finally, the Mortgage Reform Act would provide that its mortgage originator compensation rules are not intended to address the amount of compensation a creditor receives upon the sale of a consummated loan to a subsequent purchaser. As a mortgage originator appears to be defined to include a creditor in a table funded transaction for this purpose, it would appear that this rule of construction applies to sales of closed mortgage loans by funding loan purchasers and subsequent assignees. Thus, it appears the following options for mortgage loan originator compensation would remain available under the new law (assuming they comply with other applicable law):

• A flat fee, paid by the consumer;

• A fee that varies based on the principal loan amount, paid by the consumer;

• A fee, paid by the consumer, based on any factor other than the loan terms (e.g., loan type);

• An origination fee or charge from someone other than the consumer, so long as the fee does not vary based on the terms of the loan (other than the amount of the principal), the originator receives no compensation from the consumer, and the consumer otherwise does not make an upfront payment for origination fees.

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The bottom line is that YSPs now must RIP (rest in peace), unless the borrower chooses to finance a predetermined, fixed amount of total broker compensation through a higher interest rate. This would enable, for example, no-points loans. The key is that the total broker compensation has to be fixed and paid entirely by either the borrower or the mortgage lender in the case of third party originations. Retail lenders, on the other hand, could structure loans where part of their compensation is paid at closing by the consumer and part is paid through increased principal or interest rate. Moreover, variable compensation paid to a retail loan officer by the employer will be restricted if the compensation formula is tied to the interest rate on the loan. Prohibition Against Steering by Mortgage Originators The Mortgage Reform Act would require the Board to prescribe regulations to prohibit several acts or practices that generally constitute, according to the law, improper steering of consumers to “bad” loans by mortgage originators. Interestingly, the inclusion of creditors in table-funding transactions into the definition of mortgage originators does not appear, by its terms, to apply to this subsection of the Act. In summary, the Board must prohibit, by regulation, the following by mortgage originators:

1. Steering any consumer to a residential mortgage loan for which the consumer lacks a reasonable ability to repay (in accordance with regulations);

2. Steering any consumer to a residential mortgage loan that has predatory characteristics or effects (such as equity stripping, excessive fees, or abusive terms); the law does not provide any additional guidance as to which characteristics are “predatory,” nor does it provide guidance as to which characteristics are benign but have “predatory” effects;

3. Steering any consumer away from a “qualified” residential mortgage loan for which the consumer is qualified, to a residential mortgage loan that is not a “qualified” mortgage;

4. Mischaracterizing the credit history of a consumer or the residential mortgage loans available to a consumer;

5. Mischaracterizing or suborning the mischaracterization of the appraised value of the property securing the extension of credit;

6. Discouraging a consumer from seeking a home mortgage loan secured by a consumer’s principal dwelling from another mortgage originator, if the mortgage originator is unable to suggest, offer, or recommend to a consumer a loan that is not more expensive than a loan for which the consumer qualifies.

The Mortgage Reform Act does not provide any guidance as to what type of activity constitutes “steering.” The Department of Housing and Urban Development (HUD) issued a proposed rule to solicit comments on implementing the S.A.F.E. Act for state licensed loan originators, and provided some indications that HUD may view nearly any activity of a loan originator to constitute “steering.” HUD indicates that it considers a mortgage loan originator as any individual who takes any action that makes a prospective borrower more likely to accept a particular set of loan terms or an offer from a particular lender, where the individual may be influenced by a duty to or incentive from any party other than the borrower. Thus, according to HUD’s proposal, any time an individual has a contractual duty to recommend one lender or product, that individual is a mortgage loan originator. Thus, whether under the Mortgage Reform Act a mortgage originator may conduct any activity in the course of its business that does not constitute steering (thus essentially prohibiting mortgage loans that are not “qualified,” as discussed below) is an open question. Once again, as this provision requires the Board/Bureau7 to prescribe regulations to prohibit the enumerated activities, it would appear they will become effective upon the effective date of those future regulations. “Unfair” Rulemaking Authority In spite of any criticisms of federal regulators for lax scrutiny and enforcement leading up to the subprime mortgage crisis, the Mortgage Reform Act

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would provide the Board broad authority to deem mortgage practices and products unfair and to prohibit them. In a sweeping (albeit confusing) sentence, the Act would provide that the Board shall, by regulations, prohibit or condition terms, acts, or practices relating to residential mortgage loans that the Board finds to be abusive, unfair, deceptive, predatory, necessary, or proper to ensure that responsible, affordable mortgage credit remains available to consumers in a manner consistent with the purposes of the new expansive TILA, or necessary or proper to effectuate those purposes, to prevent circumvention or evasion thereof, or to facilitate compliance with those provisions, or are not in the borrower’s interest. (This rulemaking authority applies to all residential mortgage loans but not to timeshare financing.) The Board has already addressed certain unfair practices through rulemaking, which we described in a prior alert,8 and it asserted it has the authority under Section 129(l)(2) of TILA to address unfair mortgage loans. Moreover, our alert on the Bureau notes that the Bureau would independently have the authority to issue regulations outlawing unfair and deceptive acts and practices by covered persons. Nonetheless, this new provision of the Mortgage Reform Act appears to make the Board responsible for ensuring the availability of affordable mortgage credit – a phrase that resonates with the purposes behind the government sponsorship of Fannie Mae and Freddie Mac (and even the creation of HUD and FHA). The Board also must prescribe regulations to prohibit abusive or unfair lending practices that promote disparities among consumers of equal credit worthiness but of different race, ethnicity, gender, or age. The law does not provide any definition as to what practices the Board must prohibit. Of course, discrimination is already prohibited under the Fair Housing Act and the Equal Credit Opportunity Act (although those laws prohibit discrimination that has occurred based on one’s status as a member of a protected class, while this provision appears to be forward-looking to disparities that might occur in the future). It may stretch the bounds of optimism to hope that the new Bureau will fulfill its statutory mandate by simply creating a cross-reference to the existing requirements and regulations under those authorities.

Mortgage Loan Originator Liability for Violations The new law amends TILA to provide liability for mortgage loan originators that fail to comply with the applicable new requirements above. Section 130 of TILA generally addresses civil liability for violations by a “creditor” (i.e., the person who regularly extends credit subject to a finance charge and to whom the obligation is initially payable). The Mortgage Reform Act provides that for purposes of providing a cause of action for any failure by a mortgage originator that is not a creditor to comply with the new requirements (i.e., qualification requirements, unique identifier requirements, anti-steering, restructuring of compensation), Section 130 will be applied with respect to any such failure. The Mortgage Reform Act simply requires one to imagine that the term “creditor” in that section is replaced by “mortgage originator.” The maximum amount of any liability of a mortgage originator to a consumer for this purpose is the greater of actual damages or an amount equal to 3 times the total amount of direct and indirect compensation or gain accruing to the mortgage originator in connection with the residential mortgage loan involved in the violation, plus the costs to the consumer of the action, including a reasonable attorney’s fee. We expect that the Bureau will interpret how this cap on liability will dovetail with the ceilings in class actions and individual actions contained in Section 130 of TILA. We discuss below an important amendment that allows a consumer to assert a defense alleging a violation of the mortgage originator compensation restrictions or the ability to repay requirements (although this particular defensive right does not apply to other requirements, such as the enumerated anti-steering prohibitions), without regard for the statute of limitations. (We also discuss other amendments related to liability and enforcement.) Ability to Repay / Verification and Documentation The Mortgage Reform Act would amend TILA to provide that all creditors must consider a borrower’s ability to repay. (A creditor in a table-funded transaction would appear to be the creditor for purposes of this requirement, since the definition of “mortgage originator” appears to extend the

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definition to include table-funded creditors only in the case of the restrictions on compensation.) Specifically, the Board is authorized to issue regulations prohibiting a creditor from making a residential mortgage loan (thus, a closed-end, dwelling secured mortgage loan, excluding for this purpose a reverse mortgage and a temporary or bridge loan with a term of 12 months or less) unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan according to its terms, and all applicable taxes, insurance (including mortgage guarantee insurance), and assessments. If the creditor knows, or has reason to know, that one or more residential mortgage loans secured by the same dwelling will be made to the same consumer, the creditor must determine the borrower’s repayment ability of the combined payments of all loans on the same dwelling according to the terms of those loans. The creditor’s reasonable and good faith determination of a consumer’s ability to repay the loan would have to include consideration of the following in connection with the consumer:

• Credit history,

• Current income,

• Expected income the consumer is reasonably assured of receiving,

• Current obligations,

• Debt-to-income ratio, or the residual income the consumer will have after paying non-mortgage debt and mortgage-related obligations,

• Employment status,

• Other financial resources other than the consumer’s equity in the dwelling or real property that secures repayment of the loan.

Thus, in determining a consumer’s ability to repay, nothing in the Mortgage Reform Act expressly prohibits a creditor from relying solely on automated underwriting tools, assuming one can demonstrate that the required elements are considered in the model. There are (as yet) no relative weighting requirements of the various elements as long as one

can show that each required element has been considered. Paradoxically, although the Mortgage Reform Act would require consideration of “expected income the consumer is reasonably assured of receiving,” the Act also would permit a creditor to consider the “seasonality and irregularity” of income (if documented), including income from a small business, in the underwriting of and scheduling of payments. Given the significant penalties for violating the ability to repay requirements, lenders may be reluctant to consider any non-regular income unless and until the Board/Bureau clarifies this seemingly inconsistent language. Moreover, when the Board issued its ability to pay regulations for higher-priced mortgage loans in July 2008, it addressed public concerns regarding whether lenders were required somehow to consider the financial stability of an applicant’s employer and its industry in determining reasonable assurance of expected future income. The Board responded at that time by including commentary in its rules examples such as a creditor that might have knowledge of a likely reduction in income or employment (e.g., a consumer’s written application indicates that the consumer plans to retire within 12 months or transition from full-time to part-time employment). The Board clarified that it did not intend to place unrealistic requirements on a creditor to speculate or inquire about every possible change in a borrower’s life circumstances. The Board also has stated that any reliance on expected income must be reasonable and based on reasonably reliable evidence. The creditor also would have to verify amounts of income or assets on which it relies to determine repayment ability, including expected income or assets, by reviewing the consumer’s Internal Revenue Service Form W–2, tax returns, payroll receipts, financial institution records, or other third party documents that provide reasonably reliable evidence of the consumer’s income or assets. To the extent the creditor considers the consumer’s income history in making a determination, the creditor must verify that income based on IRS transcripts of tax returns, or a method that quickly and effectively verifies income documentation by a third party subject to rules prescribed by the Board. If the recent bad experiences of servicers trying to

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obtain verification documents from borrowers seeking loan modifications under the Home Affordable Mortgage Program (HAMP) are any indication, one should expect delays in the timing of loan approvals. Nonetheless, while it is not clear that the Board/Bureau will require the borrower to submit tax returns in every case, we have come a long way from stated income or reduced documentation loans to a place where serious documentation must be obtained for every transaction. The Mortgage Reform Act would provide certain guidance as to how the creditor must calculate the monthly payment amount for principal and interest on an applicable loan for determining the borrower’s ability to repay. Specifically, the creditor must make the following assumptions:

(i) The loan proceeds are fully disbursed on the date of loan consummation;

(ii) The loan is to be repaid in substantially equal monthly amortizing payments for principal and interest over the entire term of the loan with no balloon payment, unless the loan contract requires more rapid repayment (including balloon payment), in which case the calculation must be made in accordance with regulations prescribed by the Board, with respect to any loan with an annual percentage rate (APR) that does not exceed the higher-priced mortgage loan thresholds (specified below); For loans that require more rapid repayment or a balloon payment, and with an APR that exceeds the higher-priced mortgage loan thresholds, the creditor must use the contract’s repayment schedule; and

(iii) The interest rate over the entire term of the loan is a fixed rate equal to the fully indexed rate at the time of the loan closing, without considering the introductory rate.

(The APR thresholds for a higher-priced mortgage loan are, for first-lien mortgage loans, an APR that exceeds the average prime offer rate for a comparable transaction, as of the date the interest rate is set, by 1.5 or more percentage points; or by

3.5 or more percentage points for a subordinate-lien residential mortgage loan.) A creditor must determine the ability of the consumer to repay using a payment schedule that fully amortizes the loan over the term of the loan, taking into consideration any balance increase that may accrue from any negative amortization. For variable rate loans that allow or require the consumer to defer the repayment of any principal or interest, the creditor must nonetheless use a fully amortizing repayment schedule to determine the consumer’s ability to repay. For interest-only loans (that permit or require the payment of interest only), the creditor must use the payment amount required to amortize the loan by its final maturity. The statute provides for special considerations when attempting to refinance an existing hybrid loan into a standard loan to be made by the same creditor that would result in lower monthly payments. If the mortgagor has not been delinquent on any payment on the existing hybrid loan, the creditor may consider the mortgagor’s good standing, whether the mortgagor is likely to default upon a reset of the existing loan, and whether the new “standard” loan would prevent that default. Under those circumstances, the creditor may offer rate discounts and other favorable terms to the mortgagor that would be available to new customers with high credit ratings. The law does not provide any guidance as to what constitutes a “standard” loan, other than its new category of “qualified” mortgage loans, or a guess that it simply means a loan that is not a hybrid. The law addresses “hybrid adjustable rate mortgages” (ARM) in connection with a new reset disclosure requirement (which we will address in a separate K&L Gates client alert). In that context, a “hybrid ARM” means a consumer credit transaction secured by the consumer’s principal residence with a fixed interest rate for an introductory period that adjusts or resets to a variable interest rate after such period. With respect to loans made, guaranteed, or insured by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Department of Agriculture, or the Rural Housing Service, those agencies may exempt “streamlined refinancings” (i.e., non-cash out refinancings) from

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this new income verification requirement as long as the following conditions are met:

(A) The consumer is not 30 days or more past due on the prior existing residential mortgage loan;

(B) The refinancing does not increase the principal balance outstanding on the prior existing residential mortgage loan, except to the extent of fees and charges allowed by the relevant agency;

(C) Total points and fees (as defined in TILA), other than bona fide third party charges not retained by the mortgage originator, creditor, or an affiliate of the creditor or mortgage originator) payable in connection with the refinancing do not exceed 3 percent of the total new loan amount;

(D) The interest rate on the refinanced loan is lower than the interest rate of the original loan, unless the borrower is refinancing from an adjustable rate to a fixed-rate loan, under guidelines that the relevant agency established or may establish;

(E) The refinancing is subject to a payment schedule that will fully amortize the refinancing in accordance with the regulations prescribed by the department or agency making, guaranteeing, or insuring the refinancing;

(F) The terms of the refinancing do not result in a balloon payment; and

(G) Both the residential mortgage loan being refinanced and the refinancing satisfy all of the relevant agency’s requirements.

As indicated above, this ability to repay requirement is “in accordance with regulations prescribed by the Board.” That appears to indicate that it will become effective upon the effective date of future final regulations. Presumption of Ability to Repay / “Qualified Mortgage” Loans The Mortgage Reform Act would provide that a creditor under a residential mortgage loan, and any assignee of the loan subject to liability under TILA,

may presume that the loan has met these new ability to repay requirements if the loan is a qualified mortgage. A “qualified mortgage” means any residential mortgage loan (again, a closed-end, dwelling secured loan) for which all the following apply:

(i) The regular periodic payments for the loan may not: (I) Result in an increase of the principal balance; or (II) Except for certain balloon loans, described below, allow the consumer to defer repayment of principal;

(ii) The terms of the loan do not result in a balloon payment (i.e., a scheduled payment that is more than twice as large as the average of earlier scheduled payments), except under certain circumstances;

(iii) The income and financial resources relied upon to qualify the obligors on the loan are verified and documented;

(iv) In the case of a fixed rate loan, the underwriting process is based on a payment schedule that fully amortizes the loan over the loan term and takes into account all applicable taxes, insurance, and assessments;

(v) In the case of an adjustable rate loan, the underwriting is based on the maximum rate permitted under the loan during the first 5 years, and a payment schedule that fully amortizes the loan over the loan term and takes into account all applicable taxes, insurance, and assessments;

(vi) The loan complies with any guidelines or regulations the Board establishes relating to debt-to-income ratios or alternative measures of ability to pay regular expenses after payment of total monthly debt, taking into account the borrower’s income levels and such other factors the Board establishes

(vii) The total points and fees (defined below) payable in connection with the loan do not exceed 3 percent of the total loan amount (the Board is required to prescribe a points

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and fees threshold for “smaller loans” to meet the requirements of this presumption, considering the potential impact on rural areas and other areas where home values are lower); and

(viii) The loan term does not exceed 30 years, except as such term may be extended under certain circumstances, such as in high-cost areas.

Interestingly, the law adopts a new definition of “points and fees” for this purpose, relying upon a modification of the standard TILA “points and fees” definition, but excluding either of the two following amounts (depending upon the loan’s interest rate): (I) up to and including 2 bona fide discount points9 payable by the consumer in connection with the mortgage, but only if the interest rate from which the mortgage’s interest rate will be discounted does not exceed by more than 1 percentage point the average prime offer rate; or (II) if the interest rate from which the mortgage’s interest rate will be discounted does not exceed by more than 2 percentage points the average prime offer rate, and unless 2 bona fide discount points have been excluded under clause (I), above, up to and including 1 bona fide discount point payable by the consumer in connection with the mortgage. Nonetheless, the definition of “points and fees” relies in the first instance upon the definition used for HOEPA loans, which as explained below, has been expanded to include all mortgage broker compensation (both direct and indirect, paid by a consumer, the creditor, or any other source), upfront premiums for credit insurance and similar products, and maximum prepayment penalties (but would exclude FHA and certain other mortgage guaranty insurance premiums). In spite of the exclusion of balloon loans from the definition of a “qualified mortgage,” the Board is authorized to issue regulations providing that a certain very limited set of balloon loans do qualify. The Board’s regulations may provide that a balloon loan is a “qualified mortgage” if the creditor determines that the consumer can make all scheduled payments (except the balloon payment) out of income or assets other than the collateral; the underwriting is based on a fully amortizing payment schedule, considering taxes, insurance, and assessments; and it otherwise generally meets the criteria described above. In addition, a “qualified”

balloon mortgage must be made by a creditor that operates predominantly in rural or underserved areas; together with all affiliates, has total annual mortgage loan originations that do not exceed a limit set by the Board; retains the balloon loans in portfolio; and meets any asset size threshold and any other criteria the Board establishes. The Board can prescribe regulations that revise, add to, or subtract from the criteria that define a qualified mortgage, in its furtherance of the availability of responsible, affordable mortgage credit. However, unlike the definition of “qualified residential mortgage loans” in the risk retention sections of the Dodd-Frank Act, the Mortgage Reform Act’s ability to repay requirement does not provide a categorical exemption for government insured or guaranteed mortgage loans. Nevertheless, the Act would require HUD, VA, the Department of Agriculture, and the Rural Housing Service to prescribe rules, in consultation with the Board, defining the types of loans they insure, guarantee, or administer, as the case may be, that are “qualified mortgages,” and those rules may revise, add to, or subtract from the criteria used to define a qualified mortgage upon a finding that the rules are consistent with the Act’s purposes, will prevent circumvention or evasion, or will facilitate compliance. Prohibitions Against “Bad” Loan Terms The Mortgage Reform Act then provides a familiar litany of prohibitions against loan terms that policymakers have determined are just not good for anybody – not for borrowers with costly mortgage loans, and now, not for borrowers under any mortgage loans. Below, we summarize some of the Act’s largely predictable targets for scorn. These prohibitions do not expressly require implementation by regulation, and thus it is unclear, as described above, when they would become effective. Prohibition Against Prepayment Penalties The Mortgage Reform Act provides that only lower priced, fixed-rate, “qualified mortgages” may contain a penalty fee for prepaying all or part of the principal. Thus, loans such as those with an adjustable rate, or those with an APR that exceeds certain higher-priced mortgage loan thresholds,

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must not contain a prepayment penalty. For this purpose, the only loans in which a creditor may impose a prepayment penalty are fixed-rate loans with an APR that does not exceed the average prime offer rate for a comparable transaction, as of the date the interest rate is set: (I) by 1.5 or more percentage points, for first lien residential mortgage loans with an original principal amount that is equal to or less than the Freddie Mac maximum limits; or (II) by 2.5 or more percentage points, for first lien loans with an original principal obligation amount that exceeds Freddie Mac’s maximum limits; or (III) by 3.5 or more percentage points, in the case of subordinate lien residential mortgage loans. Of course, even for fixed-rate lower-priced qualified mortgage loans, the Mortgage Reform Act imposes restrictions on the creditor’s imposition of a prepayment fee. First, in a fixed-rate lower-priced qualified mortgage, as specifically described above, a creditor must not offer a consumer a product that has a prepayment penalty without offering the consumer a loan product that does not have a prepayment penalty. Second, the Act restricts the amount of a prepayment penalty, based upon when the prepayment occurs. In a fixed-rate, lower-priced qualified mortgage as described above, the loan must not contain a prepayment penalty in excess of the following limitations:

(A) For a prepayment within the first year, 3 percent of the outstanding loan balance;

(B) For a prepayment within the second year, 2 percent of the outstanding loan balance;

(C) For a prepayment within the third year, 1 percent of the outstanding loan balance; and

(D) After the end of the 3-year period, no prepayment penalty may be imposed on a qualified mortgage.

Single Premium Credit Insurance If any creditors are still considering offering single premium credit insurance, the Mortgage Reform Act prohibits a creditor from financing, directly or indirectly, in connection with any residential mortgage loan or with any open-end credit plan secured by the principal dwelling of the consumer, any credit life, credit disability, credit unemployment, or credit property insurance, or any

other accident, loss-of-income, life, or health insurance, or any payments directly or indirectly for any debt cancellation or suspension agreement or contract, except if the insurance premiums or debt cancellation or suspension fees are calculated and paid in full on a monthly basis. This prohibition does not, however, apply to credit unemployment insurance for which the unemployment insurance premiums are reasonable, the creditor receives no direct or indirect compensation in connection with the unemployment insurance premiums, and the unemployment insurance premiums are paid pursuant to another insurance contract and not paid to an affiliate of the creditor. Prohibition Against Mandatory Arbitration No residential mortgage loan and no open end credit plan secured by the consumer’s principal dwelling may include terms that require arbitration or any other nonjudicial procedure as the method for resolving any controversy or settling any claims arising out of the transaction. However, the consumer and the creditor or any assignee may still agree to arbitration or any other nonjudicial procedure as the method for resolving any controversy at any time after a dispute or claim under the transaction arises. Nonetheless, no provision of any such loan, and no other agreement between the consumer and the creditor relating to such a loan, may be applied or interpreted to bar a consumer from bringing an action in a court of competent jurisdiction. New Disclosures The Mortgage Reform Act would also impose a number of new disclosure requirements. These new disclosure requirements do not expressly require regulations for implementation, and thus it is unclear when they would become effective. As you will see, nobody said that mortgage reform necessarily means mortgage simplification, because in many cases the information to be provided is already covered by other mandated disclosures under existing federal consumer credit laws. We describe those new disclosures applicable to the servicing of a loan (as opposed to those required to be provided at or near the time of origination) in a separate client alert. However, below we summarize the new origination-related disclosure requirements.

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Disclosure of Partial Payment Policies In the case of any residential mortgage loan (other than a timeshare loan), a creditor must disclose prior to settlement (or at the time a person becomes a creditor), the creditor’s policy regarding the acceptance of partial payments; and if partial payments are accepted, how they will be applied to the mortgage loan and whether they will be placed in escrow. This is an odd requirement since it merely discloses the originating lender’s requirements and does not bind assignees and their servicers. Disclosure for Closed-End Variable Rate Loans Section 128(a) of TILA provides disclosure requirements for all closed-end consumer credit transactions. The Mortgage Reform Act adds new required disclosures for those transactions that are residential mortgage loans. First, for a variable rate residential mortgage loan for which an escrow or impound account will be established for the payment of all applicable taxes, insurance, and assessments, the creditor must disclose the following information:

(A) The amount of initial monthly payment due under the loan for the payment of principal and interest, and the amount of such initial monthly payment including the monthly payment deposited in the account for the payment of all applicable taxes, insurance, and assessments; and

(B) The amount of the fully indexed monthly payment due under the loan for the payment of principal and interest, and the amount of such fully indexed monthly payment including the monthly payment deposited in the account for the payment of all applicable taxes, insurance, and assessments.

Second, in the case of any residential mortgage loan (fixed or variable rate), the creditor must disclose the aggregate amount of settlement charges for all settlement services provided in connection with the loan, the amount of charges that are included in the loan and the amount of such charges the borrower must pay at closing, the approximate amount of the wholesale rate of funds in connection with the loan,

and the aggregate amount of other fees or required payments in connection with the loan. This is a terribly confusing requirement that appears to have survived through the House’s contributions to the Dodd-Frank Act.10 First, it appears to duplicate some of the disclosure requirements under RESPA to be included in the HUD-1 Settlement Statement. Then, if not settlement charges, what other fees or charges are required to be disclosed? Finally, what does it mean to disclose the “wholesale rate of funds”? The bill would not include any guidance as to its meaning, although it apparently goes to a criticism that RESPA requires the disclosure of YSPs, but not the spread a lender receives between the rate the borrower will pay and the lender’s cost of funds (or the amount the lender will earn in connection with the loan in the secondary market). Third, for any residential mortgage loan, the creditor must disclose the aggregate amount of fees paid to the mortgage originator in connection with the loan, the amount of such fees paid directly by the consumer, and any additional amount received by the originator from the creditor. However, this information is already generally required in the HUD-1 under RESPA. Perhaps the consolidation of rulemaking authority within the new Bureau will finally force the issue of compatible and nonduplicative mortgage disclosures, as the Bureau is tasked with combining the TILA and RESPA disclosures into a single, integrated disclosure form. Fourth, for any residential mortgage loan, the creditor must disclose the total amount of interest that the consumer will pay over the life of the loan as a percentage of the principal of the loan. That amount must be computed assuming the consumer makes each monthly payment in full and on-time, and does not make any over-payments. Again, this information is generally provided to the consumer in his or her TILA disclosure. Disclosure Regarding Escrow Payments For first-lien, closed-end dwelling secured loans (other than reverse mortgage loans), for which an impound, trust, or other type of account has been or will be established for the payment of property taxes, hazard and flood (if any) insurance premiums, or other periodic payments or premiums with respect to the property, the information required to be provided under Section 128(a) of

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TILA with respect to the number, amount, and due dates or period of payments scheduled to repay the total of payments must take into account the amount of any monthly payment to the escrow account. The amount must reflect the taxable assessed value of the real property securing the transaction after the consummation of the transaction, including the value of any improvements on the property or to be constructed on the property (whether or not such construction will be financed from the proceeds of the transaction), if known, and the replacement costs of the property for hazard insurance, in the initial year after the transaction. How will the lender know what the taxable assessed value of the real property securing the loan would be after the transaction? Disclosure and Counseling for Negative Amortization Loans In connection with an open- or closed-end dwelling-secured mortgage loan, other than a reverse mortgage, that provides or permits a payment plan that may at any time result in negative amortization, a creditor must, before the loan transaction is consummated, provide the consumer with a statement that the transaction will or may result in negative amortization, which would increase the outstanding principal balance and reduce the consumer’s equity in the property. In the case of a first-time borrower with respect to a residential mortgage loan that is not a qualified mortgage, the borrower must receive homeownership counseling from a HUD-certified counselor and provide the creditor with documentation of that counseling. Anti-Deficiency Protection Disclosure In the case of any residential mortgage loan (i.e., closed-end, dwelling secured) that is, or upon consummation will be, subject to protection under an anti-deficiency law, the creditor or mortgage originator must provide a written notice to the consumer, before the loan is consummated, describing the law’s protection and the significance for the consumer of the loss of such protection. Similarly, if a creditor or mortgage originator provides an application to a consumer, or receives an application from a consumer, for any type of refinancing for such a loan subject to anti-deficiency law protection, that would cause the loan to lose that law’s protection, the creditor or mortgage originator

must provide a written notice to the consumer describing the anti-deficiency protection and the significance for the consumer of the loss of such protection before any agreement for the refinancing is consummated. For this purpose, an “anti-deficiency law” is a law of any state that provides that, in the event of foreclosure on the residential property of a consumer securing a mortgage, the consumer is not liable for any deficiency between the foreclosure sale price and the loan’s outstanding balance. RESPA Special Information Booklet The Mortgage Reform Act also revises RESPA’s Special Information Booklet, now called the Home Buying Information Booklet, intended to help consumers applying for federally related mortgage loans to understand the nature and costs of real estate settlement services. The law requires the Bureau Director to revise the booklet at least once every 5 years, and to prepare the booklet in various languages and cultural styles to be understandable and accessible to homebuyers of different ethnic and cultural backgrounds. The Director must distribute the booklets to all lenders that make federally related mortgage loans, and to lenders’ lists of homeownership counselors. Then the lender is obligated to provide the consumer the booklet in the version that is most appropriate for him or her. The law provides a list of loan terms and practices, and consumer rights and obligations that the booklet must, at a minimum, explain. The booklet also must provide a list and explanation of questions a consumer should ask regarding the loan, including whether the consumer will have the ability to repay the loan, whether the consumer sufficiently shopped for the loan (an interesting question for a consumer to ask his or her prospective creditor), whether the loan terms include prepayment penalties or balloon payments, and whether the loan will benefit the borrower. When the lender provides the consumer the booklet, the lender also must provide a list of certified homeownership counselors. Credit Scores The Dodd-Frank Act would also amend FCRA to require creditors that make adverse decisions based on information in an applicant’s credit report to disclose the applicant’s credit score and other information. Specifically, when a consumer report

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user takes an adverse action on the basis of consumer report information, or when such a person offers credit on materially less favorable terms than the most favorable available terms, as specified in FCRA, the person must disclose the following (in addition to other required information):

(A) A numerical credit score used in taking the action;

(B) The range of possible credit scores under the model used;

(C) The key factors (up to 4) that adversely affected the consumer’s credit score in the model used;

(D) The date on which the credit score was created; and

(E) The name of the person or entity that provided the credit score or the credit file upon which the credit score was created.

As with many of the new disclosures in the Mortgage Reform Act, this requirement is somewhat repetitive. FCRA already requires any person who makes or arranges loans and who uses a consumer credit score in connection with an application initiated or sought by a consumer for a residential mortgage loan to provide the information above “as soon as reasonably practicable.”11 The Board also has established extensive regulations (effective in January) to implement risk-based pricing disclosure requirements that address credit score disclosures.12 Thus, this new requirement may mean the consumer receives duplicative credit score disclosures that serve only to confuse. Broad Disclosure Rulemaking Authority In addition, the Board may amend or create exemptions from disclosure requirements for any class of residential mortgage loans, if the Board determines that it is in consumers’ and the public interest. It is unclear if this applies only to disclosure requirements imposed under TILA, or under other disclosure regimes (RESPA, ECOA, FCRA, etc.). Liability and Enforcement As mentioned above, the Mortgage Reform Act adds civil liability exposure under TILA for mortgage

loan originators for violations of requirements and restrictions newly applicable to those individuals or entities, similar to the liability to which creditors are currently exposed, although subject to different limits in damages. In addition, the Mortgage Reform Act makes other “enhancements” to TILA liability and enforcement exposure for mortgage lending. In a nutshell, if a creditor makes a non-“qualified” loan that falls outside the protection of the S.A.F.E. harbor described above (e.g., because the points and fees exceed 3 percent), the creditor and its assignees are subject to the borrower’s claims of a violation by the creditor of certain requirements up to the point the creditor or assignee attempts to collect or foreclose. In addition, the loan can much more easily fall into HOEPA territory (and its accompanying exposure to liability for creditors and assignees), due to the expanded triggers for those loans. Civil Liability Limits The law raises the limits on statutory damages for class actions in Section 130(a) of TILA, particularly for larger institutions. Currently, that section provides (among other provisions for statutory and actual damages) that a creditor who fails to comply with TILA is liable for an amount, in the case of a class action, of up to the lesser of $500,000 or 1 percent of the creditor’s net worth. This law raises that limit to the lesser of $1,000,000 or 1 percent of the creditor’s (or mortgage originator’s) net worth. (Congress raised the limits for individual actions in the Housing and Economic Recovery Act of 2008, to an amount from $400 to $4,000; the Mortgage Reform Act would leave those limits on individual actions in place.) In addition, the law makes available so-called “enhanced” damages (an amount equal to the sum of all finance charges and fees paid by the consumer) for the new restrictions on mortgage originator compensation and the requirements for determining a consumer’s ability to repay. (Enhanced damages presently are available under TILA only for violations of HOEPA with respect to “high-cost” loans and for certain violations in connection with “higher-priced mortgage loans.”) Even under the Mortgage Reform Act, the enhanced damages provisions would not apply to the anti-

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steering restrictions on mortgage originators that do not involve compensation (e.g., prohibitions on steering borrowers to loans with predatory characteristics or that promote disparities), the new substantive restrictions on bad loan terms, the new disclosure requirements described above, or the qualification requirements for mortgage originators. Extension of Statute of Limitations for Section 129 Violations The general limitations period for civil actions under TILA is one year from the date of the occurrence of the violation. However, the law amends Section 130(e) by making an exception for actions with respect to violations of TILA related to HOEPA loans, as well as the new requirements and prohibitions of the Mortgage Reform Act (restrictions on compensation, prohibitions against steering, requirements for determining ability to repay, prohibitions against prepayment fees, single premium credit insurance, and mandatory arbitration, and disclosures regarding anti-deficiency law protection and partial payment policies). For actions in connection with violation of those provisions, the new limitations period will be 3 years (except in the case of certain alleged violations which the consumer may assert as a defense to a collection or foreclosure action, as addressed below). Defense to Foreclosure or Collection While the final version of the Mortgage Reform Act appears to have rejected the House’s provisions regarding the right of consumers to assert rescission against assignees for violation of the ability to repay requirements, it did add a form of assignee liability. It amended Section 130 of TILA to provide an outlet for defenses in recoupment when a creditor or assignee attempts to collect or foreclose. The new provision states that when a creditor, assignee, or other holder of a residential mortgage loan (or anyone acting on their behalf) initiates a judicial or nonjudicial foreclosure of the loan or any other action to collect the debt in connection with the loan, a consumer may assert a defense, by recoupment or set-off, alleging a violation by a creditor of the mortgage originator compensation restrictions or the ability to repay requirements without regard for the statute of limitations (described above). As with the limitation on the right to pursue enhanced damages, this defensive right would not apply to the anti-

steering restrictions on mortgage originators not involving compensation (e.g., prohibitions on loans with predatory characteristics or that promote disparities), the new substantive restrictions on bad loan terms, or the new disclosure requirements described above. The amount available to the consumer in recoupment or set-off is generally limited to the amount to which the consumer would otherwise be entitled in civil damages under Section 130(a) (e.g., actual damages, statutory damages, and enhanced damages) for a valid claim brought in an original action against the creditor (within the applicable statute of limitations), plus the costs to the consumer of the action and a reasonable attorney’s fee. Lender Rights Upon Borrower Deception The law provides relief from liability for creditors and assignees to an obligor under Section 130 of TILA if the obligor or a co-obligor has been convicted of obtaining the residential mortgage loan by actual fraud. Authority of State Attorneys General TILA has historically afforded state attorneys general the authority (or the co-authority) to enforce a violation of Section 129 on “high-cost” loans under HOEPA. The Mortgage Reform Act would expand that co-authority to include the requirements described in this client alert (along with many other new requirements). Authority of the Bureau Otherwise, as one might guess, the Bureau is afforded general authority to commence a civil action to enforce a violation under TILA, to impose a civil penalty or to seek other permissible relief.13 Our alert on the Bureau provides greater details of the wide array of administrative remedies available to the Bureau. HOEPA Revisions The law also makes substantial changes to HOEPA. Since essentially nobody knowingly makes, finances, sells, purchases, services, or securitizes HOEPA loans (called “high-cost mortgages” under the Act’s new definition), due to the onerous liability that attaches to those loans and follows them into the secondary market, we have chosen not to describe all those changes.

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High-Cost Mortgage Triggers However, the Mortgage Reform Act amends the high-cost thresholds or financial triggers that cause a loan to be considered a high-cost mortgage, aligning them somewhat with the definitions of the newly-minted category of higher-priced mortgage loans, and adding some non-cost substantive triggers that will put another nail in the coffin for prepayment fees. We describe those changes below because the points and fees definition for “qualified mortgages” relies upon the high-cost mortgage definition, simply because the industry generally seeks to avoid triggering the high-cost thresholds. In particular, the high cost mortgage basket will for the first time include purchase money loans. Otherwise, a high cost mortgage means a consumer credit transaction that is secured by the consumer’s principal dwelling, other than a reverse mortgage transaction, if the loan exceeds the following thresholds:

(i) For a first mortgage on the consumer’s principal dwelling, the APR at consummation of the transaction will exceed by more than 6.5 percentage points (or 8.5 percentage points, if the dwelling is personal property and the transaction is for less than $50,000) the average prime offer rate for a comparable transaction; or

(ii) For a subordinate or junior mortgage on the consumer’s principal dwelling, the APR at consummation of the transaction will exceed by more than 8.5 percentage points the average prime offer rate for a comparable transaction; or

(iii) For a transaction of $20,000 or more, the total points and fees payable in connection with the transaction, other than bona fide third party charges not retained by the mortgage originator, creditor, or an affiliate of the creditor or mortgage originator, exceed 5 percent of the total transaction amount; or

(iv) For a transaction for less than $20,000, the lesser of 8 percent of the total transaction amount or $1,000 (or such other dollar amount as the Board sets); or

(v) The loan documents permit the creditor to charge or collect prepayment fees or

penalties more than 36 months after the transaction closing, or those fees or penalties exceed, in the aggregate, 2 percent of the amount prepaid.

For purposes of determining whether a loan exceeds the APR threshold, the creditor must generally use the interest rate in effect on the date of consummation of the transaction, but for transactions in which the rate of interest varies solely in accordance with an index, the creditor must use the interest rate determined by adding the index rate in effect on the date of consummation of the transaction to the maximum margin permitted at any time during the loan agreement. For other transactions with an interest rate that may change for any reason, the creditor must use the interest charged on the transaction at the maximum rate that may be charged during the term of the loan. The Mortgage Reform Act also would change the range of discretionary authority of the Board to adjust the APR thresholds. The law provides that the Board may increase or decrease the APR threshold, but it may not go below 6 percentage points or above 10 percentage points for first-lien loans; and it may not go below 8 percentage points or above 12 percentage points for subordinate-lien loans. The Act would amend the calculation of a loan’s total points and fees by providing that the calculation may exclude certain mortgage guaranty insurance premiums – specifically, the calculation may exclude any government agency insurance premium; any amount that is not in excess of the amount payable under FHA policies in effect at the time of origination in connection with upfront premiums (12 U.S.C. § 1709(c)(2)(A)), provided that the premium, charge, or fee is required to be refundable on a prorated basis and the refund is automatically issued upon notification of the satisfaction of the underlying mortgage loan; and any premium paid by the consumer after closing. In addition, the law provides that a creditor may exclude certain bona fide discount points from the points and fees calculation. However, the Act would clarify that all mortgage broker compensation must be included in the total points and fees calculation, including both direct and indirect compensation, paid by a consumer, the

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creditor, or any other source. This would include compensation paid to the creditor in a table-funded transaction. Since the anti-steering provisions prohibit back end compensation except where such compensation is the sole source of broker compensation, this change should not lead to a material expansion of loans subject to the high-cost mortgage restrictions. The law also would clarify that the calculation must include premiums or other charges payable at or before closing for any credit life, credit disability, credit unemployment, or credit property insurance, or any other accident, loss-of-income, life or health insurance, or any payments directly or indirectly for any debt cancellation or suspension agreement or contract, except that insurance premiums or debt cancellation or suspension fees calculated and paid in full on a monthly basis shall not be considered financed by the creditor. Points and fees also must include the maximum prepayment fees and penalties that may be charged or collected under the terms of the credit transaction; and all prepayment fees or penalties that are incurred by the consumer if the loan refinances a previous loan made or currently held by the same creditor or an affiliate of the creditor. As noted above, we do not discuss the amendments to the prohibitions and restrictions applicable to HOEPA loans, as again, those loans largely have disappeared. To the extent the thresholds for those loans have expanded, we predict a larger set of loans will disappear. New Cure Provisions Applicable to High-Cost Mortgages One other interesting addition to the high-cost mortgage world, however, is a new cure provision that would allow a creditor or assignee of a high-cost mortgage to avoid liability by setting the loan straight. The Mortgage Reform Act would add a provision to HOEPA stating that a creditor or assignee in a high-cost mortgage that, when acting in good faith, fails to comply with any requirement under HOEPA (i.e., Section 129 of TILA) will not be deemed to have violated that requirement if the creditor or assignee establishes that it quickly notified the consumer and fixed the situation. Specifically, the creditor or assignee must, in order to avoid liability, ensure that the consumer is

notified of or discovers the violation, appropriate restitution is made, and whatever adjustments necessary are made to the loan to either, at the consumer’s choice, make the loan satisfy TILA/HOEPA requirements, or change the terms of a high-cost mortgage in a manner beneficial to the consumer so that the loan will no longer be a high-cost mortgage. The deadline for fixing the loan is short – the creditor or assignee has 30 days from loan closing (if prior to the institution of any action). However, in the case of an unintentional violation or bona fide error, the creditor or assignee has 60 days from the creditor’s discovery or receipt of notification of the violation or error (and prior to the institution of any action). One can expect, however, that the Bureau will follow in the Board’s footsteps by construing what constitutes an unintentional violation or bona fide error very narrowly. Nonetheless, if discovered quickly, this cure provision may help the unwitting makers or purchasers of high-cost mortgages. HMDA Additions The Dodd-Frank Act also would add to HMDA new data itemization elements for the mortgage loans that applicable institutions originate or purchase. Currently, HMDA requires applicable institutions to itemize the data they maintain according to the number and dollar amount of FHA loans, non-principal residence loans, and home improvement loans; and the number and dollar amount of loans and completed applications involving mortgagors or applicants grouped according to census tract, income level, racial characteristics, and gender. The Dodd-Frank Act would require itemization by age, as well. It also would require itemization of the number and dollar amount of mortgage loans grouped according to measurements of the following:

(A) The total points and fees payable at origination in connection with the mortgage (taking into account the new HOEPA definition of that phrase);

(B) The difference between the APR associated with the loan and a benchmark rate or rates for all loans;

(C) The term in months of any prepayment penalty; and

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(D) Such other information as the Bureau may require.

The Act also would require applicable institutions to itemize the number and dollar amount of mortgage loans and completed applications grouped according to measurements of the following:

(A) The value of the real property pledged or proposed to be pledged as collateral;

(B) The actual or proposed term in months of any introductory period after which the rate of interest may change;

(C) The presence of contractual terms or proposed contractual terms that would allow the mortgagor or applicant to make payments other than fully amortizing payments during any portion of the loan term;

(D) The actual or proposed term in months of the mortgage loan;

(E) The channel through which application was made, including retail, broker, and other relevant categories;

(F) As the Bureau may determine to be appropriate, the loan originator’s unique identifier;

(G) As the Bureau may determine to be appropriate, a universal loan identifier;

(H) As the Bureau may determine to be appropriate, the parcel number that corresponds to the real property pledged or proposed to be pledged as collateral;

(I) The credit score of mortgage applicants and mortgagors; and

(J) Such other information as the Bureau may require.

The Bureau is required to consult with the other appropriate agencies to develop regulations that, among other requirements, require the collection of data as described above with respect to loans sold by each reporting institution, and the disclosure of the class of the purchaser of such loans.

While it is somewhat of a relief to note that institutions will not be required to report the new data described above before the beginning of the calendar year that is 9 months after the Bureau issues final regulations, these new elements will require significant systems and procedures adjustments. S.A.F.E. Act Amendments The Mortgage Reform Act would also amend the S.A.F.E. Act, which as mentioned above requires the licensing and/or registration of individual mortgage loan originators (as defined in the S.A.F.E. Act). The Dodd-Frank Act would transfer to the Bureau the authority to administer the S.A.F.E. Act. This means that the Bureau will be charged with developing and maintaining a system for registering with the NMLS individual mortgage loan originator employees of a depository institution, regardless of the institution’s size, employees of a subsidiary that is owned and controlled by a depository institution and regulated by a federal banking agency, and employees of an institution regulated by the Farm Credit Administration (FCA). While the S.A.F.E. Act required the federal banking agencies to develop such a system by July 2009, the agencies and the NMLS have not yet been able to complete it. The new law extends the deadline for developing the NMLS registration system for those mortgage loan originator employees for another year (July 2011), which unfortunately still could occur before the Bureau is operational. In addition, the S.A.F.E. Act in 2008 gave HUD the authority to determine whether a state had implemented a S.A.F.E. Act-compliant licensing system for state mortgage loan originators (i.e., those individual loan originators who are not employees of depository institutions, owned-and-controlled subsidiaries, or FCA-regulated institutions). If HUD determined that the state failed to do so, then HUD was required to establish a back-up licensing system. The Dodd-Frank Act would transfer HUD’s authority in this regard to the Bureau. The new law also would give the Bureau additional S.A.F.E. Act authority related to mortgage loan originator net worth, surety bond, or recovery fund requirements. Specifically, the Bureau would be

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authorized to promulgate regulations setting minimum net worth or surety bond requirements for residential mortgage loan originators and minimum requirements for recovery funds paid into by loan originators. In issuing those regulations, the Bureau once again would be tasked with promoting the availability of affordable “good” loans, by factoring in the need to provide originators adequate incentives to originate affordable and sustainable mortgage loans, as well as the need to ensure a competitive origination market that maximizes consumer access to affordable and sustainable mortgage loans. As indicated above, the Mortgage Reform Act would depart from the S.A.F.E. Act by providing its own (substantially broader) definition of “mortgage originator.” For purposes of the new TILA requirements applicable to mortgage originators, those requirements apply not just to individuals, but also to entities. It also would apply not only to originators that take applications or offer or negotiate loan terms, but to persons that in any way assist a borrower in obtaining or applying for a residential mortgage loan. However, the Mortgage Reform Act would clarify a nagging source of ambiguity that persists under the S.A.F.E. Act, by expressly excluding from the definition of “mortgage originator” servicers and their employees, agents and contractors, including those who offer or negotiate terms of a residential mortgage loan for purposes of renegotiating, modifying, replacing and subordinating principal of existing mortgages where borrowers are behind in their payments, in default, or have a reasonable likelihood of being in default or falling behind. Since neither HUD nor the federal banking agencies have finalized their rulemakings to clarify whether they intend to impose loan originator licensing on servicer employees, perhaps the Bureau will follow the lead of Congress and exclude them when it takes over those agencies’ authority in this regard.

We note also that a S.A.F.E. Act amendment that had been included in the House’s version of the financial reform package does not appear in the current conference version of the Dodd-Frank Act. The dropped provision would have allowed a state loan originator supervisory authority to grant exceptions, on a case-by-case basis, to the ban on individuals who have been convicted of fraud, dishonesty, breach of trust, or money laundering. Currently, the S.A.F.E. Act prohibits such individuals from ever obtaining a loan originator license in any state. That authority to make exceptions on a case-by-case basis did not, however, make it into the current version of the Mortgage Reform Act. Conclusion Although we have anticipated many of the Mortgage Reform Act’s provisions for months, the Act nonetheless will rock the foundations of the residential mortgage loan industry – the delivery channels for those loans, the variety of and innovation in those loans, and likely even the cost of those loans. Significant work is ahead for the Bureau to shape the rules for the next generation. Congress has given the Bureau an incredible amount of authority to hammer out the recipe for the future of residential mortgage loans, but it appears the industry will only feasibly be able to offer plain vanilla. Consumers may want strawberry, or even rocky road. In the end, as consumers, the industry, and other agencies continue to voice their concerns and demands, Supreme Court Justice Breyer may be the final authority on how to define a plain vanilla mortgage and the Mortgage Reform Act’s other ambiguous provisions. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.



San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d’Alene Taipei Tokyo Warsaw Washington, D.C. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.


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K&L Gates is comprised of multiple affiliated entities: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), in Tokyo, and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong; a Polish limited partnership (K&L Gates Jamka sp. k.) maintaining an office in Warsaw; and a Delaware limited liability company (K&L Gates Holdings, LLC) maintaining an office in Moscow. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners or members in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. ©2010 K&L Gates LLP. All Rights Reserved.

1 As indicated above, the Dodd-Frank Act, which has been making its way through Congress over the past year, is not yet law. The bill that emerged from the conference committee on June 25 passed the House of Representatives on June 30. Senate Majority Leader Harry Reid stated that the Senate will vote on the measure when the Senate returns from recess on July 12. Although the vote is likely to be close—supporters may get exactly the 60 they need to avert a filibuster—Chairmen Dodd and Frank are publicly confident that the President will sign the bill by mid-July. 2 See Laurence E. Platt, Striking the Right Balance, Mortgage Banking & Consumer Financial Products Alert (Nov. 12, 2008); available; see also Laurence E. Platt, Kristie D. Kully, Satisficing Subprime, Mortgage Banking & Consumer Financial Products Alert (Aug. 5, 2008); Kristie D. Kully, Kerri Smith, and Laurence E. Platt, The Senate Moves to Reform Mortgage Loan Origination and Underwriting Practices, Mortgage Banking & Consumer Financial Products Alert (May 19, 2010); all available at http://www.klgates.com/practices/ServiceDetail.aspx?service=35&view=5. 3 The Mortgage Reform Act would also (sort of) exclude from the definition of “mortgage originator” individuals engaged in seller-financing, but even in that context the Act requires the seller/financer to make a “good” loan that the buyer has the ability to repay (similar to what is required of mortgage originators). Specifically, the definition would exclude a person (or an estate or trust) that provides mortgage financing for the sale of 3 properties (presumably the regulations will clarify that this means “up to 3” properties, and not exactly 3 properties) in any 12-month period to purchasers of those properties, each of which is owned by that person (or estate or trust) and serves as security for the loan. However, that exclusion would only be applicable if the loan meets the following criteria: (i) The person making the loan is not the person that constructed, or acted as a contractor for the construction of, a residence on the property in the person’s ordinary course of business; (ii) The loan is fully amortizing; (iii) The seller has determined in good faith and documents that the buyer has a reasonable ability to repay the loan; (iv) The loan has either a fixed rate or an adjustable rate that is fixed for the first 5 years and is afterwards subject to reasonable annual and lifetime limitations on interest rate increases; and (v) The loan meets any other criteria the Board may prescribe. Thus, while a seller/financer as described above will be relieved of certain obligations under the Mortgage Reform Act, it must still ensure that the buyer/borrower can repay

the financing and that the financing otherwise meets federal statutory and/or regulatory criteria, even if the seller/financer performs only one such transaction. 4 See Kerri M. Smith, Costas A. Avrakotos, HUD’s Adventures in Wonderland, Mortgage Banking & Consumer Financial Products Alert (Feb. 8, 2010); Laurence E. Platt, Kristie D. Kully, Kerri M. Smith, HUD Hinders HAMP, Mortgage Banking & Consumer Financial Products Alert (Aug. 5, 2009) (both available at http://www.klgates.com/newsstand/search.aspx). 5 Actually, many states adopted model language requiring unique identifiers on all residential mortgage loan application forms, solicitations, advertisements, business cards, websites, and any other documents as established by regulators. 6 The Mortgage Reform Act largely refers to the rulemaking authority of the Board of Governors of the Federal Reserve System. Of course, since the authority over the enumerated statutes moves to the Bureau, the Bureau, rather than the Board, will be responsible for issuing the new regulations. See Consumer Financial Protection Act of 2020, Title X of the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong., Title X, § 1100A(1). Nonetheless, this client alert refers to the Board throughout simply to match the Act’s terminology. 7 See supra note 5 regarding the transfer of authority to the Bureau. 8 See Laurence E. Platt, Kristie D. Kully, Satisficing Subprime, Mortgage Banking & Consumer Financial Products Alert (Aug. 5, 2008) (available at http://www.klgates.com/newsstand/Detail.aspx?publication=4809). 9 The term “bona fide discount points” means loan discount points that are knowingly paid by the consumer for the purpose of reducing, and that in fact result in a bona fide reduction of, the interest rate or time-price differential applicable to the mortgage. The exclusion from points and fees does not apply to discount points used to purchase an interest rate reduction unless the amount of the interest rate reduction purchased is reasonably consistent with established industry norms and practices for secondary mortgage market transactions. 10 See Kristie D. Kully, Will a Deluge of Disclosures Lead to a “Do Not Send” Law?, Mortgage Banking & Consumer Financial Products Alert (June 24, 2009) (available at http://www.klgates.com/newsstand/Detail.aspx?publication=5729). 11 See 15 U.S.C. § 1681g(g) 12 See Fair Credit Reporting Risk-Based Pricing Regulations, 75 Fed. Reg. 2,724 (Jan. 15, 2010). 13 See Title X, § 1054.

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July 9, 2010 Authors: Edward G. Eisert [email protected] +1.212.536.3905 Rebecca H. Laird [email protected] +1.202.778.9038 Cary J. Meer [email protected] +1.202.778.9107 Mark D. Perlow [email protected] +1.415.249.1070 The authors acknowledge the assistance of associates Megan Munafo and Jarrod Melson in the preparation of this Alert. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Increased Regulation of U.S. and Non-U.S. Private Fund Advisers Under the Dodd-Frank Act K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The long-awaited financial reform bill, now entitled The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Bill” or the “Bill”), appears to be moving toward passage by the Senate and enactment into law later this month.1 This Alert provides an overview of those provisions of the Dodd-Frank Bill that are likely to most directly affect investment advisers to hedge, private equity and venture capital funds, wherever such advisers and funds are domiciled.2 Please see the K&L Gates Newsstand and the K&L Gates Global Financial Market Watch Blog for additional background and detailed analysis about the legislative history of the Dodd-Frank Bill.

I. Overview The Dodd-Frank Bill, as currently drafted, would:

• dramatically alter the scope of required federal investment adviser registration under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), by:

o removing the private adviser exemption in Section 203(b)(3), which many advisers to “Private Funds”3 have relied upon in remaining unregistered;

o creating new exemptions from federal registration, including exemptions for:

“foreign private advisers”;

advisers solely to Private Funds if these advisers have assets under management in the United States of less than $150 million;

1 The Dodd-Frank Bill initially emerged from a joint House-Senate Conference Committee in the early hours of Friday, June 25, based upon a heavily negotiated integration of the bill passed by the House on December 12, 2009 and the bill passed by the Senate on May 20, 2010. The Dodd-Frank Bill was passed by the House on June 30, 2010, but its consideration by the Senate has been delayed until after the July 4th holiday recess. 2 Most, but not all, of the provisions relating to investment advisers to Private Funds are contained in Title IV of the Dodd-Frank Bill, entitled the “Private Fund Investment Advisers Registration Act of 2010.” Many other provisions of the Dodd-Frank Bill indirectly affect investment advisers, including advisers to Private Funds. Please see the following K&L Gates Alerts on additional topics related to the Dodd-Frank Bill: Financial Regulatory Reform - The Next Chapter: Unprecedented Rulemaking and Congressional Activity (July 7, 2010); Consumer Financial Services Industry, Meet Your New Regulator (July 7, 2010); Investor Protection Provisions of Dodd-Frank (July 1, 2010); New Executive Compensation and Governance Requirements in Financial Reform Legislation (July 7, 2010). 3 The Dodd-Frank Bill defines a “Private Fund” for purposes of Title IV as one that would be an investment company but for the exclusions in Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act of 1940, as amended. Unless otherwise noted, the term “Private Fund” as used in this Alert should be read to have the same meaning.


http://www.globalfinancialmarketwatch.com/










July 9, 2010 2


advisers solely to “venture capital funds” (subject to new recordkeeping and filing requirements);

advisers to small business investment companies;

“family offices”; and

advisers registered with the Commodity Futures Trading Commission (“CFTC”) as commodity trading advisors (“CTAs”) that advise Private Funds;

o increasing the minimum assets under management for federal registration from $25 million to $100 million (subject to certain conditions), and giving the Securities and Exchange Commission (the “SEC”) the authority to further increase this minimum;

• impose significant new recordkeeping and filing requirements upon registered investment advisers to Private Funds and subject them to new examination requirements;

• change the manner in which a natural person’s net worth is calculated for purposes of determining whether such person is an “accredited investor” under Regulation D of the Securities Act of 1933, as amended (the “Securities Act”), to exclude the value of the person’s primary residence;

• permit the SEC initially to review the natural person accredited investor standard (other than the net worth test) and also require the SEC to review, and possibly adjust, the accredited investor standard in its entirety no earlier than four years after the enactment of the Bill and then every four years thereafter;

• require the SEC periodically to adjust for inflation any dollar amount used in determining if a client or investor is a “qualified client” under the Advisers Act (from whom a registered adviser may receive a performance-based fee or allocation);

• place severe limitations on the ability of U.S. and certain non-U.S. financial institutions

regulated by the Federal Reserve to sponsor or invest in “hedge funds” or “private equity funds” (“Covered Funds”);4

• grant the Financial Stability Oversight Council (the “FSOC”)5 the ability to impose additional regulation on certain nonbank financial companies deemed large enough to pose a systemic risk, which could include certain large Private Funds or Private Fund complexes and their advisers; and

• mandate that the Government Accountability Office (the “GAO”) and the SEC conduct several studies and make reports thereon to Congress.

II. Dramatic Changes to the Scope and Contours of Investment Adviser Registration The Dodd-Frank Bill dramatically reshapes the universe of advisers required to register under the Advisers Act, as described below. The Bill provides that all of the provisions discussed below (other than the provisions described in Sections VI and VII) take effect one year after the passage of the Bill, although an adviser may register with the SEC prior to that date in the adviser’s discretion and 4 For these purposes, the Dodd-Frank Bill explicitly defines “hedge fund” and “private equity fund” to mean: “an issuer that would be an investment company, as defined in the Investment Company Act of 1940… but for section 3(c)(1) or 3(c)(7) of that Act, or such similar funds as the appropriate Federal banking agencies, the [SEC] and the [CFTC] may, by rule… determine.” 5 The FSOC, created by the Dodd-Frank Bill, is an inter-agency body charged with identifying and monitoring systemic risks to the financial markets, including those posed by U.S. and non-U.S. “nonbank financial companies.” The FSOC is composed of ten voting members, nine of which are granted a seat ex officio and one independent member appointed directly by the President. The ex officio members include, among others, the Secretary of the Treasury (who serves as chairperson of the FSOC), the Chairman of the Federal Reserve, the Comptroller of the Currency, the Director of the Bureau of Consumer Financial Protection created under the Dodd-Frank Bill, the Chairperson of the SEC, the Chairperson of the CFTC, the Chairperson of the Federal Deposit Insurance Corporation (the “FDIC”) and other high ranking officials from various governmental and regulatory authorities. The Dodd-Frank Bill provides that the FSOC shall have certain non-voting members serving in an advisory capacity, including a state banking supervisor, a state insurance commissioner and a state securities commissioner.

July 9, 2010 3


subject to the rules of the SEC. The SEC will likely provide some guidance on how advisers can register (or de-register) in advance of the effective date in order to provide for as smooth a transition as possible. A. Rescission of the Private Adviser Exemption. The Dodd-Frank Bill rescinds Section 203(b)(3) of the Advisers Act, commonly referred to as the “Private Adviser Exemption” on which many advisers to Private Funds have relied. The Private Adviser Exemption has provided an exemption from Advisers Act registration for an adviser that would have otherwise been required to register if (1) during any rolling 12-month period it had fewer than 15 clients, (2) it did not serve as adviser to a registered investment company under the Investment Company Act of 1940, as amended (the “Company Act”), or a company that had elected to be registered as a business development company under the Company Act (a “BDC”), and (3) it did not hold itself out to the public as an investment adviser. Generally, subject to certain exceptions, an adviser to a private investment fund could treat each fund it advised as a single client, allowing an adviser to manage up to 14 funds without registration.6 Most of the advisers that have relied upon the Private Adviser Exemption will be required to register either with the SEC or state regulators because of the limited scope of the new exemptions from registration provided in the Bill. B. New Exemptions from Registration. 1. Foreign Private Adviser Exemption.

a. Overview of the Exemption. The Dodd-Frank Bill provides an exemption from the registration requirements of the Advisers Act to any “Foreign Private Adviser,” defined to mean any adviser who:

6 Rule 203(b)(3)-1 generally provides that an investment adviser could deem “the following to be a single client for purposes of [the Private Adviser Exemption]… (2)(i) a corporation, general partnership, limited partnership, limited liability company, trust… or other legal organization… to which [the adviser provides] investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, members or beneficiaries[.]”

• has no place of business in the United States;

• has, in total, fewer than 15 clients and investors in the United States in Private Funds advised by the investment adviser;7

• has aggregate assets under management attributable to clients in the United States and investors in the United States in Private Funds advised by the investment adviser of less than $25 million, or such higher amount as the SEC may, by rule, deem appropriate; and

• neither:

o holds itself out generally to the public in the United States as an investment adviser; nor

o acts as (i) an investment adviser to any investment company registered under the Company Act; or (ii) a BDC.

Although the Dodd-Frank Bill definition of Foreign Private Adviser is based upon the Private Adviser Exemption, it differs from that exemption in its computation of clients and investors in two key respects that are likely to raise interpretive issues. First, the Dodd-Frank Bill does not provide a timeframe for calculating the number of clients for purposes of the 15-client limit, as did the Private Adviser Exemption. Accordingly, it is not clear under the Dodd-Frank Bill whether non-U.S. domiciled advisers will be able to rely upon the Foreign Private Adviser exemption if they have 15 or fewer current U.S. clients or if the exemption becomes unavailable once an adviser has had more than 15 current and former U.S. clients. This omission will create uncertainty for non-U.S. advisers until it is resolved through interpretative relief or enforcement action.

7 This language is intended to make clear that advisers would be required to aggregate the number and assets of U.S.-based clients and investors in Private Funds they manage for purposes of counting the number of their clients and of the assets under management test.

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Second, the Dodd-Frank Bill makes it clear that, in calculating the number of its clients, a Foreign Private Adviser must “look through” the Private Funds it advises to count the number of investors in the United States in such funds.8 This new methodology of counting the number of clients of a non-U.S. adviser is inconsistent with the methodology applied under the Advisers Act subsequent to the Goldstein decision9 as reflected in Rule 203(b)(3)-1 and Rule 222-2 of the Advisers Act. Under Rule 203(b)(3)-1, as noted above, a Private Fund generally counts as one client. Under Rule 222-2, this definition of client remains relevant for purposes of determining whether, under Section 222 of the Advisers Act, a state may require an investment adviser with no place of business in such state to register as an investment adviser with that state, since the state may only do so if the adviser has, within the preceding 12-month period, at least six clients who are residents of that state. If a non-U.S. adviser with a principal office and place of business outside of the United States does not meet the exemption for a Foreign Private Adviser, it should still be able to register federally regardless of the newly increased $100 million minimum asset under management requirement for federal registration (discussed below). As set forth in Section 410 of the Dodd-Frank Bill, the minimum assets under management requirement is drafted to apply only to an adviser that otherwise would be subject to registration with the securities commission (or like agency) of the state in which it maintains its principal office and place of business.

8 However, Section 406 of the Bill explicitly prohibits the SEC from defining the term “client” for purposes of 206(1) and (2) of the Advisers Act, two of the Advisers Act’s antifraud provisions, “to include an investor in a private fund managed by an investment adviser, if such private fund has entered into an advisory contract with such adviser.” It is unclear whether a limited partnership agreement or limited liability company agreement that contains the provisions normally found in an advisory contract would constitute an “advisory contract” between the general partner or managing member of such fund and its investors for this purpose. 9 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

. b. Issues Regarding the Exemption. The Bill’s definition of Foreign Private Adviser includes a requirement that the adviser have no more than $25 million in assets under management attributable to the adviser’s clients or investors in the United States (a concept which it does not define). This requirement may prove to be too crude a measure of whether the activities of a foreign adviser may have a substantial likelihood of having a material impact on U.S. persons or markets.10 For example, a foreign adviser with one large and sophisticated client investing more than $25 million solely in non-U.S. securities would be regulated by the SEC, whereas a foreign adviser with 14 unsophisticated individual clients (with an aggregate of less than $25 million in assets under management from those clients) investing in U.S. securities would not be regulated.

In addition, the Bill defines a “Private Fund” to be a fund that relies upon either Section 3(c)(1) or Section 3(c)(7) of the Company Act without regard to whether the fund is formed in a non-U.S. jurisdiction or the percentage of its securities held by U.S. persons.11 Of course, as a general matter, a non-U.S. fund with a single U.S. investor may have to rely on one of these two sections to avoid Company Act registration. Accordingly, under the Bill, the definition of a Private Fund includes funds organized outside of the United States and managed by non-U.S. advisers without regard to the percentage ownership of such funds by U.S. persons, their investment programs, or whether the non-U.S. advisers or funds are subject to a robust regulatory scheme administered by a competent non-U.S. regulator. For example, a fund organized in the Cayman Islands, managed by an adviser that has its only place of business in the U.K. and

10 This is the standard that the SEC and the courts traditionally have used in determining the extraterritorial effect of the U.S. securities laws. 11 In other instances, the SEC has used the definition of “U.S. person” set forth in Rule 902 of Regulation S under the Securities Act when a definition of “U.S. person” is required. See, e.g., Rule 500 of Regulation AC under the Securities Exchange Act of 1934, as amended.

July 9, 2010 5


that invests all of its assets in securities that are not traded on U.S. markets is a Private Fund if any of the shares or interests in the fund are owned by U.S. persons. Under these circumstances, the U.K.-based adviser would be required to register, unless it qualifies as a Foreign Private Adviser or under another exemption. Complicated issues may arise as to the extent to which the requirements of the Advisers Act would apply to the non-U.S. operations, clients or accounts managed or serviced by such adviser and its non-U.S. regulated affiliates.12 These issues may lead many non-U.S. Private Fund advisers to avoid U.S. investors.13

2. Advisers Solely to Venture Capital Funds.

a. Overview of the Exemption. Section 407 of the Dodd-Frank Bill provides an exemption from registration for advisers that solely advise one or more “venture capital funds,” a term the Dodd-Frank Bill requires the SEC to define within one year after the enactment of the Bill. Although such advisers are exempt from registration, the Dodd-Frank Bill mandates the SEC “to require such advisers to maintain such records and provide to the [SEC] such annual or other reports as the [SEC] determines necessary or appropriate in the public interest or for the protection of investors.” There is no similar exemption for advisers solely to private equity funds, as had been included in an earlier version of the financial reform bill.

b. Issues Regarding the Exemption. There is no commonly accepted definition of “venture capital fund.” Because of the blurring of the lines between the private equity and venture capital industries, it may be difficult for the SEC to define “venture capital fund” in a manner that is not open to abuse by private fund advisers seeking to avoid registration. Accordingly,

12 See, e.g., Uniao de Banco de Brasileiros S.A., SEC No-Action Letter (pub. avail. July 28, 1992); ABN AMRO Bank, N.V., SEC No-Action Letter (pub. avail. July 1, 1997). 13 For a more detailed discussion of these issues, please see the discussion of the definition of a “hedge fund” in K&L Gates’ March Alert entitled: “New Dodd Bill Would Dramatically Step Up Regulation of Private Fund Advisers.”

there is a significant possibility that the SEC will create a very narrow definition of “venture capital fund,” erring on the side of overinclusiveness in requiring adviser registration. Such a narrow definition could undermine the Congressional purpose in exempting venture capital fund advisers.

When the SEC attempted to compel hedge fund advisers to register in 2004, it distinguished between private funds that did, and did not, lock up their investors’ capital for two years or more as a means of distinguishing between “hedge funds” and other types of Private Funds; it is conceivable that in implementing the Bill, the SEC would use similar criteria, perhaps with a longer lock-up period required to avoid registration. This could lead to changes in the structure of the Private Fund industry as advisers seek to avoid registration by extending the lock-up period of their funds, as was the case after the 2004 registration requirement was adopted.

3. “Mid-Sized” Private Fund Advisers. Section 408 of the Dodd-Frank Bill requires the SEC to provide an exemption from registration “to any investment adviser [who]… acts solely as an adviser to Private Funds and has assets under management in the United States of less than $150,000,000.” Although they will be exempted from registration, the SEC must require this class of exempted advisers to maintain “such records and provide to the [SEC] such annual or other reports as the [SEC] determines necessary or appropriate in the public interest or for the protection of investors.”14

The scope of the exemption that will be provided under these provisions is unclear because, among other matters, in prescribing regulations to carry out the foregoing requirements, the Bill requires the SEC to “take into account the size, governance, and investment strategy of such funds to determine whether they pose systemic risk, and shall provide for registration and examination

14 Dodd-Frank Bill § 408.


July 9, 2010 6


procedures with respect to the investment advisers of such funds which reflect the level of systemic risk posed by such funds.”15 These advisers and funds could, therefore, still be subject to regulation and oversight similar in nature or rigor as that applicable to registered advisers and their Private Funds. The utility of this exemption also is limited because it is unavailable to advisers who provide management services to Private Funds as well as other types of clients, such as separate account clients.

4. Advisers to “Small Business Investment Companies.” The Dodd-Frank Bill provides an exemption from the requirement to register under the Advisers Act for advisers (other than entities regulated as BDCs) who solely advise small business investment companies that are licensed by the Small Business Administration (the “SBA”) under the Small Business Investment Act of 1958, have received from the SBA notice to proceed to qualify for a license, or are pending applicants that are affiliated with one or more licensed small business investment companies.

5. Family Offices. The Dodd-Frank Bill provides a new exemption from the definition of “investment adviser” under the Advisers Act for a “family office.” The Dodd-Frank Bill requires the SEC to define the term “family office,” but, in contrast to the requirement for defining “venture capital fund,” the Bill does not specify a date by which the SEC must provide a definition. The Bill also requires the SEC to implement the family office exemption in a manner consistent with regulatory relief granted in the past, to recognize “the range of organizational, management, and employment structures and arrangements employed by family offices.” The SEC also may not exclude from the exemption certain persons who were not registered or required to be registered on January 1, 2010 in providing investment advice to, among others, any “company owned exclusively and controlled by members of the family of the family office” and certain

15 Id.

registered investment advisers that identify investment opportunities to the family office and invest in those opportunities on substantially the same terms, subject to specified conditions. Unlike exempt advisers to venture capital funds, however, exempted family offices are not required by the Bill to maintain such records and provide to the SEC such reports as the SEC determines to be necessary or appropriate in the public interest or for the protection of investors.

The scope and contours this exemption will take as a result of SEC rulemaking are unclear. Previously, many advisers to a single family attempted to stay within the Private Adviser Exemption. The SEC has, however, historically granted exemptive orders to certain family offices that exceeded the 15-client limitation of the Private Adviser Exemption on a case-by-case basis.16 Given that the Private Adviser Exemption will be rescinded on the first anniversary of the Bill’s passage and that there is no timeframe specified for the adoption of a rule defining “family office,” these advisers may face increased uncertainty.

6. Registered CTAs. The Advisers Act has

provided and continues to provide an exemption from registration for an adviser that is registered with the CFTC as a CTA whose business “does not consist primarily” of acting as an investment adviser, as defined in the Advisers Act, and that does not primarily act as an investment adviser or act as an investment adviser to investment companies registered under the Company Act or BDCs. The Dodd-Frank Bill adds a new exemption for an adviser that is registered with the CFTC as a CTA and advises a Private Fund, provided that, if after the enactment of the Dodd-Frank Bill, the “business of the advisor should become

16 The first of these orders was In the Matter of Donner Estates, Inc., Investment Advisers Act Release No. 21 (Nov. 3, 1941). Over the years, the SEC has granted exemptive relief on a case-by-case basis in other circumstances where an adviser provides services to a single family and a limited number of closely related persons (such as the portfolio managers of the family office adviser) and where the family office is intended to serve the family’s interests, is controlled by family members and does not itself pursue profit.

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predominantly the provision of securities-related advice, then such adviser shall register with the [SEC].”

C. Raising the Federal Registration Minimum Assets Under Management. Section 410 of the Dodd-Frank Bill prohibits an adviser from registering with the SEC if: (i) it is required to be registered as an investment adviser with the securities regulator of the state in which it maintains its principal office and place of business and, if registered, it would be subject to examination; and (ii) it has assets under management between $25 million and $100 million (as such amounts may be increased by the SEC by rule), unless: (x) it is an adviser to an investment company registered under the Company Act or a company that has elected to be a BDC pursuant to the Company Act and has not withdrawn its election; or (y) it would be required to register with 15 or more states.

Previously, an investment adviser with $25 million under management, but less than $30 million, had the option of registering federally. An adviser with $30 million or more under management was required to register federally, absent an exemption. As a result of the change effected by the Dodd-Frank Bill, state agencies and examiners will take over the regulation of a large portion of smaller advisers, including advisers to small Private Funds. Some, including SEC Commissioners, have expressed concern over the states’ ability to assume the increased financial and inspection burden resulting from this higher registration threshold.17 Another issue presented by the Bill is whether an adviser that is now registered based on satisfying the existing $25 million asset threshold will be required 17 In an April 19, 2010 interview with Melanie Waddell on the website www.investmentadvisor.com, Chairwoman Schapiro stated that the increase to $100 million “results in about 40% of investment advisors who are currently subject to SEC registration being state regulated—about 4,000 plus advisors” and expressed concern about “whether the states have resources, particularly at this time, to take on an additional 4,000 registrants[.]” See Melanie Waddell, As Goldman Fraud Case Raises SEC Self-Funding Issue and Reform Bill Looms, Schapiro Talks to IA on Reform, www.investmentadvisor.com (April 19, 2010)(available here.)See also Commissioner Elisse B. Walter, Remarks at the 2010 Investment Adviser Compliance Forum (February 25, 2010) (available at http://www.sec.gov/news/speech/2010/spch022510ebw.htm).

to deregister if it no longer qualifies for federal registration; it is not clear whether the SEC will provide some form of “grandfathering” relief.

III. Imposition of Significant New Recordkeeping and Filing Requirements and Potential Additional Custody Requirements A. Private Fund Records and Reports. 1. Types of Records and Information. Section 404

of the Dodd-Frank Bill provides the SEC with the authority to require advisers to Private Funds to maintain records, file reports and, upon request or examination, produce records regarding those Private Funds. Under the Dodd-Frank Bill, a registered adviser to Private Funds must maintain records regarding its Private Funds (which will be treated as the adviser’s own records and be made available for inspection by the SEC) that include a description of:

• amount of assets under management and use of leverage, including off-balance-sheet leverage,

• counterparty credit risk exposure,

• trading and investment positions,

• valuation policies and practices,

• types of assets held,

• side arrangements or side letters whereby certain investors obtain more favorable rights than other investors,

• trading practices, and

• such other information as the SEC (in consultation with the FSOC) determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

The Dodd-Frank Bill requires the SEC to issue rules requiring each adviser to a Private Fund to file reports containing such information as the SEC deems necessary and appropriate. The SEC is given the ability to establish different reporting requirements for different “classes” of Private Fund advisers based on the type or size

http://www.investmentadvisor.com

http://www.investmentadvisor.com

http://www.sec.gov/news/speech/2010/spch022510ebw.htm

http://www.investmentadvisor.com/News/2010/4/Pages/Schapiro-Talks-to-IA-on-Reform.aspx?k=Schapiro+Talks+to+IA+on+Reform

July 9, 2010 8


of Private Fund(s) advised. As noted above, advisers solely to venture capital funds are exempted from registration but will be required to “maintain such records and provide to the [SEC] such records… as the [SEC] determines necessary or appropriate.”18 Taken as a whole, the provisions of the Bill mandating more rigorous regulation and recordkeeping will create greater challenges for smaller managers, which may lack the resources to comply with these requirements, and thus may accelerate the trend toward concentration in the hedge fund industry.

2. Maintenance Period. The Dodd-Frank Bill grants the SEC the ability to determine by rule the period for which these records must be maintained. Thus, information regarding Private Funds could be subject to the normal record retention requirements of the Advisers Act, or it could be subject to a different holding period or set of holding period requirements. Different holding periods could create complications for advisers managing Private Fund and other types of accounts.

B. Confidentiality of Private Fund Records and Reports. 1. Information Sharing. As noted above, the SEC

must make available to the FSOC any “reports, documents, records, and information filed with or provided to the SEC by an investment adviser” regarding a Private Fund as the FSOC considers necessary for assessing systemic risk.

It is important to note that the Dodd-Frank Bill amends the client confidentiality protections set forth in Section 210(c) of the Advisers Act. Section 210(c) provides that nothing in the Advisers Act shall allow the SEC to require an adviser to disclose the identity, investments or affairs of any client “except insofar as such disclosure may be necessary or appropriate in a particular proceeding or investigation having as its object the enforcement of a provision or provisions of [the Advisers Act].” The Dodd-Frank Bill adds to the end of this provision the

18 See Dodd-Frank Bill § 407.

additional factor: “or for the purposes of assessing potential systemic risk.”

2. Broad Exemption from the Freedom of Information Act (“FOIA”). Section 404 of the Dodd-Frank Bill provides that the SEC, the FSOC “and any other department, agency, or self-regulatory organization that receives information, reports, documents, records, or information from the [SEC] under this subsection [e.g., information regarding Private Funds, as set forth in Section III.A. above] shall be exempt from the provisions of Section 552 of title 5 [FOIA].”

3. Proprietary Information. The Dodd-Frank Bill provides that any “proprietary information” ascertained by the SEC as a result of reports required to be filed by Private Fund advisers shall be treated in the same manner as facts ascertained during an examination pursuant to Section 210(b) of the Advisers Act. “Proprietary information” is defined to mean “sensitive, non-public information regarding: (i) the investment or trading strategies of the investment adviser; (ii) analytical or research methodologies; (iii) trading data; (iv) computer hardware or software containing intellectual property; and (v) any additional information the [SEC] determines to be proprietary.” Section 210(b) of the Advisers Act provides that neither the SEC, nor any member, officer or employee of the SEC shall publicly reveal “any facts ascertained during any… examination or investigation[,]” except with the approval of the SEC, in the course of a public SEC hearing or in response to a request or resolution from either House of Congress.

4. Specific Treatment of Filed Reports. For reports filed with the SEC regarding Private Funds, the Dodd-Frank Bill provides that “[n]otwithstanding any other provision of law, the [SEC] may not be compelled to disclose any report or information contained therein required to be filed with the [SEC,]” except that the SEC may not “withhold information from Congress, upon an agreement of confidentiality” or prevent the SEC from complying with “a request for information from any other Federal department or agency or any self-regulatory

July 9, 2010 9

organization requesting the report or information for purposes within the scope of its jurisdiction” or “an order of a court of the United States in an action brought by the United States or the [SEC].” The Dodd-Frank Bill provides that any other federal agency or any self-regulatory organization (“SRO”) that receives reports or information pursuant to a request described above shall maintain the confidentiality of such information in a manner “consistent with the level of confidentiality” established for the SEC.

5. Annual Report to Congress. The SEC must report annually to Congress on how it has used the data regarding Private Funds provided pursuant to the Dodd-Frank Bill provisions.

Notwithstanding the Bill’s provisions designed to protect the confidentiality of information regarding Private Funds, mistakes in handling information and leaks from government agencies are always a possibility. In a recent example, earlier this year the SEC inadvertently publicly posted on its website an earnings report provided to it by Citadel Securities, LLC that was intended for internal SEC review only, giving competitors access to Citadel’s business and operations.19 In providing documents to government agencies, particularly in cases in which those documents may be shared among a wide range of agencies, information leaks (either intentional or inadvertent) are a justified concern for Private Fund managers.

C. Potential Additional Custody Requirements. The SEC recently amended Rule 206(4)-2 under the Advisers Act, the rule governing custody of client assets by registered advisers.20 The Dodd-Frank Bill creates a new Section 223 of the Advisers Act that

19 See Miles Weiss, Citadel Securities Filing Gives Glimpse of Ken Griffin’s Banking Startup, Bloomberg (May 20, 2010), available at http://www.bloomberg.com/news/2010-05-20/rg-citadel-securities-filing-gives-glimpse-of-ken-griffin-s-banking-start.html (last visited July 5, 2010). 20 For a discussion of the amendments to the custody provisions of the Advisers Act, see the following K&L Gates Alerts: SEC Releases Amended Custody Rule (January 8, 2010) and SEC Offers Guidance on Looming Custody Rule Amendments (March 10, 2010).

provides an investment adviser “shall take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the [SEC] may, by rule, prescribe.” It is unclear what additional custody rules are envisioned or contemplated, if any, but given the weaknesses in the custody requirements revealed by the Madoff scandal and the SEC’s recent focus on custody in its examination and rulemaking, new custody provisions and requirements are possible.

IV. Restrictive Changes to the Accredited Investor Standard for Natural Persons

A. Exclusion of Value of Primary Residence. Under existing law, a natural person qualifies as an accredited investor if he or she (1) has an individual net worth, or joint net worth with his or her spouse, including any net equity in a primary residence, that exceeds $1 million at the time of the purchase of securities (the “Net Worth Test”), or (2) had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year (the “Income Test”). The Dodd-Frank Bill requires the SEC to exclude the value of a natural person’s primary residence in determining whether he or she satisfies the Net Worth Test. This change will have a particularly significant effect upon less wealthy individual investors and the Private Funds that are designed for this class of prospective investors.

B. Initial Adjustment. The Dodd-Frank Bill permits the SEC to undertake an initial review of the accredited investor definition as it applies to natural persons. In this initial review (and for four years following the enactment of the Dodd-Frank Bill), the SEC cannot increase the $1 million level of the Net Worth Test. Based on its initial review, however, the SEC can, by notice and comment rulemaking, modify or adjust the definition in other ways.21 The Dodd-Frank Bill expressly prohibits

21 The SEC issued a set of proposed rules in 2007 (which were not adopted) that would have revised portions of Regulation D, including the definition of the term “accredited


http://www.bloomberg.com/news/2010-05-20/rg-citadel-securities-filing-gives-glimpse-of-ken-griffin-s-banking-start.html







July 9, 2010 10


the SEC from raising the dollar level of the Net Worth Test for the first four years following its enactment, but, notably, does not include any such prohibition on increases to the amount required to satisfy the Income Test or the other dollar-based tests in the definition of “accredited investor.”

C. Subsequent Adjustments. After the initial review, the Dodd-Frank Bill requires that the SEC review the accredited investor definition as it applies to natural persons in its entirety no earlier than four years after the Bill’s passage, and not less frequently than every four years thereafter. In one or more of these subsequent reviews, the SEC may, by notice and comment rulemaking, propose additional changes to the definition of accredited investor as it applies to natural persons, including increasing the $1 million amount of the Net Worth Test or increasing the Income Test.

D. Issues Presented. The exclusion of a prospective investor’s primary residence in satisfying the Net Worth Test as well as the SEC’s initial and subsequent adjustments to the definition of “accredited investor” (to a lesser extent) will shrink the pool of natural persons who meet this standard. Although this would not affect those natural persons who also qualify as “qualified purchasers” and may invest in Private Funds that rely on Section 3(c)(7) of the Company Act, it will affect natural persons who seek to invest in Private Funds that rely on Section 3(c)(1) of the Company Act and the advisers to those funds. Among other things, it is unclear how these adjustments will affect the ability of existing investors in a Private Fund who become ineligible after the exclusion of a primary residence from the Net Worth Test, or after the initial or subsequent changes to the accredited investor definition, from making additional investments in the same Private Fund. It is unclear whether the SEC might adopt some form of grandfathering provision, which might permit such investors to make additional investments in the Private Funds in which they had invested prior to any such change.

investor.” The proposing release may provide guidance on the changes the SEC could seek to make in its initial review. See Revisions of Limited Offering Exemptions in Regulation D, Securities Release No. 33-8828 (August 3, 2007).

V. Indexing the Qualified Client Standard to Inflation A. Initial and Periodic Adjustment. The Advisers Act generally prohibits an adviser from charging a client performance-based compensation, such as the performance fee or incentive allocation normally charged by fund advisers to Private Funds (and their investors).22 Rule 205-3 under the Advisers Act, however, permits such a fee to be charged against a client (or the investors in a Private Fund) if that client (or each investor in a fund) is a “qualified client” as defined in the Rule.23 Section 418 of the Dodd-Frank Bill requires that, if the SEC uses a dollar amount test to determine who is a “qualified client,” as it now does, it shall, not later than one year after the enactment of the Bill and every five years thereafter, adjust such amount for the effects of inflation. The Bill requires any such adjustment that is not a multiple of $100,000 to be rounded to the nearest multiple of $100,000.

B. Issues Presented. As for adjustments to the definition of “accredited investor,” discussed above, it is unclear how the SEC will treat persons who previously qualified as “qualified clients” but, as a 22 See Section 205(a) of the Advisers Act, which states:

“No investment adviser, unless exempt from registration pursuant to section 203(b), shall make use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to enter into, extend, or renew any investment advisory contract, or in any way to perform any investment advisory contract entered into, extended, or renewed on or after the effective date of this title, if such contract … (1) provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client…”

23 “Qualified client” is defined to mean (1) a natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser, (2) a natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either: (i) has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1.5 million at the time the contract is entered into; or (ii) is a qualified purchaser as defined in Section 2(a)(51)(A) of the Company Act at the time the contract is entered into; or (3) certain key personnel, officers, directors and employees of the adviser.

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result of the initial or subsequent changes to this definition required by the Dodd-Frank Bill, no longer meet the dollar-amount requirements. Under such circumstances, it is uncertain whether an adviser to a Private Fund could still charge a performance fee. In addition, it is not clear whether the SEC, in its initial adjustment of the dollar-amount test, will adjust for the effects of inflation in the many years since the test was adopted.

VI. Volcker Rule as Applied to Covered Funds The provisions of the Dodd-Frank Bill that are known as the “Volcker Rule” will become a new Section 13 of the Bank Holding Company Act (“BHCA”). These provisions generally prohibit any “banking entity”24 from engaging in proprietary trading, “sponsoring” or investing in Covered Funds or “such similar funds” as certain federal agencies may determine by rule. “Sponsoring” a Covered Fund is defined to include: (1) serving as a general

24 See Section 619 of the Dodd-Frank Bill, which contains the Volcker Rule provisions. Banking entities are defined to include any FDIC-insured institution. FDIC-insured entities include commercial banks, savings banks, cooperative banks and thrifts, but also industrial loan companies and credit card banks. The insured institution definition does not include non-depository trust companies, which are not FDIC-insured, or those FDIC-insured trust companies that comply with the trust company exemption under the BHCA. In addition, a “banking entity” includes any company that controls an insured institution, as defined, which would include the parent holding company of an industrial loan company or credit card bank, i.e., entities that would otherwise be exempt under the BHCA because they are not bank holding companies for purposes of the BHCA. Further, any company that “is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978” is a “banking entity.” This includes any foreign banking organization with a United States branch, agency, commercial lending company or depository institution subsidiary. It would not include a foreign banking company with only a representative office in the United States. Finally, a “banking entity” includes any affiliate or subsidiary of any of the foregoing entities, which means that all subsidiaries and affiliates of any of the “banking entities” are themselves “banking entities.”

The Volcker Rule provisions generally apply as well to systemically important nonbank financial companies, as designated under the Dodd-Frank Bill. Under the Bill, the authority of the Federal Reserve with respect to a non-U.S. nonbank financial company, generally, includes only the U.S. activities and subsidiaries thereof. For ease of reference, this discussion refers only to “banking entities,” which should be read to include a “nonbank financial company supervised by the [Federal Reserve] Board.”

partner, managing member or trustee of a Covered Fund; (2) selecting or controlling in any manner a majority of the directors, trustees or management of a Covered Fund; or (3) sharing with the Covered Fund the same name or variant of a name, which is used for corporate, marketing, promotional, or other purposes. A. Permissible Activities. While the Dodd-Frank Bill contains a general prohibition on a banking entity acquiring or retaining any equity, partnership or other ownership interest in, or sponsoring any Covered Fund, a banking entity, to the extent permitted by any other provision of federal or state law and any restrictions or limitations that the appropriate federal regulators may determine, may organize and offer a Covered Fund, and sponsor it, if all of the following conditions are met:

• The banking entity provides bona fide trust, fiduciary, or investment advisory services;

• The Covered Fund is organized and offered only in connection with the provision of bona fide trust, fiduciary or investment advisory services and only to customers of such services of the banking entity;

• The banking entity does not, directly or indirectly, guarantee, or assume or otherwise insure the obligations or performance of the Covered Fund or of any other Covered Fund in which the Covered Fund invests;

• The banking entity does not share the same name, or variation thereof, with the Covered Fund;

• No director or employee of the banking entity takes or retains an equity interest, partnership interest or other ownership interest in the Covered Fund, except for any director or employee who is directly engaged in providing investment advisory or other services to the Covered Fund;

• The banking entity discloses to prospective and actual investors in the Covered Fund, in writing, that any losses in such Covered Fund are borne solely by investors in the Covered Fund and not by the banking entity, and otherwise complies

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with any additional regulatory requirements; and

• The banking entity does not acquire or retain an equity interest, partnership interest or other ownership interest in the Covered Fund, other than:

a) A seed investment in connection with establishing a Covered Fund, for a period of up to one year, which may be up to 100% of the ownership interests; and

b) De minimis longer term investments, which after one year are reduced to an amount that is not more than three percent of the total ownership, and are “immaterial” to the banking entity. 25

In no case may the banking entity’s seed and de minimis investments in Covered Funds exceed three percent of the banking entity’s tangible common equity.

The de minimis exception has generally been reported as permitting investments in Covered Funds as to which the banking entity has no sponsorship role, i.e., a pure investment, as well as in Covered Funds sponsored by the banking entity. However, under the actual wording of the Bill, it appears that the de minimis exception is available only for investments in Covered Funds organized and offered by the banking entity and sold only to customers subject to the limitations listed above. However, no transaction, class of transactions or activity may be deemed to be a permitted activity if it would:

• Involve or result in a material conflict of interest (to be defined by the appropriate regulatory agencies) between the banking entity and its clients, customers or counterparties;

25 A banking entity is required to seek unaffiliated investors to reduce or dilute its seed investment to the three percent de minimis level or make redemptions to meet this test if not accomplished by new investments in the initial one year period.

• Result directly or indirectly in an unsafe and unsound exposure (to be defined by the appropriate regulatory agencies) by the banking entity to high risk assets or high-risk trading strategies;

• Pose a threat to the safety and soundness of such banking entity; or

• Pose a threat to the financial stability of the United States.

B. Transactions with Affiliates Restrictions. In addition, any banking entity that serves, directly or indirectly, as the investment manager, investment adviser of a Covered Fund, or organizes and offers a Covered Fund under the rules described above, and any affiliate of such banking entity, is prohibited from entering into a transaction with such Covered Fund, or any other Covered Fund controlled by such Covered Fund, that would be a covered transaction under Section 23A of the Federal Reserve Act. A “covered transaction” in this context would include: (1) a loan or extension of credit to the Covered Fund, (2) a purchase of, or an investment in, securities issued by the Covered Fund, (3) a purchase of assets, including assets subject to repurchase, from the Covered Fund, (4) the acceptance of securities issued by the Covered Fund as collateral security for a loan, or (5) the issuance of a guarantee, acceptance, or letter of credit on behalf of the Covered Fund.

Under the provisions of the Volcker Rule noted above, it is permissible for a banking entity to make an investment in a Covered Fund in the form of a seed or de minimis investment. This provision is clearly inconsistent with a prohibition against entering into a transaction that would be a prohibited Section 23A covered transaction, which includes investing in securities issued by an affiliate. Furthermore, there is no special exemption for transactions by foreign banking entities such as those permitting investments in certain offshore funds discussed below. Still, Congress’s clear intent was to permit seed and other de minimis investments, which should supersede the application of Section 23A. Resolution of these conflicts must await the federal regulatory agencies’ interpretation of these provisions.

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In addition, any banking entity that serves, directly or indirectly, as the investment manager or investment adviser – but not sponsor – of a Covered Fund, or that organizes and offers a Covered Fund as a permissible activity, will be subject to Section 23B of the Federal Reserve Act. Section 23B generally requires that all transactions between a member bank and its affiliates be conducted on terms that are at least as favorable to the bank as those prevailing at the time for comparable transactions with unaffiliated companies. This could mean, for example, that, when a banking entity is serving as investment adviser to a Covered Fund, the Covered Fund would have to pay the bank affiliated adviser and all other bank-affiliated service providers no less than market rates. Banking entities might also be restricted in the extent to which they can provide waivers of service fees to Covered Funds. The Federal Reserve Board may grant an exemption from the transactions with affiliates rules found in Section 23A of the Federal Reserve Act to allow a banking entity to enter into a prime brokerage transaction with a Covered Fund managed, sponsored or advised by such banking entity if the banking entity is in compliance with the permissible activities provisions, the banking entity enters into an enforceable undertaking that the transaction will not be used to avoid losses to any investor in a Covered Fund, and the Federal Reserve Board has determined that such transaction is consistent with the safe and sound operation of the banking entity. C. Offshore Funds. The Volcker Rule provisions also contain an exception for the acquisition or retention of any equity, partnership, or other ownership interest in, or sponsorship of, a Covered Fund by a banking entity described in paragraphs (9) or (13) of Section 4(c) of the BHCA that is solely outside of the United States, but only if no ownership interest in such Covered Fund is offered for sale or sold to a resident of the United States. Further, the banking entity may not be directly or indirectly controlled by a U.S. banking entity. Section 4(c)(9) of the BHCA exempts from the BHCA’s non-banking prohibitions shares held or activities conducted by a foreign company, the greater part of whose business is conducted outside of the United States. Under Section 4(c)(13) of the BHCA, shares of, or activities conducted by,

companies that do no business in the United States, except as incidental to their international or foreign business, are exempted from the BHCA. This exemption will not be of use to sponsors of offshore Covered Funds that have both U.S. and non-U.S. investors. Moreover, foreign banking entities may still be restricted in dealing with Covered Funds by the transactions with affiliates rules discussed above.

D. Capital. The federal regulatory agencies are required to adopt rules imposing additional capital requirements and quantitative limitations on permissible activities as necessary to protect the safety and soundness of banking entities. For purposes of determining compliance with any such rules, the aggregate amount of outstanding investment by a banking entity in seed capital and de minimis investments in a Covered Fund must be deducted from the assets and the tangible capital of the banking entity.

E. Exceptions and Anti-Evasion. The federal regulatory agencies may determine that other activities are permissible that would “promote and protect” the safety and soundness of banking entities and the financial stability of the United States. The federal regulatory agencies must issue rules regarding internal controls and recordkeeping to insure compliance with the Volcker Rule. In addition, the federal regulatory agencies are required to order termination of an investment or activity that functions as an evasion of the rules.

F. Effective Date and Rulemaking and Transition. Regulations implementing the Volcker Rule must be promulgated by the appropriate Federal banking agencies (with regard to insured depository institutions), the Federal Reserve Board (with regard to holding companies and affected nonbank financial companies), the SEC (with respect to any entity for which the SEC is the primary regulatory agency) and the CFTC (with respect to entities for which the CFTC is the primary federal agency), after coordination among the agencies and with the intent of adopting comparable regulations. In addition, the Chair of the FSOC has responsibility for coordinating the regulations issued by the agencies. The agencies are required to act within nine months after the

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completion of a six month study by the FSOC on implementation of the Volcker Rule.

In any event, the Volcker Rule provisions will take effect on the earlier of 12 months after the issuance of final rules implementing the Bill or two years after the date of enactment. Within two years after the effective date of the requirements, banking entities must bring their investments and activities into compliance with the statute. The Federal Reserve Board may extend the two-year period for not more than one year at a time for a total of three years in the aggregate. With regard to divestiture of illiquid Covered Funds, the Federal Reserve Board may extend the transition period for up to a maximum of five years on a case-by-case basis. An illiquid Covered Fund is a Covered Fund that, as of May 1, 2010, was principally invested in and contractually committed to principally invest in illiquid assets, such as portfolio companies, real estate investments and venture capital investments and that makes all investments pursuant to and consistent with an investment strategy to invest in illiquid assets.

VII. Potential for Additional Regulation at FSOC Recommendation The FSOC is charged with identifying and monitoring systemic risks to the financial markets, including those posed by certain U.S. and non-U.S. “nonbank financial companies,” a term defined in Section 102 of the Dodd-Frank Bill broadly enough to encompass Private Funds and their advisers. Under Section 113 of the Dodd-Frank Bill, the FSOC could require, by a two-thirds vote (including a vote of the Chairperson of the FSOC), that any nonbank financial company (including a non-U.S. nonbank financial company) whose material financial distress could pose a threat to the financial stability of the United States be placed under the supervision of the Federal Reserve.26 Section 113 provides for notice and an opportunity for a hearing

26 Section 170 of the Dodd-Frank Bill would require the Federal Reserve to promulgate regulations on behalf of, and in consultation with, the FSOC that set forth the criteria “for exempting certain types or classes of U.S. nonbank financial companies or [non-U.S.] nonbank financial companies” from supervision by the Federal Reserve.

before the FSOC, as well as judicial review, of these determinations. The Dodd-Frank Bill contemplates that the Federal Reserve will regulate systemically significant companies under stringent prudential standards based on those recommended by the FSOC or that the Federal Reserve establishes on its own. The recommendations of the FSOC with respect to nonbank financial companies could include: (1) risk-based or contingent capital requirements; (2) leverage limits; (3) liquidity requirements; (4) resolution plan and credit exposure report requirements; (5) concentration limits; (6) enhanced public disclosures; (7) short-term debt limits; and (8) overall risk management requirements. However, in making such recommendations, the FSOC is required to take into account, among other things, differences among nonbank financial companies and bank holding companies.27 These enumerated requirements are primarily oriented toward the regulation of banks and broker-dealers, and advisers to Private Funds are likely to find it difficult to operate within such a framework, unless it is tailored to their particular circumstances.

VIII. Mandated Studies The Dodd-Frank Bill requires various government agencies to conduct a wide range of studies. Listed below are those studies most relevant to Private Funds and their advisers, though this list is by no means exhaustive. A. GAO Studies. Among a range of other required studies, the Dodd-Frank Bill directs the Comptroller General, the head of the GAO, the investigative agency of Congress, to conduct studies and submit reports to specified House and Senate Committees on the following subjects:

1. Accredited Investor Qualifications Study. Notwithstanding that the SEC is required periodically to review the definition of “accredited investor” in the context of a natural

27 In making recommendations concerning the prudential standards applicable to such non-U.S. nonbank financial companies, the FSOC would be required to “give due regard to the principle of national treatment and equality of competitive opportunity.”

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person, the GAO is required to study the appropriate criteria for determining the financial thresholds or other criteria needed to qualify as an “accredited investor” and the eligibility to invest in any Private Fund and issue a report within three years of the enactment of the Bill.

2. Private Fund SRO Study. The GAO is required to study the feasibility of forming an SRO to oversee “Private Funds” and to issue a report within one year of the enactment of the Bill. Such an SRO (or placing oversight of the Private Fund industry with an existing SRO, such as the Financial Industry Regulatory Authority, Inc. (“FINRA”)) is an idea that has been raised at various times, most recently during the 2008-2009 market turmoil, but has not been embraced by the industry, partly because of the industry’s resistance to another layer of regulation and potential regulation by an SRO oriented toward broker-dealers.

3. Custody Rule Costs Study. The GAO is required to study the compliance costs associated with SEC Rules 204-2 and 206(4)-2 under the Advisers Act regarding custody of funds or securities of clients by investment advisers and the additional costs associated with eliminating the requirement in such rules relating to “operational independence.” The GAO is required to submit a report on the results of such study to the Committee on Banking, Housing and Urban Affairs of the Senate and the Committee on Financial Services of the House no later than three years after the enactment of the Bill.

B. SEC Studies. The SEC’s newly formed Division of Risk, Strategy and Financial Innovation (the “Division”) is required to conduct two studies focusing on short selling:

1. Short Selling Study. In the first study, the Division must examine the state of short selling on exchanges and in the over-the-counter market, with particular attention to the impact of recent rule changes and the incidence of the failure to deliver shares sold short, i.e., “naked” short selling (the “Short Selling Study”). The SEC is required to submit a report on the results of the Short Selling Study to the Committee on

Banking, Housing and Urban Affairs of the Senate and the Committee on Financial Services of the House no later than two years after the enactment of the Bill.

2. Short Reporting Study. In the second study, the Division must examine the feasibility, benefits and costs of (1) requiring public reporting of real time short sale positions of publicly listed securities or, alternatively, providing such reports only to the SEC and FINRA, and (2) conducting a voluntary pilot program in which public companies would agree to have trades of their shares marked as “short,” “market maker short,” “buy,” “buy-to-cover” and “long” and reported in real time through the Consolidated Tape (the “Short Reporting Study”). The SEC is required to submit a report on the results of the Short Reporting Study to the Committee on Banking, Housing and Urban Affairs of the Senate and the Committee on Financial Services of the House no later than one year after the enactment of the Bill.

IX. The Need for Future Rulemaking and an Increased Focus on Enforcement

In implementing the Bill, the SEC will need to propose and adopt many new rules and regulations to provide clarity and guidance to the Bill’s potentially ambiguous language. In the wake of the Madoff scandal and the financial crises, and given the current political climate, it may be difficult for the SEC to take positions or issue rules that the public would perceive as “easy” on Private Funds and their advisers. There also is concern that the SEC’s actions might be motivated in part by a fear that it might miss the next scandal. Thus, any new rules aimed at the private fund industry are likely to be broad and stringent. In addition, the Bill gives the SEC staff the power to obtain significant amounts of new information about Private Funds and their advisers. The SEC has made clear that its enforcement program will focus on hedge fund advisers: in prosecuting the Galleon insider trading case,28 the SEC’s Enforcement Division staff have

28 See SEC v. Galleon Management, 09-CV-8811 (S.D.N.Y. 2009).

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stated that they believe that insider trading is endemic to the private fund industry, and the Enforcement Division has organized a new Asset Management Unit that is concentrating on bringing cases against fund managers. The SEC’s examination staff also is likely to direct a substantial portion of its efforts toward Private Fund advisers for several years so that it can obtain better information about and a better understanding of industry practices. In sum, the Bill carries the potential of subjecting the hedge fund industry, and

to a lesser extent the entire private fund industry, to a rapidly evolving and uncertain regulatory regime that will create an environment in which it is considerably more difficult for Private Funds and their advisers to operate.






July 9, 2010 Author: David L Beam [email protected] +1.202.778.9026 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Preemption for National Banks and Federal Thrifts After Dodd-Frank: Answers to the Ten Most Asked Questions K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The last ten years have been a period of consistent expansion of federal preemption for national banks and federal thrifts. That period of expansion will come to a grinding halt if the Senate passes and President Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”), which most observers expect to happen shortly after the Senators return from recess on July 12. (For more information on the Dodd-Frank Act, see the other alerts in the K&L Gates alert series.) The Dodd-Frank Act, however, is hardly a total victory for critics of preemption. In fact, all things considered, the preemption provisions of the Dodd-Frank Act could have been much worse for national banks and federal thrifts. Still, the preemption rules are changing. National banks, federal thrifts, and the operating subsidiaries of both need to review and reconsider the extent to which they rely on federal law to preempt state laws. This alert identifies the ten questions that clients are asking (or, in our view, should be asking) most about how the Dodd-Frank Act affects the scope of preemption under the National Bank Act (“NBA”) and the Home Owners’ Loan Act (“HOLA”), the primary two laws governing the activities of national banks and federal thrifts, respectively. These ten questions, not necessarily in the order of importance, are:

• What is the new preemption standard for national banks and federal thrifts? (Page 2)

• Will national banks and federal thrifts still be able to “export” interest rate rules from the states where they are located? (Page 4)

• Will federal thrifts still enjoy broader preemption than national banks? (Page 5)

• Last year, the Supreme Court placed significant limits on state attorney general investigations of national banks. Does the Act overturn those limits? (Page 6)

• What role will the OCC and OTS (now a division of the OCC) have in defining the scope of preemption? (Page 8)

• What happens to the existing OCC and OTS preemption regulations? (Page 9)

• What happens to preemption for operating subsidiaries? (Page 10)




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• How does the repeal of preemption for operating subsidiaries affect the licensing exemption that the S.A.F.E. Mortgage Licensing Act provides to employees of bank subsidiaries? (Page 10)

• Does the Act change the rules governing preemption for agents of national banks and federal thrifts? (Page 11)

• When do these changes go into effect? (Page 12)

only when the state law at issue is a state consumer financial law. The discussion that follows first dissects the definition of state consumer financial law. It then describes the preemption standard that the Act establishes for these state laws.

B. Definition of State Consumer Financial Law

When reading this alert, bear in mind that the Dodd-Frank Act abolishes the OTS and transfers most of its supervisory authority over federal thrifts to the OCC. Thus, throughout this alert we refer to the OCC as the future regulator of federal thrifts. However, there could be a period after the preemption provisions go into effect during which the OTS will still be in existence and still primarily responsible for supervising federal thrifts.1 For more information about transfer of functions and personnel from the OTS to the OCC (and several other agencies), see the forthcoming alert in this series, which will be available at www.klgates.com/practices/ServiceDetail.aspx?service=139&view=5.

I. What is the new preemption standard for national banks and federal thrifts?

There’s no short and easy answer to this question. The Act divides the universe of state laws into two categories: (1) state consumer financial laws; and (2) state laws that are not state consumer financial laws. The Act does not modify the preemption standards for the latter. It purports to “clarify” the preemption standard for the former, but it is debatable whether it changes the standard from current law. A. Overview

After the preemption provisions go into effect (see Part X, starting on page 13), every preemption analysis under the NBA and HOLA will begin with the following question: “Is this a state consumer financial law?” That’s because the new preemption standard under the NBA and HOLA that the Act establishes, and the more restrictive procedures it imposes on OCC preemption determinations, apply

Section 1044 of the Dodd-Frank Act adds a provision to the NBA which defines state consumer financial law as “a State law that does not directly or indirectly discriminate against national banks and that directly and specifically regulates the manner, content, or terms and conditions of any financial transaction . . . , or any account related thereto, with respect to a consumer.” As discussed in Part III, the Dodd-Frank Act also incorporates this definition and the related preemption provisions into HOLA. Thus, aside from the requirement that the law not discriminate against national banks, a state law must meet several requirements to be a state consumer financial law under the NBA or HOLA:

• It must regulate the manner, content, or terms and conditions of a financial transaction or account;

• It must do so “directly and specifically”; and

• The financial transaction or account that the law regulates must be “with respect to a consumer.”

This definition of state consumer financial law is not as broad as it could have been. For example, arguments could be made that none of the following types of consumer laws qualify as state consumer financial laws:

• Licensing Requirements: A requirement that a company obtain a license before engaging in a financial transaction arguably does not regulate the manner of the transaction; it does not regulate the content of the transaction; and it does not regulate the terms and conditions of those transactions. Of course, some state laws that impose licensing requirements also impose substantive requirements (which might apply only to licensees, or might apply more broadly).

http://www.klgates.com/practices/ServiceDetail.aspx?servi

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Whether these substantive requirements survive if the provisions that require a license are preempted is a separate question that generally will be governed by the applicable state’s rules on severability of invalid provisions in laws (assuming that the requirements are not themselves preempted under the applicable standard).

• UDAP Laws: Laws that broadly prohibit unfair and deceptive business practices (“UDAP laws”) have become a favorite tool of state attorneys general and plaintiffs’ attorneys to impose ex post facto rules on lenders, servicers, and other providers of financial services to consumers. We would argue that these UDAP laws do not “specifically and directly” regulate financial transactions or accounts, and therefore are not state consumer financial laws.

• Advertising Rules: Rules on advertising arguably do not regulate the manner of a financial transaction, nor do they regulate the content or terms of a financial transaction. Rather, advertising rules regulate the manner by which a financial institution may communicate its products and services to the public.

The important takeaway from the arguments above is that the new preemption rules are not going to govern with respect to every state law that regulates consumer financial transactions. The term state consumer financial law likely will not cover every state law designed to protect consumers in connection with financial transactions. C. The Standard

The NBA (as amended by Section 1044 of the Dodd-Frank Act) and HOLA (as amended by Section 1046 of the Act), respectively, will preempt a state consumer financial law only in the following two circumstances: (1) “application of a State consumer financial law would have a discriminatory effect on national banks [or, with respect to HOLA, federal thrifts], in comparison with the effect of the law on a bank chartered by that State;” or

(2) “in accordance with the legal standard for preemption in the decision of the Supreme Court of the United States in” Barnett Bank of Marion County, N. A. v. Nelson, 517 U.S. 25 (1996), “the State consumer financial law prevents or significantly interferes with the exercise by the national bank [or federal thrift] of its powers[.]” The preemption provisions also clarify that they only limit the extent to which the NBA or HOLA preempts state consumer financial laws. A state consumer financial law still will be preempted for a national bank or federal thrift if the “State consumer financial law is preempted by a provision of Federal law other than” the NBA or HOLA. Since very few state laws discriminate against national banks, the dispositive question for most preemption analyses involving state consumer financial laws will be whether, in accordance with the Barnett decision, the state consumer financial law prevents or significantly interferes with the exercise by a national bank or federal thrift of its powers. D. Impact

Since 2004, most preemption analyses for national banks revolved around the proper interpretation of the OCC’s preemption rules; Barnett and court decisions interpreting Barnett were an afterthought, if they were considered at all. Barnett also rarely factored into a preemption analysis for federal thrifts, which would focus primarily on preemption rules that the OTS adopted in 1996. Lawyers for national banks and federal thrifts must now become intimately familiar with the case law interpreting Barnett. This body of case law is substantial. On July 2, 2010, the Shepherd’s report for Barnett identified 277 court decisions that used the word preemption or a derivation thereof. These included four Supreme Court decisions, 55 decisions by the federal courts of appeals, 118 decisions by federal district or bankruptcy courts, and 34 decisions by state supreme courts. No one should be surprised to learn that national banks did not have a 277-0 record in the case law interpreting and applying Barnett. But, on balance, the case law is quite good for national banks.

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Courts, including the Supreme Court, generally concluded that a state law does not need to wreak too great an interference with a national bank’s ability to exercise its powers before the state law will be preempted under the Barnett standard. Our initial survey of the Barnett case law reveals that courts have interpreted Barnett to leave little room for state regulation of national bank activities. Part of the reason for this is that courts usually define the national bank “power” at stake fairly granularly—and the more narrowly the power at stake is defined, the broader the preemption. For example, if one says that the ability to charge a fee for a service (such as providing cash at an ATM) is itself a discrete power of a national bank (as the Ninth Circuit Court of Appeals concluded in a 2001 decision), then any state law that prohibits ATM fees “prevents . . . the exercise by the national bank” of a power. There is nothing in the Dodd-Frank Act that would suggest courts should understand the term “power” differently when courts are applying the Barnett standard via the statutory preemption provision for state consumer financial laws. Indeed, the opening clause (“in accordance with the legal standard for preemption in the decision of the Supreme Court of the United States in” Barnett) would suggest that courts should not interpret the preemption standard in the statute any differently than they interpreted the preemption standard in Barnett itself. Remember also that the preemption standard in the Dodd-Frank Act applies only to state consumer financial laws, which does not include many state laws that regulate financial transactions with consumers. Presumably, the existing preemption standards under the NBA will continue to apply to state laws that are not state consumer financial laws.

II. Will national banks and federal thrifts still be able to “export” interest rate rules from the states where they are located?

Very little of the information in this alert could be considered good news for national banks and federal thrifts, except perhaps in comparison to what the news could have been. But the provision of the Act

that deals with interest exportation qualifies as bona fide good news: The Act expressly provides that no provision of the NBA “shall be construed as altering or otherwise affecting the authority conferred by [12 U.S.C. § 85] for the charging of interest by a national bank at the rate allowed by the laws of the State, territory, or district where the bank is located, including with respect to the meaning of ‘interest’ under such provision.” The Act also amends HOLA to incorporate the premption standards under the NBA, which presumably would include the limits in the foregoing provision on the extent to which these new legal standards affect the interest exportation statutes. Interest exportation is the term commonly used to describe the ability of most banks to charge interest at the rate allowed by the laws of the states where they are located, even when making loans to borrowers in other states. (It is also sometimes called “most favored lender authority.”) Section 30 of the NBA (codified at 12 U.S.C. § 85, and thus more commonly known as “Section 85”) has authorized a national bank to charge interest at the rate allowed by the laws of the state where the bank is located since 1864. The comparable provision for federal thrifts is in Section 4 of HOLA. The OCC and OTS have issued identical rules to implement the interest exportation provisions of the NBA and HOLA. These rules define “interest,” for purposes of Section 85, as “any payment compensating a creditor or prospective creditor for an extension of credit, making available of a line of credit, or any default or breach by a borrower of a condition upon which credit was extended.”2 According to the regulation itself, this broad definition encompasses, among other types of fees, the numerical periodic rate; late fees; NSF fees; overlimit fees; annual fees; and cash advance fees. Thus, a bank exercising its interest exportation authority may follow the laws of its location state for all of these fees, and restrictions on these fees under the laws of the borrower’s state will be preempted. The broad definition of interest in the rules appears to be what the Dodd-Frank Act is referring to when it says “including with respect to the meaning of ‘interest’ under such provision.” That the Dodd-Frank Act preserves interest exportation authority for national banks and federal

news:The

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thrifts should be an enormous relief to them. Without interest exportation, it would be nearly impossible to offer credit cards in some states except to the most creditworthy sliver of consumers. Other types of lending also would be made significantly more difficult. States impose complex and inconsistent rules about how lenders may allocate the finance charges among different fees. Most of these laws are not unduly difficult to follow when they are viewed in isolation, but it can be burdensome for a lender operating in more than one state to adapt the fee structures on its products to the peculiarities of individual state laws. The Act’s provision on interest exportation would appear to trump the provisions (discussed above, starting on page 2) that establish a new preemption standard for state consumer financial laws. Even if the interest restrictions in the borrower’s state qualified as state consumer financial laws, they could still be preempted in accordance with the interest exportation provisions, without regard to whether the otherwise applicable preemption standard for state consumer financial laws, described above, is met.

III. Will federal thrifts still enjoy broader preemption than national banks?

As a general rule, no. The Act amends HOLA to provide, in essence, that HOLA preempts state laws for federal thrifts to the same extent that the NBA preempts state laws for national banks. The Act also adds a new provision to HOLA which provides that the visitorial powers provision in the NBA “shall apply to Federal savings associations, and any subsidiary thereof, to the same extent and in the same manner as if such savings associations, or subsidiaries thereof, were national banks or subsidiaries of national banks, respectively.’’ A. Background

Although the gap narrowed substantially in recent years, preemption for federal thrifts historically was broader than for national banks. Much of this gap came from the fact that it has been clear since a 1982 Supreme Court decision that the OTS and its predecessor agency, the Federal Home Loan Bank Board (“FHLBB”), had the authority to issue rules that preempt state laws for federal thrifts.3 Armed

with this authority, the OTS issued a rule in 1996 that “occupied the field” of federal thrift lending regulation. This meant that federal thrifts were not required to comply with any state laws that regulated lending, except with respect to a few discrete subjects identified in the OTS rule and other federal laws. The OCC proceeded much more cautiously than the OTS on preemption matters. The OCC did not issue a set of preemption rules comparable to the OTS’s 1996 rules until 2004. Even the 2004 rules refrained from “occupying the field” of national bank lending regulation, although they arguably established a preemption regime that was, for all practical purposes, just as broad as under the OTS’s rules. B. Impact of the Act

As mentioned above, the Dodd-Frank Act would amend HOLA to provide that the preemption standards under the NBA govern preemption under HOLA. A separate provision also explains that the visitorial powers limits in the NBA apply to federal thrifts. These two provisions should eliminate any remaining vestiges of the preemption gap. Federal thrifts were for the most part on the good side of the preemption gap, so ending it may seem like a modest net negative for them. But there are at least two crucial ways in which the preemption equivalence clearly benefits federal thrifts. First, it recognizes explicitly that federal thrifts are not subject to “visitorial powers” by the states. Second, the Dodd-Frank Act amendments to HOLA arguably extend to federal thrifts the holding in Beneficial National Bank v. Anderson, which said that the interest exportation provisions for national banks “completely preempted” state usury laws, allowing any lawsuits against a national bank for violating state restrictions on “interest” charges to be removed to federal court.

1. Visitorial Powers

The NBA has always expressly provided that national banks are not subject to visitorial powers except as authorized by federal law. The exact meaning of the term visitorial powers has been the subject of dispute. Still, no one seriously doubts that it includes the authority to conduct routine

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examinations of national banks and to enforce their compliance with applicable law through an administrative process. Since federal law authorizes state officials to exercise visitorial powers over national banks only with respect to a few discrete subjects, this limit on visitorial powers severely limits the ability of state officials to supervise national banks or enforce national banks’ compliance with state or federal laws. The OTS has always taken the position that states also may not examine federal thrifts or bring enforcement actions against them. Unlike with national banks, however, there was no statute that expressly limited the supervisory authority of states over federal thrifts. Not that this meant federal thrifts were actually subject to supervision by states. For example, in the Ninth Circuit decision Conference of Federal Savings & Loan Associations v. Stein,4 which was summarily affirmed by the Supreme Court,5 the court explained that the “broad regulatory authority over the federal associations conferred upon the [FHLBB] by HOLA does wholly pre-empt the field of regulatory control over these associations.”6 “If state-conferred rights are to be enforced against the federal associations by any regulatory body,” the court said, “enforcement must be by the [FHLBB].”7 The Dodd-Frank Act basically codifies this holding. This should eliminate the possibility that states might have pointed to the absence of a visitorial powers provision in HOLA as giving states greater supervisory authority over federal thrifts than national banks.

2. Complete Preemption

Establishing explicitly that preemption for federal thrifts is identical to preemption for national banks also should mean that the interest exportation provision in HOLA “completely preempts” state laws that purport to regulate interest fees. Normally, a federal district court will not have federal question jurisdiction over a matter if the complaint alleges only causes of action under state law. This is true even if the defendant is likely to plead a defense based on federal law—such as the defense that federal law preempts the state law causes of action in the complaint. When the complaint alleges only state law causes of action, the defendant can remove the case to federal court only

if the case falls under the court’s diversity jurisdiction. An exception to the foregoing general rules is the so-called “complete preemption” doctrine. The Supreme Court has held that a handful of federal statutes preempt state laws on a subject so completely that there is no state cause of action with respect to the subject. If a plaintiff asserts claims under a state law preempted by one of these federal statutes, then the defendant may remove the case to federal court, even if the complaint does not mention federal law. In Beneficial, the Supreme Court held that the interest exportation provision in the NBA “completely preempted” for national banks state laws that regulated interest.8 Courts have not addressed whether the same rule applies for the interest exportation provision in HOLA. An argument could be made that it does, since the interest exportation provision in HOLA was modeled on the interest exportation provision in the NBA. However, courts have split over the merits of this argument with respect to another provision modeled on Section 85 of the NBA—Section 521 of DIDMCA, which provides interest exportation authority to state-chartered banks with federal deposit insurance.9 The Dodd-Frank Act should lay to rest any questions about whether the interest exportation provisions of HOLA completely preempt for federal thrifts under state laws that regulate interest.

IV. Last year, the Supreme Court placed significant limits on state attorney general investigations of national banks. Does the Act overturn those limits?

No. The Dodd-Frank Act does not appear to overturn the limits on state attorney general investigations of national banks that the Supreme Court established in Cuomo v. Clearing House Association.

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A. Background

The NBA bars state officials, including state attorneys general, from exercising “visitorial powers” over national banks (subject to limited exceptions). In Cuomo v. Clearing House Association, the Supreme Court held that the OCC went too far when it issued a rule that defined the term “visitorial powers” to include suing a national bank to enforce state law. Because the Supreme Court partially invalidated a rule that had protected national banks, the headlines after Cuomo was decided reported the decision as a loss for national banks and the OCC. But while the Cuomo decision was far from an unequivocal victory for national banks, the Court did affirm that there are significant limitations on the ability of a state attorney general to launch investigations of national banks. The Cuomo decision distinguished between the exercise of visitorial powers and what the decision called “ordinary law enforcement.” Visitorial powers, the Court said, included “any form of administrative oversight that allows [the government] to inspect books and records on demand, even if the process is mediated by a court[.]” According to the Court, a state attorney general who brings a lawsuit against a national bank is engaged in mere ordinary law enforcement. Applying this distinction to the facts before it, the Court concluded that Attorney General Cuomo was not barred from bringing a civil suit against a national bank to enforce state law, or even from obtaining a judicial search warrant.10 However, New York law authorizes the Attorney General to issue subpoenas without going to court, and the Cuomo litigation arose in response to a threat from the Attorney General to issue such subpoenas against national banks if they did not comply with a request for voluntary disclosure of information.11 The Court held that issuance of extra-judicial subpoenas by a state attorney general did constitute the kind of visitorial powers that the NBA prohibited states from exercising over national banks. Consequently, the Court allowed to stand the district court’s injunction against the Attorney General issuing subpoenas against national banks.

Not being able to subpoena information at will from national banks is a huge limit on the powers of attorneys general. Attorney General Cuomo’s modus operandi is not to bring a lawsuit and then slog through the civil discovery process. Why should it be? New York law allows Attorney General Cuomo to issue broad subpoenas without going to court. However, the Cuomo decision says that when the target of an investigation is a national bank, going to court and dealing with discovery procedures is exactly what Attorney General Cuomo must do. B. Provisions of the Act Dealing With Cuomo

Section 1047 of the Dodd-Frank Act amends the NBA to provide that in “accordance with the decision of the Supreme Court of the United States in” Cuomo v. Clearing House Ass’n, LLC, 129 S. Ct. 2710 (2009), “no provision of [the NBA] which relates to visitorial powers or otherwise limits or restricts the visitorial authority to which any national bank is subject shall be construed as limiting or restricting the authority of any attorney general (or other chief law enforcement officer) of any State to bring an action against a national bank in a court of appropriate jurisdiction to enforce an applicable law and to seek relief as authorized by such law.” This provision should mean that state attorneys general will continue to be subject to the limits on their investigatory powers described in Cuomo. Further, as explained above beginning on page 7, Section 1047 of the Act also extends the visitorial powers provisions in the NBA to federal thrifts. Thus, the limits established by Cuomo should apply to attorney general investigations of federal thrifts. For more information on the role of state attorneys general in the Dodd-Frank Act’s enforcement regime, see the K&L Gates alert entitled Consumer Financial Services Industry, Meet Your New Regulator, by Melanie H. Brody and Stephanie C. Robinson (available at www.klgates.com/newsstand/Detail.aspx?publication=6527.)

http://www.klgates.com/newsstand/Detail.aspx?publicatio

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V. What role will the OCC and OTS (now a division of the OCC) have in defining the scope of preemption?

The OCC and OTS (now a division within the former, but still separately responsible for addressing preemption issues for federal thrifts) will not be permitted to issue broad preemption rules for state consumer financial laws; the agencies will be allowed to determine that such laws are preempted only on a “case-by-case basis.” The Act also instructs courts to scrutinize these preemption determinations more carefully than courts do currently. A. Background

In recent years, the banking agencies have played a major role in defining the scope of federal preemption for national banks and federal thrifts. As discussed above on page 5, the Supreme Court held in 1982 that the OTS’s predecessor had broad authority to issue rules that preempted state laws for federal thrifts. Since 1996, OTS rules occupied the field of federal thrift lending and deposit-taking, which meant that state laws generally did not apply to the lending or deposit-taking activities of federal thrifts (subject to a few exceptions). Since 1996, most court decisions addressing preemption for federal thrifts have started and ended by interpreting and applying these rules. When states began enacting draconian anti-predatory lending laws in the beginning of the decade, the OTS was at the forefront of declaring these laws to be preempted for federal thrifts through a series of legal opinions. The OTS also established the groundwork for preemption for agents of federal thrifts in its State Farm Letter. As is also explained above, the OCC has historically been less assertive about defining the scope of preemption for national banks. For over 140 years after the NBA was enacted in 1864, the OCC was largely content to let courts define through case law the extent to which the NBA preempted state laws. Although there were exceptions, OCC preemption rules tended to be reactive, codifying preemption rules only after they had become well established by case law. In 2003, the OCC decided to flex some more muscle. It issued a preemption determination and

order that declared almost all the provisions of Georgia’s anti-predatory lending law to be preempted for national banks and their operating subsidiaries. At the same time, the OCC proposed rules modeled on the OTS’s broad preemption rules (although the OCC proposal fell short of explicitly occupying the field of national bank lending regulation). The agency finalized these rules early in 2004. State officials and consumers have at various times challenged the validity of these agency rules, but courts have mostly sided with the agencies (the most notable recent exception being the Cuomo decision discussed above). As a result, preemption today is in no small part a creation of the OCC and OTS. B. No More Broad Preemption Regulations for

Consumer Financial Protection Laws

As discussed above beginning on page 2, the Act distinguishes for preemption purposes between state consumer financial laws and all other state laws. The OCC may issue a determination that a state consumer financial law “prevents or significantly interferes with a national bank’s exercise of its powers only on a “case-by-case basis.” The Act defines case-by-case basis to mean “a determination . . . made by the [OCC] concerning the impact of a particular State consumer financial law on any national bank that is subject to that law, or the law of any other State with substantively equivalent terms.” This rule appears to prohibit the OCC from issuing rules that declare entire broad categories of state consumer financial laws to be preempted. Note that the requirement that preemption determinations be made on a “case-by-case basis” applies only with respect to state laws that qualify as state consumer financial laws. No provision of the Dodd-Frank Act purports to limit the OCC’s authority to enact broad preemptive rules for state laws that do not qualify as state consumer financial laws. The amendments by the Dodd-Frank Act do not address one way or another whether the OCC must follow the notice-and-comment rules under the Administrative Procedure Act when issuing preemption determinations.

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C. Potentially Greater Judicial Scrutiny of Agency Preemption Determinations

In most instances, courts decide whether to defer to an agency rule (and some other types of formal agency issuances) using the standard set forth in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc.12 (“Chevron”). Under Chevron, a court will first ask whether the statute that the agency rule or issuance purports to implement clearly addresses the issue presented in the case. If it does, there is no need for any further analysis—the court will apply the rule set forth in the statute. If the statute is silent or ambiguous with respect to the specific question, then the court will ask whether the agency rule or issuance represents a “permissible construction of the statute.” If so, the court will defer to the agency. If not, then the court will ignore the agency’s position and use other tools of statutory interpretation to resolve the ambiguity. The Dodd-Frank Act amends the NBA to supply the standard of review that courts should use when assessing the validity of an OCC preemption determination. A court reviewing an OCC preemption determination should consider the following factors:

• The thoroughness evident in the consideration of the agency;

• The validity of the reasoning of the agency;

• The consistency with other valid determinations made by the agency; and

• Other factors which the court finds persuasive and relevant to its decision.

VI. What happens to the existing OCC and OTS preemption regulations?

The Act does not expressly address how its provisions affect the existing OCC and OTS preemption rules. Arguably, the OCC rules survive for laws that are not state consumer financial laws, but their vitality with respect to state consumer financial laws is less clear. The OTS rules probably will not fare as well, although it would appear that the rules in any OCC rules that survive with respect to national banks now would apply to federal thrifts.

A. OCC Rules

As noted in various placed above, the OCC issued comprehensive preemption rules in 2004. These rules provide that any state law that “obstructs, impairs, or conditions” a national bank’s ability to exercise its federally-authorized lending or deposit-taking powers was preempted. The rules then identified specific types of state laws that were preempted under these standards. The Dodd-Frank Act does not specifically repeal these rules. Moreover, the Dodd-Frank Act addresses only the specific preemption standard for “state consumer financial laws.” Arguably, preemption of any state law that is not a state consumer financial law is governed by the same law that applied before the Dodd-Frank Act—which would include the OCC’s 2004 preemption rules. (This assumes, of course, that the OCC does not repeal or alter these rules as part of the regulatory review and overhaul that it will probably need to perform as a result of the Act.) A decent argument also could be made that courts should continue to apply the OCC rules in cases involving state consumer financial laws, or at least treat the rules as persuasive authority. The preamble to these rules carefully and persuasively described the legal foundation upon which they were based. The OCC explained that it intended these rules not to create new law, but to be a codification of the preemption standards laid down by the Supreme Court in the preceding 140 years, including Barnett:

We have adopted in this final rule a statement of preemption principles that is consistent with the various formulations [in Supreme Court decisions] noted earlier. The phrasing used in the final rule—obstruct, impair, or condition—. . . . [is] drawn directly from applicable Supreme Court precedents[.] The OCC intends this phrase as the distillation of the various preemption constructs articulated by the Supreme Court, as recognized in Hines and Barnett, and not as a replacement construct that is in any way inconsistent with those standards.13

Since the OCC rules purport to apply Barnett and the holdings of other Supreme Court decisions upon which Barnett itself relied, the list of preempted

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state laws in the rules represent the agency’s assessment that the listed laws prevent or significantly interfere with a national bank’s powers within the meaning of Barnett. B. OTS Rules

As discussed above, the primary OTS rule that preempts state lending laws for federal thrifts “occupies the field” of federal thrift lending regulation. This means that federal thrift lending activities are not subject to any state laws, except in a few areas specifically identified by the rules or other federal laws. Like other OTS rules governing federal thrifts, the preemption rule is not automatically repealed by the abolition of the OTS and the transfer of its authority over federal thrifts to the OCC. Unfortunately for fans of this rule, the Dodd-Frank Act amends HOLA to expressly provide that HOLA “does not occupy the field in any area of State law.” Since the OTS preemption rules purport to implement HOLA, and the agency derives its authority to enact those rules from HOLA, this amendment would appear to pull the foundation out from under the OTS’s preemption rules. All is not lost for federal thrifts, however. As noted in the discussion of the preemption gap on pages 5 to 8, the laws and legal standards that govern preemption of state law by the NBA for national banks also govern the preemption of state law by HOLA for federal thrifts. If the OCC rules still have any vitality—and, as discussed above, there is good reason to believe that they will, unless the OCC repeals them—then the preemption principles established by those rules should govern preemption under HOLA also. The OCC rules do not explicitly “occupy the field,” but they do preempt broad swaths of state laws.

VII. What happens to preemption for operating subsidiaries?

In Watters v. Wachovia Bank, N.A., the Supreme Court held that the NBA preempted a Michigan mortgage lender registration law for operating subsidiaries (“op subs”) of national banks. The sweeping reasoning of the decision suggested strongly that the Court would also hold, in an appropriate case, that the NBA preempted for op

subs any substantive state laws (e.g., restrictions on loan terms or practices) that the NBA preempts for national banks. The Dodd-Frank Act provides that no provision of the NBA will preempt the application of any state law to a subsidiary or affiliate of a national bank (unless the subsidiary or affiliate is itself a national bank). As explained above, an amendment to HOLA will provide that preemption under HOLA is governed by “the laws and legal standards applicable to national banks regarding the preemption of State law.” As a result of these provisions, national banks and federal thrifts have basically two options for their op subs. One is to merge the operating subsidiaries into the parent. The other option is to bring the op subs into compliance with state law, which could include obtaining a number of state licenses (depending on the specific activities in which the op subs engage). Note, however, that many states provide exemptions from licensing requirements (and other laws regulating financial transactions) for subsidiaries or affiliates of depository institutions. The repeal of preemption for op subs would not affect their ability to rely on any exemptions granted to them by state law.

VIII. How does the repeal of preemption for operating subsidiaries affect the licensing exemption that the S.A.F.E. Mortgage Licensing Act provides to employees of bank subsidiaries?

The repeal of preemption for op subs does not change the exemption in the S.A.F.E. Mortgage Licensing Act (the “SAFE Act”) for loan originators employed by bank subsidiaries. However, it does mean that states now have the power to go beyond the federal floor and impose a licensing requirement on these loan originators. The SAFE Act, which became law in 2008, essentially requires every “loan originator”14 to be licensed under state law (subject to provisions for licensure by HUD of loan originators operating in states with licensing regimes that do not meet

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certain standards), unless the loan originator is an employee of:

• A depository institution;15

• A subsidiary of a depository institution that is (i) owned and controlled by a depository institution; and (ii) regulated by a federal banking agency;16 or

• An institution regulated by the Farm Credit Administration.17

The Dodd-Frank Act does not eliminate the foregoing exemption for employees of bank subsidiaries. Thus, even after the Dodd-Frank Act goes into effect, the SAFE Act itself will not require employees of op subs to obtain state loan originator licenses. Whether state law will require these employees to obtain state loan originator licenses, however, is another matter. The SAFE Act does not expressly preempt state laws that require loan originators employed by such subsidiaries to obtain state licenses. Until now, the fact that the SAFE Act did not preempt these state requirements for employees of op subs did not matter much—the NBA and HOLA did. The repeal of preemption for op subs removes this obstacle to states requiring employees of op subs to obtain state licenses. This does not mean that states will impose this licensing obligation, however. The model state law to implement the SAFE Act proposed by the Conference of State Bank Supervisors (“CSBS”) and the American Association of Residential Mortgage Regulators (“AARMR”) incorporated the exemption in the SAFE Act for employees of bank subsidiaries that are registered with the Nationwide Mortgage Licensing System and Registry to be established by the federal banking agencies. Most states adopted this model law without changing this exemption. However, some states removed this exemption and, thus, require loan originators employed by bank subsidiaries to obtain state licenses.

IX. Does the Act change the rules governing preemption for agents of national banks and federal thrifts?

Yes—the NBA and HOLA will no longer preempt any state laws for agents of national banks and federal thrifts, respectively, simply by virtue of their status as agents. A. Background

In 2004, the OTS issued a letter to State Farm Bank opining that certain exclusive agents of State Farm Bank were not subject to state licensing requirements purportedly triggered by the services they provided to the bank.18 The OTS reasoned that allowing states to regulate the services that the agents provided to or on behalf of State Farm Bank—including requiring the agents to obtain state licenses as a condition of being able to perform those services—was tantamount to regulating the manner in which State Farm Bank marketed its products. The OTS’s position would be upheld by the United States District Court for the District of Connecticut and, in a separate case, by the United States Court of Appeals for the Sixth Circuit (albeit after an initial loss in the district court). The OCC never issued a preemption determination or interpretive letter comparable to the State Farm Letter for agents of national banks. However, a number of courts have held, following reasoning that mirrors the reasoning of the OTS in the State Farm Letter, that the NBA preempts state laws for agents of national banks in some situations.19 B. Provisions of the Dodd-Frank Act

The Dodd-Frank Act adds a provision to the NBA which provides that no provision of the NBA will preempt the application of any state law to an agent of a national bank (unless the agent is itself a national bank). As explained above, a provision that the Dodd-Frank Act adds to HOLA will provide that preemption under HOLA is governed by “the laws and legal standards applicable to national banks regarding the preemption of State law.” This HOLA amendment arguably would operate to stop HOLA from preempting any state laws for federal thrifts.

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X. When do these changes go into effect?

The preemption amendments go into effect on the “designated transfer date,” which is also the date that many of the consumer protection enforcement powers of the existing federal agencies are consolidated in the new Bureau of Consumer Financial Protection. The Treasury Secretary must fix the designated transfer date within 60 days of the Act becoming law. The date cannot be sooner than six months after the Act becomes law, and (unless the Treasury Secretary submits a report to Congress explaining the reasons for the delay) not later than one year after the Act becomes law. The process for fixing the designated transfer date is discussed in more detail in the alert in this series on the Bureau, Consumer Financial Services Industry, Meet Your New Regulator, by Melanie H. Brody and Stephanie C. Robinson (available at www.klgates.com/newsstand/Detail.aspx?publication=6527.)

* ** ** * It’s a new world for federally-chartered institutions and their operating subsidiaries, and there is not much time for these institutions to come into compliance with state laws. If you have any additional questions, or would like someone to design or perform a “preemption audit” to identify areas where you might not be able to continue to rely on preemption, please contact us. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.

1 As discussed later in this alert, the preemption provisions will become effective sometime between six and 18 months after the Dodd-Frank Act becomes law. The OTS will be abolished and most of its authority with respect to federal thrifts transferred to the OCC on a date, to be determined by the Treasury Secretary, between 12 and 18 months after the Act becomes law. Thus, it could in theory be as long as a year between the time that the preemption provisions discussed in this alert go into effect and the the time that OTS’s authority over federal thrifts is transferred to the OCC. 2 12 C.F.R. § 7.4001(a); Id. § 560.110. 3 Fidelity Fed. Sav. & Loan Ass’n v. de la Cuesta, 458 U.S. 141 (1982). 4 604 F.2d 1256, 1260 (9th Cir. 1979). 5 445 U.S. 921 (1980). 6 Id. Although the phrase “regulatory control” might be understood to encompass the power to prescribe substantive rules governing the activities of an institution, it appears from the context of the opinion that the court was using the phrase more narrowly to refer to the power to monitor, examine, or investigate the activities of an institution, and to bring enforcement actions for violations. 7 Id. 8 See id. (quoting Evans, 251 U.S. at 114 and Farmers’ and Mechanics’ Nat. Bank v. Dearing, 91 U.S. 29, 32-33 (1987)). 9 Compare Thomas v. US Bank Nat’l Ass’n ND, 575 F.3d 794, 797-98 (8th Cir. 2009) (“Complete preemption does not exist here because the [interest exportation provision for state-chartered banks], unlike the [interest exportation provision in the] NBA, does not reflect Congress’ intent to provide the exclusive cause of action for a usury claim against a federally-insured state-chartered bank.” Later, the court compares the interest exportation provision for state banks with the provision for federal thrifts, and suggests strongly that it would reach the same conclusion with respect to the latter provision.) with In re Cmty. Bank of N. Va., 418 F.3d 277, 294 (3rd Cir. 2005) (Section 521 should be interpreted consistent with Section 85; thus, the former should be interpreted to “completely preempt” state laws regulating interest) and Discover Bank v. Vaden, 489 F.3d 594, 606 (4th Cir. 2007) (reversed on other grounds in Vaden v. Discover Bank, 129 S. Ct. 1262 (2009)) (same). 10 Id. 11 After the Attorney General—still Eliot Spitzer at the time—sent “letters of inquiry” to national banks that threatened subpoenas if the banks did not voluntarily turn over the information requested, the Clearing House Association (on behalf of its member banks) and the OCC filed actions in federal district court seeking an injunction barring Spitzer from issuing the threatened subpoenas or bringing an enforcement action in court against any national bank. 12 467 U.S. 837 (1984). 13 Bank Activities and Operations; Real Estate Lending and Appraisals, 69 Fed. Reg. 1904, 1910 (January 13, 2004) (final rule) (footnotes omitted). 14 The SAFE Act defines “loan originator,” subject to certain exceptions, as “and individual who (1) takes a residential mortgage loan application; and (2) offers or negotiates terms of a residential mortgage loan for compensation or gain.” 12 U.S.C. § 5103(3)(A)(i). 15 Id. § 5103(7)(A)(i). 16 Id. § 5103(7)(A)(ii). 17 Id. § 5103(7)(A)(iii).

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18 OTS Op. of Chief Counsel 2004-7 (October 25, 2004). 19 See, e.g., Pacific Capital Bank, N.A. v. Blumenthal, 542 F.3d 341, 353 (2nd Cir. 2008) (“If a state statute subjects non-bank entities to punishment for acting as agents for national banks with respect to a particular NBA-authorized activity and thereby significantly interferes with national banks’ ability to carry on that activity, the state statute does not escape preemption on the theory that, on its face, it regulates only non-bank entities.”); State Farm Bank, N.A. v. Reardon, 539 F.3d 336 (6th Cir. 2008) (federal banking laws preempt any state laws that hinder a federal thrift’s lending authority, even if

the state laws purport to apply to a party other than the thrift); SPGGC, LLC v. Ayotte, 488 F.3d 525 (1st Cir. 2007) (It “would be contrary to the language and intent of the National Bank Act to allow states to avoid preemption simply by enacting laws that prohibited non-bank firms from providing national banks with the resources to carry out their banking activities.”); SPGGC, LLC v. Blumenthal, 505 F.3d 183, 190 (2nd Cir. 2007) (preemption analysis under federal banking laws should focus “less on the identity of the plaintiff . . . than on whether and to what extent the [gift card being sold by the bank’s agent in the case] represented an exercise of” the bank’s powers under federal law).





July 13, 2010 Authors: Diane E. Ambler [email protected] +1.202.778.9886 András P. Teleki [email protected] +1.202.778.9477 Collins R. Clark [email protected] +1.202.778.9114 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Financial Regulatory Reform Increases Federal Involvement in Insurance K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. Two provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R. 4173) specifically target the insurance industry and are intended to promote a higher level of uniformity in the U.S. insurance industry regulatory landscape. First, the Federal Insurance Office Act of 2010 (“FIO Act”) creates a new Federal Insurance Office (“FIO”) within the Department of the Treasury and signals the beginning of a new era of federal involvement, at least at the macro level, in the U.S. insurance industry. Significantly, the FIO Act does not include a federal insurance charter provision, long sought by many in the insurance industry, and the states will remain the primary insurance regulatory authority. Second, the Nonadmitted and Reinsurance Reform Act of 2010 (“NRRA”) changes how authority over some forms of insurance is allocated among the states. In addition, a new provision regarding the treatment of “index annuities” under the Securities Act of 1933 was added to the Dodd-Frank bill during conference negotiations. This new provision directs the Securities and Exchange Commission (the “Commission”) to treat certain index annuity contracts as “exempt securities” and thus not subject to the registration requirements of the Securities Act. This provision would put an abrupt end to a battle that has been raging between the Commission and certain insurers regarding whether products known as “index annuities” are securities for purposes of the Securities Act and thus subject to regulation by the Commission as provided in its Rule 151A, which was challenged in court. The House has passed the final reconciled version of the Dodd-Frank bill, and the Senate is expected to pass it in mid or late July.

Federal Insurance Office Overview The FIO, a creature of compromise to avoid direct federal insurance regulation, will: (i) monitor the U.S. insurance industry, (ii) coordinate federal efforts and policy relating to international insurance matters, (iii) determine which state insurance measures are preempted by international agreements, (iv) report to Congress annually on the state of the insurance industry, and (v) identify insurers that could pose a threat to financial stability. The FIO is generally authorized to gather data and information from any entity that writes insurance or reinsures risk in the United States. The FIO has subpoena power, provided that it first coordinates with state and federal regulators to determine whether they can obtain the information in a timely manner. The FIO has authority, such as it is, over all lines of insurance other than health insurance, long-term care insurance, and crop insurance. As with its handling of many controversial issues, the Dodd-Frank bill calls for a study of, among other things, the

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costs and benefits of regulating insurance at the federal level, foreshadowing the possibility of future increases in federal authority over the insurance industry. The Secretary of the Treasury will be responsible for appointing a Director to head the FIO. The Director must be a career employee and will serve in an advisory capacity on the Financial Stability Oversight Council, which is the new systemic risk watchdog. Preemption of State Insurance Measures The FIO Director will have the authority to determine when state insurance measures are inconsistent with international agreements relating to prudential measures for insurance or reinsurance. Inconsistent state insurance measures will be unenforceable if the FIO Director finds that they result in less favorable treatment to a foreign insurer than a U.S. insurer. Prior to making a preemption determination, the FIO Director will have to publish notice in the Federal Register, notify the appropriate state regulator and the U.S. Trade Representative (“USTR”), and consider any comments received. Earlier drafts of the FIO Act considered by Congress would have authorized the FIO to negotiate and enter into international insurance agreements, but the final FIO Act only goes so far as to permit the FIO Director to assist the Secretary of the Treasury, who will negotiate these agreements jointly with the USTR.

Nonadmitted Insurance The NRRA creates a uniform system for nonadmitted (or “surplus lines”) insurance premium tax (surplus lines insurance is an insurance policy from an insurance company that is not licensed in the policyholder’s state) by calling on the states to enter into an interstate compact. If the states are able to come to agreement, the interstate compact would create nationwide requirements, forms, and procedures for reporting, paying, collecting, and allocating premium taxes when risk is spread across multiple states. By default, the general rule is that only the home state of the insured may require premium tax payments.

Under the NRRA, the insured’s home state will have exclusive authority over the placement of nonadmitted insurance and licensing of surplus lines brokers. States must, however, establish eligibility requirements consistent with the Non-Admitted Insurance Model Act. States may not prohibit a surplus lines broker from placing nonadmitted insurance with or procuring nonadmitted insurance from a foreign nonadmitted insurer listed by the National Association of Insurance Commissioners (“NAIC”) as an alien insurer. Within two years of enactment, states are encouraged to participate in a national insurance producer database. As an incentive, states that do not participate would be prohibited from collecting licensing fees from surplus lines brokers. Subject to certain conditions, surplus lines brokers are exempt from state due diligence requirements when large commercial purchasers of insurance request that the broker use a nonadmitted insurer.

Reinsurance The NRRA also expands the ability of reinsurers to operate across state lines. If a state accredited by the NAIC recognizes credit for reinsurance for an insurer’s ceded risk, no other state may deny such credit. The home state of the ceding insurer is granted exclusive regulatory authority; the application of related laws beyond the home state’s borders is preempted. A reinsurer’s solvency is regulated solely by the state in which it is incorporated or licensed, if such state is NAIC-accredited.

Status of Index Annuities under Section 3(a)(8) of the Securities Act of 1933 During conference negotiations to reconcile the House and Senate versions of the bill, the conferees unexpectedly added a provision that directs the Commission to treat certain index annuity contracts as “exempt securities” under Section 3(a)(8) and thus not subject to Commission jurisdiction. The provision will effectively limit federal regulation and oversight of index annuities. To be considered exempt under this provision, the annuity contract: (i) must have a value that does not vary according to the performance of a separate

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account, (ii) must satisfy state nonforfeiture laws or, in the absence of applicable standard nonforfeiture laws, satisfy the Model Standard Nonforfeiture Law for Life Insurance or Model Standard Nonforfeiture Law for Individual Deferred Annuities or any successor model law, and (iii) be offered by (a) an insurance company subject to suitability requirements that meet or exceed those of the NAIC or (b) an insurance company that adopts and implements practices on a nationwide basis for the sale of any insurance contract that meets or exceeds the minimum requirements established by the NAIC Suitability in Annuity Transactions Model Regulations and is therefore subject to examination by the state of domicile of the insurance company or by any other state where the insurance company conducts sales of such products.

This provision brings to a sudden close a long battle regarding the status of index annuities under the Securities Act and leaves regulation of these types of products firmly in the hands of the states. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.




Originally Published July 14, 2010 Updated July 23, 2010 Authors: Jonathan D. Jaffe [email protected] +1.415.249.1023 Steven M. Kaplan [email protected] +1.202.778.9204 Kerri M. Smith [email protected] +1.202.778.9445 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Loan Servicing Déjà Vu K&L Gates originally published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. Loan servicers that are reeling from ever changing state laws and HAMP requirements can breathe a sigh of relief that the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) left most of its ammunition for other segments of the financial services industry.1 Title XIV of the Dodd-Frank Act, entitled Mortgage Reform and Anti-Predatory Lending Act (the “Mortgage Reform Act” or the “Act”), would impose new restrictions and requirements on the residential mortgage industry, but in many cases these changes piggyback the regulations issued by the Federal Reserve Board (“FRB” or “the Board”) in 2008. Nevertheless, there are changes that may have a material impact on loan servicers and open them up to a federal cause of action with a private right of enforcement. In this Alert, we address the provisions of the Mortgage Reform Act that impose duties on mortgage servicers, which are found primarily in Subtitles E and G of the Act. Those Subtitles’ servicing provisions address:

• Qualified written requests

• Escrow accounts

• Force placed insurance

• Periodic statements

• Crediting of payments

• Payoff statements

• HAMP requirements

• Tenant protections following foreclosure

Other K&L Gates client alerts describe the abundant other provisions in the Mortgage Reform Act and the larger Dodd-Frank Act relating to residential mortgage lending, including the creation of the new gargantuan Consumer Financial Protection Bureau (“the Bureau”) within the Federal Reserve, the imposition of new mortgage loan origination requirements, the dilution of federal preemption of state laws for national banks (and the remaining entities with federal thrift charters) and their operating subsidiaries, the impact of the amendments to the Alternative Mortgage Transactions Parity Act, and the consequences of the new “skin in the game” requirements under the new risk retention rules. In addition, other alerts from K&L Gates will address other aspects of financial reform in the Dodd-Frank Bill on the K&L Gates web site specially dedicated to Financial Services Reform.





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A loan servicer reviewing these provisions may get a sense of déjà vu. In fact, many of the Act’s loan servicing provisions are duplicative of current federal requirements. Others represent standards set by highly publicized settlement agreements between some loan servicers and federal and state governmental authorities. Yet others appear to legislate against what are common industry practices (but which will now be accompanied by a federal cause of action for failure to comply). Another reason for a sense of déjà vu is that these servicing provisions were topics of the mortgage reform efforts of the 110th Congress and the FRB, on which we reported in a 2008 client alert.2 And in fact, many of the servicer-related requirements found in the Mortgage Reform Act, such as timely crediting payments, promptly responding to payoff requests, and establishing escrow accounts on “higher risk” mortgages are currently law under Regulation Z, leading to potentially redundant (and sometimes inconsistent) requirements. The few things the Act does not do are noteworthy. The Act does not set limits on specific servicing fees (except certain fees relating to qualified written requests (“QWRs”) and “high-cost” loans). Nor does the Act appear to fundamentally alter the nature of the loan servicing business, which is in contrast to some of the sea changes the Act imposes on the residential mortgage loan origination side of the business.

Effective Date Assuming the Mortgage Reform Act is signed into law, when will it become effective? Unfortunately, the Act’s description of its effective dates is not a model of clarity. According to the Mortgage Reform Act, a section or provision of the Act will generally not take effect until any required rulemaking process is complete and final regulations implementing the pertinent section or provision are final. For those provisions that do not specifically require a regulator to issue implementing regulations, the effective date is unclear. On one hand, the Act says that any section of the Mortgage Reform Act “for which regulations have not been issued on the date that is 18 months after the designated transfer date shall take effect on such date.” This would seem to say that those provisions

of the Mortgage Reform Act that do not specifically require the applicable regulator to adopt implementing regulations do not become effective until 18 months after the designated transfer date, unless the applicable regulator decides to adopt regulations to implement the provisions anyway, and specifies an earlier effective date in those regulations. On the other hand, others have asserted that the foregoing effective date applies only to those provisions of Mortgage Reform Act for which the applicable regulator is required to issue regulations. This would mean that the provisions for which a regulator is not required to issue regulations (either because regulations are authorized, but not required, or the section is silent with respect to implementing regulations) would be subject to the Dodd-Frank Act’s default effective date—which is the day after the President signs the bill. This would be an alarming and unreasonable result given the time it would take to implement the many statutory requirements in an orderly manner. Hopefully, the Board will clarify the effective date of the provisions of the Mortgage Reform Act for which regulations are not expressly required.

Responding to Qualified Written Requests and Other Requests Under RESPA The Mortgage Reform Act would amend the Real Estate Settlement Procedures Act (“RESPA”) to shorten existing time frames for responding to QWRs. Section 6(e) of RESPA requires a loan servicer, upon receipt of a QWR, to take certain actions with respect to borrower inquiries regarding “information related to the servicing” of a federally related mortgage loan. Such action includes providing information requested by the borrower, conducting an investigation of the borrower’s concerns, providing an explanation or clarification of the reasons the servicer believes the account is correct and, if necessary, making appropriate corrections to the borrower’s account. Upon a violation of Section 6 of RESPA, a borrower may recover actual damages if the loan servicer fails to comply with these provisions and statutory damages if there is a pattern or practice of noncompliance with RESPA by the loan servicer. Loan servicers would be required to acknowledge receipt of a QWR within 5 days of receipt, versus

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the existing 20 day time frame. Actual responses to QWRs would be required within 30 days, versus the existing 60 days, with a possible 15 day extension if the servicer notifies the borrower of the delay and its reason. In addition, servicers would be prohibited from charging fees for responding to a “valid QWR.” A servicer may consider the Mortgage Reform Act’s contemplated shortened time frame burdensome, since many requests involve tracking down a particular document from storage or from a transferor servicer, or information from prior servicers. Indeed, for large servicers with large mail rooms, the risk of QWRs not arriving at the right desk within the right time frame could create material liability. The Mortgage Reform Act, however, would not amend the regulations made pursuant to RESPA that allow a servicer to establish a separate and exclusive office and address for the receipt and handling of QWRs. Because of the potential for substantial penalties for failing to meet the new QWR deadline, any timeline imposed by statute or regulation should be designed to accommodate the most difficult requests rather than the most simple requests. While RESPA provides remedies for violations of Section 6, discussed above, the Bureau would have the additional power under the Consumer Financial Protection Act of 2010 (“CFPA”) to order remedies such as rescinding or reforming contracts, civil money penalties of up to $1 million per day in some cases, disgorgement for unjust enrichment, and restitution upon violations of federal consumer financial laws, which includes RESPA. While many—probably the majority—of QWRs are reasonable, the mortgage industry believes that the QWR process sometimes is abused by gadflies who want to harass their servicers, or by attorneys for borrowers who use it as a discovery tool. In fact, servicers have had to expend considerable resources trying to respond to overbroad discovery-type requests that are delivered under the guise of QWRs. The industry had wanted Congress to clarify that a QWR is a request for an explanation concerning how an account has been serviced and why certain charges were imposed, rather than a vehicle for informal discovery, but Congress chose not to clarify the existing requirements. The Bureau is expressly charged with further describing in regulations what qualifies as a valid

QWR. Since the provision requires the Bureau to prescribe regulations, it would appear that this provision would become effective upon the date of the future regulations. Hopefully, the Bureau will address the industry’s legitimate concerns regarding QWRs. The Mortgage Reform Act also imposes a set of new servicer requirements under Section 6(k) of RESPA concerning borrowers’ inquiries. According to the new provisions, a servicer of a federally related mortgage may not fail to take “timely action to respond to a borrower’s requests to correct errors relating to allocation of payments, final balances for purposes of paying off the loan, or avoiding foreclosure, or other standard servicer’s duties.” Since RESPA currently requires a servicer to respond to a QWR within a specified time period, and since this new provision does not reference QWRs, the new “timely response” requirement appears to apply to all requests by the borrower, although this conclusion is far from certain. The requirement to respond to a request related to “other standard servicer’s duties” is similarly ambiguous. Violations of this requirement, like others found in Section 6, could result in the recovery of actual damages and statutory damages if there is a pattern or practice of noncompliance with RESPA by the loan servicer.

In addition, Section 6(k) provides that a servicer (a) may not fail to respond within 10 business days to a request by the borrower to provide the identity, address, and other relevant information about the owner or assignee of a home mortgage loan, and (b) must comply with any other obligation established by the Bureau by regulation. Again, it is unclear whether the timely response to a borrower’s inquiry about a loan’s ownership is triggered by the servicer’s receipt of a QWR, but the response time is clearly shorter than under the QWR process. This is duplicative of information assignees are already obligated to provide mortgage loan borrowers under the Truth in Lending Act (“TILA”). And considering that TILA permits the assignee to designate another person (e.g., the servicer) to respond to questions, this new requirement seems somewhat nonsensical. In short, it is unclear why this provision is necessary to protect the consumer, or why there are significant penalties for

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noncompliance when there is no harm to the borrower for noncompliance. The Mortgage Reform Act permits (but does not require) the Bureau to issue regulations imposing obligations on loan servicers (in addition to those otherwise contemplated in Section 6(k)) as “appropriate to carry out the consumer protection purpose of [RESPA].”

Force Placed Insurance The Mortgage Reform Act will amend RESPA to prohibit a servicer from obtaining force placed insurance,3 unless there is “a reasonable basis to believe the borrower has failed to comply with the loan contract’s requirements to maintain property insurance.” But don’t let the open-ended “reasonable basis to believe” standard lull you into thinking that servicers have flexibility. The Act is extremely specific about the process that a servicer must follow before it can form a “reasonable basis to believe” that the borrower has let his or her insurance lapse:

• The servicer would need to send a written notice to the borrower, by first-class mail, containing a reminder of the borrower’s obligation to maintain insurance on the property securing the federally related mortgage. This notice would need to state that the servicer is without evidence of insurance coverage on the property, and explain clearly how the borrower may demonstrate coverage on the property. The notice would have to state that the servicer may obtain the coverage at the borrower’s expense if the borrower does not demonstrate existing coverage in the timely manner.

• Further, a servicer would need to send a second written notice by first class mail at least 30 days after the first notice, with the same required information as the first.

If by the end of the 15 day period after the second notice was sent the servicer has not received from the borrower any demonstration of insurance coverage, then the servicer may impose a charge for force placed insurance.

These requirements in our experience track the practices of most servicers (although some members of the industry have argued that providing second notices is costly, and unnecessary). What might be burdensome is the Mortgage Reform Act’s requirement that a servicer accept any reasonable form of written confirmation from a borrower of existing insurance coverage, including the existing insurance policy number along with the identity of, and contact information for, the insurance company or agent, or as otherwise required by the Bureau. These new force placed insurance rules would further require that the premium charged to the consumer be “bona fide and reasonable.” The Bureau is not given express authority under the Mortgage Reform Act to define these terms, but is given general authority to prescribe regulations to carry out the consumer protection purposes of RESPA. Again, we would hope that the Bureau would exercise appropriate discretion and issue regulations setting an objective standard for “bona fide and reasonable.” If the servicer receives confirmation of a borrower’s existing insurance coverage, the servicer must terminate the force placed insurance within 15 days of receipt and refund to the consumer all force placed insurance premiums paid by the borrower during any period of double coverage, and any related fees charged to the borrower’s account in connection with the force placed insurance. Some in the mortgage industry may assert that servicers should not be held responsible for insurance companies’ failures to recognize that the property was doubly covered. Some in the industry also believe it is unfair for a borrower who failed to act on the notices to receive a mandatory refund, even though the force placed insurer was potentially at risk during the period of double coverage. Overall, the force placed insurance provisions appear to penalize servicers who merely seek to protect the note holder’s interests in the security property. Similar to above, the Bureau is given broad authority to issue regulations that carry out the consumer purpose of RESPA, and to specifically determine what constitutes a reasonable form of written confirmation of insurance to establish that the borrower maintains property insurance, but the Act does not require those regulations. It would be

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reasonable for the Bureau to ensure that similar provisions, such as the amendments to RESPA, would have common effective dates to allow systems and compliance processes to be modified by servicers in an orderly fashion.

Escrow Requirements Regulation Z currently requires the establishment of an escrow account for taxes and insurance for certain “riskier” first-lien loans. For example, under Regulation Z, an escrow account is required for “higher priced loans” (a first-lien loan if the annual percent rate is 1.5 percentage points above Freddie Mac’s Primary Mortgage Market Survey (“PMMS”) for first-lien loans). The Mortgage Reform Act extends this requirement to a broader range of loans, and also expands on it. Applicability The new Section 129D of TILA will obligate borrowers of certain “riskier” first-lien loans to escrow funds for the payment of taxes and insurance, and imposes certain requirements on servicers for the administration of these escrow accounts. An escrow account would be mandatory at loan consummation if: (1) required by federal or state law; (2) a loan is made, guaranteed, or insured by a state or federal governmental lending or insuring agency; or (3) a first-lien loan has an annual percentage rate that exceeds the average prime offer rate for a comparable transaction, as of the date the interest rate is set: (a) by 1.5 or more percentage points, in the case of a first-lien residential mortgage loan having an original principal obligation amount that is equal to or less than the Freddie Mac conforming loan amount for a residence of the applicable size, as of the date the interest rate is set; (b) by 2.5 or more percentage points, in the case of a first-lien residential mortgage loan having an original principal obligation amount that is more than the Freddie Mac conforming loan amount for a residence of the applicable size, as of the date the interest rate is set. Section 129D carves out from this requirement reverse mortgage loans, open-end loans, and any subordinate-lien loans. The Board (and upon transfer of authority, the Bureau) is authorized to exempt from the escrow requirement creditors that operate in rural areas, retain the mortgage in

portfolio, or meet asset or origination size thresholds, as prescribed by regulation. The Board (or the Bureau, upon transfer) is given greater flexibility to revise, add to, or subtract from the types of loans that require mandatory escrows if it is in the interest of consumers and the public. Like Regulation Z, Section 129D also provides a limited exemption for loans secured by shares in a cooperative, or in which an association must maintain a master insurance policy for the property. For these and other loans where an escrow account is not mandated, the Mortgage Reform Act provides that the borrower and lender may mutually agree to escrowing funds for taxes and insurance. Further, the Mortgage Reform Act does not preclude a lender or servicer, at its discretion, from establishing an escrow account if authorized by the loan contract. Interestingly, consumer advocates and legislators have historically complained that it is inherently unfair for lenders to require borrowers to establish escrow accounts for future tax and insurance obligations. The proposed escrow requirements reflect a marked and continuing shift in public policy to have lenders and servicers act as parens patriae for borrowers, rather than assume that borrowers have the ability and discipline to put funds aside to pay the taxes and insurance when they become due. Duration There are, of course, legitimate reasons an informed borrower might not want an escrow account, such as the desire to manage cash flow (as might be the case with borrowers who receive bonuses at year end). The new Section 129D and Regulation Z each deal with this differently. Under Section 129D, the mandated escrow account would remain for at least five years unless and until the borrower: (1) has enough equity to no longer meet the requirements of maintaining private mortgage insurance; (2) is delinquent; (3) otherwise has not complied with the legal obligation, as established by rule; or (4) the underlying mortgage establishing the account is terminated. Under Regulation Z, a creditor is permitted, but not required, to offer the borrower the ability to opt out of escrowing funds after 12 months. Thus, a consumer with a mandated escrow account would not be able to opt out of escrow arrangements until, at the earliest, five years under

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the new law, subject to certain exceptions described above, and possibly never under Regulation Z, if the creditor disfavors the option. Administration Under proposed Section 129D of TILA, there would be substantive regulation of mandated escrow accounts, including maintenance of the account in a federally insured depository institution, administration of the account in accordance with RESPA and the law of the state where the real property securing the loan is located, if applicable, and payment of interest to the consumer if prescribed by applicable federal or state law. So while TILA would not require servicers to pay interest to consumers on their escrow accounts, it would affirm the requirement to do so if required by other applicable federal or state law. Whether intended or not, the Mortgage Reform Act might be construed to subject servicers’ noncompliance with state laws regarding the administration of accounts and the payment of interest on escrow accounts to a federal cause of action under TILA. Finally, under Section 129D of TILA, lenders would be required to deliver to borrowers one type of disclosure if they are required to escrow funds (advising them of that fact), and another type of disclosure if no escrow is provided or if the borrower opts out (advising them of their responsibilities to pay taxes and insurance).4 Regulation Z does not currently impose a similar disclosure requirement. The Board (or Bureau) is authorized to issue regulations that would: exempt creditors from the escrow requirements; revise, add to, or subtract from the types of loans that require mandatory escrows; and require additional information in the disclosures that it deems necessary.

Payoff Statement Regulation Z currently requires a servicer to deliver “accurate” payoff statements within a reasonable time of a payoff request. Proposed Section 129G would impose the same requirement. However, the proposed new TILA section and Regulation Z differ as to the meaning of “reasonable” and how the borrower’s request must be sent. For example, Section 129G requires the servicer to deliver a

payoff statement within seven business days of a written request, while the Commentary to Regulation Z suggests that a reasonable time frame is generally five business days after any request, but permits a longer timeline when refinancing volume is high. Hopefully, the Board (or the Bureau) will use its authority in Section 105 in TILA to issue regulations or guidance addressing this inconsistency. Under the Mortgage Reform Act, the Board and Bureau are not expressly required to promulgate implementing regulations for Section 129G. In addition, RESPA will be amended to require that a servicer credit or return to the borrower any balance in an escrow account that is within the servicer’s control within 20 business days of payoff. The Mortgage Reform Act does not specifically require the Bureau to issue implementing regulations on this requirement.

Credit of Payments on Date Received Proposed Section 129F is identical to Regulation Z’s requirements on prompt crediting of payments. They both provide that the obligation to credit a payment on the date received applies only when a delay in crediting would result in a charge or in the reporting of negative information to a consumer reporting agency. Both Section 129F and Regulation Z contemplate that if a servicer specifies in writing requirements for a consumer to follow in making payments, but accepts a payment that does not conform to the requirements, the servicer must credit the payment as of 5 days after the receipt. There is a significant exception to the prompt payment posting rule. The Commentary to Regulation Z obligates a servicer to credit a consumer’s full periodic payment as of the date received, but would not require an early payment to be credited before its due date. Significantly, the Commentary also provides that whether a partial payment must be credited depends on the legal contractual obligations between the parties. The combined effect of these various statutory and regulatory provisions is to prohibit servicers from holding a payment that would send a borrower into default or result in a late charge, unless the borrower fails to make that payment in accordance with the terms of the loan documents.

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Periodic Statements and Other Servicer Disclosures The Mortgage Reform Act would amend Section 128 of TILA to require that the servicer, creditor or assignee provide a statement to a borrower of a residential mortgage loan for each billing cycle disclosing the following eight pieces of information (to the extent applicable) in a conspicuous and prominent manner: (1) the remaining principal; (2) the current interest rate; (3) the date of the next interest rate reset or adjustment; (4) the amount of any prepayment fee; (5) a description of any late payment fee; (6) a telephone number and electronic email address that the borrower may use to obtain information regarding the mortgage; (7) the names, addresses, telephone numbers, and Internet addresses of counseling agencies or programs reasonably available to the consumer that have been certified or approved and made publicly available by the Department of Housing and Urban Development or a state housing finance authority; and (8) any other information as the Board may prescribe in regulations. The Mortgage Reform Act requires the FRB to develop and prescribe a standard form for the periodic statement, taking into account that the statements may be transmitted in writing or electronically. The periodic statement requirement will not apply to any fixed rate residential mortgage loan where the servicer, creditor, or assignee provides the borrower with a coupon book that includes substantially the same information as required in the periodic statement, but would apply to adjustable-rate mortgages. This provision requires the Board (and upon transfer, the Bureau) to prescribe regulations to implement the provision, and it appears that it would become effective upon the date of finalized regulations. Other amendments to TILA, however, do not require implementing regulations. We believe it would be reasonable for the Board (or the Bureau) to ensure that similar provisions, such as the amendments to TILA, would have common effective dates to allow systems and compliance processes to be modified by servicers in an orderly fashion. New Section 128A of TILA would require additional disclosures with respect to the servicing of a “hybrid adjustable rate mortgage” (a consumer credit transaction secured by the consumer’s

principal residence with a fixed interest rate for an introductory period that adjusts or resets to a variable interest rate after such period).5 Under the Mortgage Reform Act, the Bureau is not expressly required to promulgate regulations on the “hybrid adjustable rate mortgage” disclosure, although the Bureau has general authority under Section 105 of TILA to issue regulations and publish model disclosure forms.

Penalties The Mortgage Reform Act will amend the penalty amounts for violations of Section 6 of RESPA, which includes the provisions on force placed insurance, refunding escrow accounts upon payoff, QWRs and other borrower requests, by increasing (a) the maximum statutory damages from $1,000 to $2,000 in the case of a pattern or practice of noncompliance, for both individual and class actions, and (b) the ceiling on the total amount of damages in class actions from $500,000 to $1,000,000 (or one percent of the net worth of the servicer, whichever is less). The Mortgage Reform Act provides penalty coordination with RESPA, stating that any action or omission that constitutes a violation of RESPA for which a person has paid any fine, or other damages, may not give rise to any additional penalty under the escrow provisions, unless the act or omission also constitutes a direct violation of the escrow requirements. A servicer would also have liability for violations of the new TILA periodic statement (Section 128(f)), escrow account for higher-risk loans (Section 129D), prompt crediting of payments (Section 129F), and timely payoff statement (Section 129G) requirements, although it is not clear whether liability would be limited to administrative penalties. According to the civil penalty provisions of TILA, except as otherwise provided, Section 130 of TILA imposes liability on the creditor, which is defined as the named payee in the note. As such, a servicer who is not the named payee may not be considered to be a creditor. We note, however, that Section 130 would apply to a mortgage originator that is not a creditor if the originator fails to comply with the Mortgage Reform Act’s new requirements (i.e., qualification requirements, unique identifier requirements, anti-steering, restructuring of

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compensation). A violation of these sections of TILA would not appear to subject the servicer to special enhanced damages (equal to the sum of all finance charges and fees paid by the consumer), as they are triggered by violations of Section 129, and, as amended by the Mortgage Reform Act, paragraph (1) or (2) of Section 129B(c), or Section 129C(a). In addition to the remedies describe above, the Bureau will have the authority to enforce RESPA and TILA, and under the CFPA, may order remedies such as rescinding or reforming contracts, civil money penalties, disgorgement for unjust enrichment, and restitution upon violations of these federal consumer financial laws. The CFPA, however, does not appear to provide a private right of action.

Mortgage Resolution and Modification Home Affordable Modification Program The Mortgage Reform Act would impose new requirements on Treasury in connection with HAMP that will impact loan servicers. Treasury would be required to amend the HAMP supplemental directives and guidelines to implement these changes, but under no fixed deadline. The Act does not alter a participating servicer’s contractual obligation to comply with HAMP, or the contractual remedies for its failure to do so. There is no private right of action under the Mortgage Reform Act for a servicer’s noncompliance with HAMP. In particular, the Mortgage Reform Act would require that Treasury establish and maintain an Internet site that provides a Net Present Value (“NPV”) calculator, based on Treasury’s methodology for calculating the NPV, that borrowers can use to input their information to determine whether the mortgage would be accepted or rejected for modification under HAMP. While the purpose of providing the NPV is to promote transparency, there is a concern that it could be ripe for abuse and borrower fraud (assuming that borrowers may be tempted to use the NPV calculator to determine NPV positive scenarios, and modify their documentation accordingly). The website would also be required to disclose that each participating servicer may use a method for calculating NPV that is different from the method used by the calculator.

The Mortgage Reform Act would require Treasury to make reasonable efforts to include on a website with the NPV calculator a method for homeowners to apply for a mortgage modification under HAMP. In addition to the NPV test, Treasury would be required to include the methodology and computer model, including all formulae used in the computer model, used for calculating the NPV, and all non-proprietary variables used in the NPV analysis. Treasury has been apprehensive about providing the NPV calculator publicly, even to mortgage counselors, arguing that the sensitivity of the model to certain inputs such as LTV (a value which will likely be different for the borrower and the servicer and that can lead to dramatically different results) leads to a high rate of false positives and false negatives. For servicers, these “false” results may lead to upset borrowers who are more susceptible to sue. Further, although already required under HAMP, the Mortgage Reform Act provides that Treasury must revise its HAMP guidance to require servicers to deliver to each borrower who was denied a modification all borrower-related and mortgage-related input data used in any NPV calculation. Under the Mortgage Reform Act, a borrower would not be eligible under HAMP if the borrower, in connection with a mortgage or real estate transaction, has been convicted within the last 10 years of any of the following: (a) felony larceny, theft, fraud, or forgery; (b) money laundering; or (c) tax evasion. The Secretary of Treasury must establish procedures to ensure compliance.

Lastly, the Mortgage Reform Act would attempt to ensure that the servicer’s HAMP data is publicly available. Not more than 14 days after each monthly deadline that a servicer is required to submit data to Treasury, Treasury would be required to make available to the public, via a report to Congress and the Internet, reports on each servicer regarding the number of modification requests the servicer received, processed, approved, and denied. The Mortgage Reform Act would also require Treasury to make “data tables” available to the public at the “individual record level,” which could subject servicers to more scrutiny, and potentially more criticism. Treasury must issue regulations prescribing the procedures for disclosing this data to

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the public, which may include deletions, as appropriate, to protect any privacy interest in any modification applicant. Protecting Tenants At Foreclosure Act The Mortgage Reform Act would also amend provisions of the Protecting Tenants At Foreclosure Act of 2009 (“PTFA”) which was enacted as part of the Helping Families Save Their Homes Act of 2009. The PTFA created a 90 day, pre-eviction foreclosure notice requirement for tenants in foreclosed properties throughout the country. This section of the Mortgage Reform Act does not expressly require implementation by regulation. First, in any foreclosure action on a federally related mortgage loan or involving a dwelling or residential real property, the PTFA requires the immediate successor in interest to provide a “bona fide” tenant 90 days’ notice prior to eviction. To be a “bona fide” lease or tenancy: (1) the tenant must not be the mortgagor or a family member thereof; (2) the lease or tenancy must be the result of an arm’s-length transaction; and (3) the lease or tenancy must require rent that is not substantially below fair market, unless it is reduced as the result of a federal, state, or local subsidy. The Mortgage Reform Act does not impact that requirement. Second, the PTFA provides that a successor in interest of a property assumes interest subject to the rights of certain bona fide tenants. Thus, a new owner of residential rental property who takes title through foreclosure must honor existing “bona fide” leases entered into prior to the date on which notice of foreclosure was given, through the end of the lease term. (Exceptions are made if the tenancy is at will or is not pursuant to a lease, or if there is an existing term lease and (1) the new owner wants to occupy the foreclosed property as his or her personal residence before the end of the lease term; or (2) there are fewer than 90 days before the end of the lease term, such as in a month-to-month lease agreement.) The Mortgage Reform Act would make two substantive changes to existing requirements. It would remove the qualifier that tenants be bona fide as of the date on which notice of foreclosure is given in order to be entitled to complete their lease terms. It also would clarify that the date on which notice of

foreclosure is given is “deemed to be the date on which complete title to a property is transferred to a successor entity or person as a result of an order of a court or pursuant to provisions in a mortgage, deed of trust, or security deed.” The Mortgage Reform Act also would extend the effective repeal of the PTFA from December 31, 2012, to December 31, 2014.

Conclusion Loan servicing has long been the subject of customer complaints, many of which are actionable under RESPA, and more recently under Regulation Z. In recent years, however, many of the putative class actions involving servicing have been brought under state unfair and deceptive practices acts because of the lack of coverage under federal law. Generally speaking, these class actions address one of three common issues: the mishandling of payments, the permissibility and timing of specific fees, and the improper imposition of lender placed insurance. A fourth issue giving rise to servicing concerns is limited to the subprime world—namely, the need for tax and insurance escrow accounts to ensure that mortgagors have sufficient funds to pay these obligations. Not surprisingly, the Mortgage Reform Act (and Regulation Z) addresses many of the same issues, but does not generally impose restrictions on servicing fees. Overall, the changes required by the Mortgage Reform Act would not appear to fundamentally alter the nature of the loan servicing business, which is in contrast to the substantial changes the Act imposes on the residential mortgage loan origination side of the business. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.

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1 The Dodd-Frank Act, which has been making its way through Congress over the past year, is not yet law. The bill that emerged from the conference committee on June 25 passed the House of Representatives on June 30. Senate Majority Leader Harry Reid stated that the Senate will vote on the measure in the near future. Although the vote is likely to be close—supporters may get exactly the 60 they need to avert a filibuster—Chairmen Dodd and Frank are publicly confident that the President will sign the bill by mid-July. 2 Jonathan Jaffe and Kerri M. Smith, Imposing Material Liabilities on Servicers and Investors for Immaterial Mistakes, Mortgage Banking & Consumer Credit Alert, March 10, 2008, available at: http://www.klgates.com/newsstand/Detail.aspx?publication=4460 3 Under the Mortgage Reform Act, force placed insurance is defined as hazard insurance coverage obtained by a servicer of a federally related mortgage when the borrower has failed to maintain or renew hazard insurance on such property as required of the borrower under the terms of the mortgage. 4 The notice advising borrowers that an escrow fund is mandated must include:

• The fact that an escrow will be established at consummation of the transaction.

• The amount required at closing to initially fund the escrow account.

• The amount, in the initial year, of the estimated taxes and hazard insurance and any other required periodic payments or premiums that reflect the taxable assessed value of the real property securing the transaction, including the value of any improvements on the property or to be constructed on the property (whether or not such construction will be financed from the proceeds of the transaction).

• The estimated monthly amount payable for

taxes, hazard insurance and any other required periodic payments or premiums.

• The fact that if the consumer chooses to terminate the account in the future, the consumer will become responsible for the payment of all taxes, hazard insurance, and flood insurance, if applicable, as well as any other required periodic payments or premiums on the property unless a new escrow or impound account is established.

• Such other information as the Board determines necessary for the protection of the consumer.

The notice advising the borrower of her responsibilities to pay taxes and insurance if no escrow is provided or if the borrower opts out must include:

• Information concerning any applicable fees associated with the subsequent closure of any such account.

• A clear and prominent notice that the consumer is responsible for personally and directly paying the non-escrowed items, in addition to paying the mortgage loan payment, in the absence of any such account, and the fact that the costs for taxes, insurance, and related fees can be substantial.

• A clear explanation of the consequences of any failure to pay non-escrowed items, including the possible requirement for the forced placement of insurance by the creditor and the potentially higher cost (including any potential commission payments to the servicer) or reduced coverage for the consumer in the event of any such creditor-placed insurance.

• Such other information as the Board determines necessary for the protection of the consumer.



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5 According to Section 128A of TILA, during the one-month period that ends 6 months before the date on which the interest rate in effect during the introductory period of a hybrid adjustable rate mortgage adjusts or resets to a variable interest rate (assuming no reset within the first six months), the servicer must provide a written notice, separate and distinct from all other correspondence to the consumer, that includes the following: (1) Any index or formula used in making adjustments to or resetting the interest rate and a source of information about the index or formula; (2) An explanation of how the new interest rate and payment would be determined, including an explanation of how the index was adjusted, such as by the addition of a margin; (3) A good faith estimate, based on accepted industry standards, of the creditor or servicer of the amount of the monthly payment that will apply after the date of the adjustment or reset, and the assumptions on which this estimate is based; (4) A list of alternatives consumers may pursue before the date of adjustment or reset, and descriptions of the actions consumers must take to pursue these alternatives, including: (A) refinancing; (B) renegotiation of loan terms; (C) payment forbearances; and (D) pre-foreclosure sales; (5) The names, addresses, telephone numbers, and Internet addresses of counseling agencies or programs reasonably available to the consumer that have been certified or approved and made publicly available by HUD or a state housing finance authority; and (6) The address, telephone number, and Internet address for the state housing finance authority for the state in which the consumer resides.

July 16, 2010 Authors: Stanley V. Ragalevsky [email protected] +1.617.951.9203 Sarah J. Ricardi [email protected] +1.617.261.3230 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

The Resolution of Systemically Important Nonbank Financial Companies… Will It Work? K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. One of the glaring problems exposed by the recent financial crisis has been the absence of supervisory authority to deal effectively with the insolvency or collapse of significant, nonbank financial companies. While bank regulators have long been empowered to close and liquidate insolvent banks to protect the public, there was no comparable authority vested in any financial services regulator to close and liquidate insolvent bank holding companies or other kinds of financial companies. To make matters worse, when several systemically important financial companies were on the verge of collapse in September 2008, they were deemed “too big to fail” and given significant government assistance. Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”) addresses the absence of regulatory authority to liquidate systemically important, nonbank financial companies by creating an “orderly liquidation authority” (“OLA”) process to allow the Treasury Secretary to close and the Federal Deposit Insurance Corporation (“FDIC”) to wind up these companies. This OLA resolution process for select, nonbank financial companies is patterned after the Federal Deposit Insurance Act (the “FDI Act”) which empowers FDIC to liquidate insolvent banks. It can be invoked, however, only with respect to a “covered financial company” that has been determined by the Treasury Secretary to present systemic risk to the U.S. financial system. Once invoked, the OLA process preempts the Bankruptcy Code with respect to a covered financial company. The OLA process is a mandatory scheme to force the liquidation of large, systemically significant but insolvent nonbank financial companies in a process that causes any losses from their failure to be borne by creditors and stockholders, not the taxpayers. In this respect, the OLA resolution process set forth in Title II of the Act seeks to eliminate the moral hazard associated with recent government bailouts of “too big to fail” financial companies. But, unlike the resolution scheme for depository institutions, there is no fund at the ready from which resolution expenses can be paid. Companies Subject to Orderly Liquidation Authority. The OLA resolution process set forth in the Act will apply only to a “financial company” that has been designated by the Treasury Secretary as a “covered financial company.” A “financial company” is a federal or state chartered company that is: (i) a bank holding company (“BHC”), as defined in the Bank Holding Company Act of 1956 (the “BHCA”), including any BHC the majority of the securities of which are owned by the U.S. or any state; (ii) a nonbank financial company supervised by the Federal Reserve;1 (iii) any company that is predominantly engaged2 in activities that the Federal Reserve has determined are “financial in nature or incidental thereto” under




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the BHCA; or (iv) any subsidiary of any of the foregoing that is predominantly engaged in activities that are financial in nature or incidental thereto under the BHCA. The term “financial company” does not include a bank or thrift, insurance company, a Farm Credit System institution, a governmental entity, F.N.M.A., F.H.L.M.C. or any affiliates, or any Federal Home Loan Bank. To be subject to the OLA resolution process, a financial company must have been designated as a “covered financial company” by the Treasury Secretary.3 Designation as a covered financial company requires a determination that the affected company represents a systemic risk to the U.S. economy. This systemic risk designation of “covered financial company” status is a fact-specific determination made only in the context of a contemporaneous decision by the Treasury Secretary to place a financial company into FDIC receivership. It is not made generically for all financial companies that might be considered systemically important. But the Treasury Secretary would not be expected to make a “covered financial company” designation for a financial company that has not been currently identified as systemically important by the Financial Stability Oversight Council or a bank holding company with less than $50 billion in consolidated assets. Further, the OLA resolution process is not likely, due to its complexity, to be invoked frequently. The initiation of the OLA resolution process for the liquidation of a covered financial company first requires a written recommendation by the Federal Reserve and the FDIC (or the SEC for a broker or dealer or the Federal Insurance Office director for an insurance company) to the Treasury Secretary to place the financial company at issue into an FDIC receivership. Any recommendation by the Federal Reserve, FDIC or SEC requires a two-thirds supermajority vote of its board (or of the Commission for the SEC) and must contain the following:

i) an evaluation of whether the company is “in default or in danger of default”;

ii) a description of the effects that such default would have on the financial stability of the United States;

iii) a description of the effect that the default would have on economic conditions or financial stability for low income, minority, or underserved communities;

iv) a recommendation as to the nature and the extent of actions to be taken under the Title II OLA;

v) an evaluation of the likelihood of a private sector alternative to prevent the default;

vi) an evaluation of why a case under the Bankruptcy Code is not appropriate;

vii) an evaluation of the effects on creditors, counterparties, and shareholders of the company and other market participants; and

viii) an evaluation of whether the affected company meets the definition of a “financial company.”

A financial company is “in default or in danger of default” if:

i) a case has been, or likely will promptly be, commenced with respect to the financial company under the Bankruptcy Code;

ii) the financial company has incurred, or is likely to incur, losses that will deplete all or substantially all of its capital, and there is no reasonable prospect for the company to avoid such depletion;

iii) the assets of the financial company are, or are likely to be, less than its obligations to creditors and others; or

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iv) the financial company is, or is likely to be, unable to pay its obligations (other than those subject to a bona fide dispute) in the normal course of business.

Upon receipt of a written recommendation from the Federal Reserve and FDIC (or SEC or Federal Insurance Office, as applicable), the Treasury Secretary (in consultation with the President) must then make a determination under Section 203(b) to put the financial company into FDIC receivership. Once the Treasury Secretary determines to appoint FDIC as receiver for the financial company, it becomes a “covered financial company” and is liquidated.4 Before it can place a covered financial company into FDIC receivership, the Treasury Secretary must determine that:

i) the company is “in default or in danger of default”;

ii) its failure and resolution under the otherwise available Bankruptcy Code or state law would have serious adverse effects on U.S. financial stability;

iii) there is no viable private sector alternative available to prevent the default;

iv) any effect of an orderly liquidation of the company under the OLA process upon creditors, counterparties, and shareholders of the financial company and other market participants is appropriate given the impact that use of the OLA process would have on U.S. financial stability;

v) use of the OLA process would avoid or mitigate adverse effects upon the financial system and the U.S. Treasury;

vi) a federal regulatory authority has ordered the company to convert all

convertible debt instruments subject to regulatory order; and

vii) the company in fact is a “financial company.”5

Once the Treasury Secretary determines that the above criteria are satisfied, he or she must notify FDIC and the covered financial company of such determination.6 If the company’s board of directors consents, FDIC is immediately appointed as receiver and begins the liquidation process. If the company does not consent, the Treasury Secretary must petition the U.S. District Court for the District of Columbia (“District Court”) for an order authorizing the appointment of FDIC as receiver. The District Court must determine within 24 hours whether the Secretary’s decision was arbitrary and capricious. The company is entitled to oppose the order at a hearing. If a determination is not made within 24 hours, the receivership order is deemed automatically granted by operation of law. While the company may appeal to the U.S. Court of Appeals for the District of Columbia and then to the Supreme Court, any appeal does not stay the order or the appointment of FDIC as receiver. Review on appeal is limited to whether the Secretary’s determination was arbitrary and capricious. The Treasury Secretary’s determination to liquidate a covered financial company and any subsequent petition and pending District Court proceedings are to be kept confidential, at least initially. The Act imposes criminal penalties on any person who “recklessly” discloses the Treasury Secretary’s determination to liquidate a financial company or any related District Court petition or pending District Court proceedings.

Orderly Liquidation Fund – The Financial Impact of Title II of the Act. Title II of the Act establishes an Orderly Liquidation Fund within the Treasury Department from which the costs of actions taken pursuant to Title II, including the liquidation of financial companies, the payment of administrative expenses, the payment of principal and interest by FDIC on obligations issued to the Treasury Secretary (described below), and the exercise of the authorities of FDIC, are to be paid. Once funded,

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the Orderly Liquidation Fund is to be managed by FDIC. Unlike the FDIC Deposit Insurance Fund, the Orderly Liquidation Fund currently has no assets or government funding.7 Its costs will be initially funded through the issuance of obligations by FDIC, as receiver for a covered financial company, to the Treasury. The Treasury can re-sell those obligations upon such terms and conditions as it determines. There are limits to the amount of debt FDIC can incur in connection with any single covered financial company receivership. FDIC may not incur obligations in an orderly liquidation of a covered financial company that exceed (i) 10% of the total consolidated assets of the covered financial company during the 30-day period immediately following the date of appointment of FDIC as receiver; and (ii) 90% of the fair value of the total consolidated assets of the financial company that are available for repayment after such 30-day period. Before FDIC can issue an obligation to the Treasury, it must have an agreement in effect with the Treasury Secretary that (i) provides a specific plan and schedule to achieve the repayment of the outstanding amount of any such borrowing; and (ii) demonstrates that income to FDIC from the liquidated assets of the financial company and assessments (described below) will be sufficient to amortize the outstanding balance within the period established in the repayment schedule and pay the interest accruing on such balance within a 5 year period. FDIC may, with the approval of the Treasury Secretary, extend the 5 year time period if determined necessary to avoid a serious adverse effect on the U.S. financial system. If FDIC will be unable to pay in full the obligations issued by FDIC to the Treasury Secretary within 5 years of the date of issuance (as extended, if necessary), FDIC is required to charge assessments to make up the difference. “Recoupment assessments” are first imposed by FDIC, as soon as practicable, on any claimant that received additional payments or amounts from FDIC in excess of the amount such claimant would have received in liquidation under a Chapter 7 Bankruptcy Code proceeding (except for payments or amounts necessary to initiate and continue operations

essential to implementation of the receivership or any bridge financial company) such that FDIC recovers the entire amount of such excess. If recoupment assessments are insufficient, then FDIC must impose additional assessments on “eligible financial companies” (any bank holding company with total consolidated assets of at least $50 billion and any nonbank financial company supervised by the Federal Reserve) and large financial companies with total consolidated assets of at least $50 billion that are not eligible financial companies (“large financial companies”). The requirement that any deficit in the Orderly Liquidation Fund from an OLA receivership be paid for through assessments on eligible and large financial companies stems from Title II’s mandate that all costs associated with the liquidation of covered financial companies be borne by the “financial sector.” Accordingly, every eligible or large financial company is exposed to liability for potentially significant and unplanned assessments to fund losses arising out of the invocation of the OLA process to liquidate an unrelated covered financial company. Title II does not set forth the basis upon which eligible or large financial companies may be liable for assessments. For one reason, not all financial companies can be certain that they are even liable for Fund assessments. As stated above, the companies subject to assessment are bank holding companies with total consolidated assets of at least $50 billion, nonbank financial companies supervised by the Federal Reserve and any other financial company with total consolidated assets of at least $50 billion. A bank holding company with over $50 million in consolidated assets will certainly be aware of its exposure to assessment. So will a nonbank financial company which the Financial Stability Oversight Council has placed under the supervision of the Federal Reserve pursuant to Title I of the Act. But a company with at least $50 billion in consolidated assets may also be subject to assessment if it is considered to be “predominantly engaged” in activities that are “financial in nature or incidental thereto” so that it meets the definition of a financial company. Given the somewhat subjective nature of this determination, and the fact that there is no

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requirement that companies which meet this definition be notified in advance, it may not be clear to some of these companies that they are “large financial companies” subject to assessment prior to an assessment actually being made. Another complicating factor is the fact that Title II provides little guidance regarding how assessments will be allocated among eligible or large financial companies, aside from stating that financial companies having greater assets and risk are to be assessed at a higher rate. The degree of risk posed by a financial company is to be determined with the aid of a “risk matrix,” to be developed by the Financial Stability Oversight Council and applied by FDIC based on a number of identified economic factors. It is not clear exactly how assessments or differentiations in assessments will be made based upon a company’s size, lines of business, financial strength or overall risk. The financial service industry includes several major sectors: banks, investment banks, mutual funds, investment companies, securities dealers and insurance companies. Imagine the consternation and distress if a systemically important financial company in one sector fails and the systemically important companies with no involvement in that sector are assessed the cost of liquidating a financial firm outside their sector of the financial services industry. Making assessment determinations, particularly on a retrospective basis, will be quite difficult. Furthermore, if undue emphasis is placed on a company’s size, Title II could cause those financial companies with the deepest pockets to fund the liquidation of their failed counterparts, irrespective of the degree of risk such companies posed to the financial system. Finally, because the Orderly Liquidation Fund is funded only after liquidation proceedings actually commence, the degree of any company’s liability for assessments will remain unclear until a covered financial company is in the process of being liquidated. Even then, FDIC might not be able to estimate reliably the cost of initial OLA receiverships given its total lack of prior experience liquidating nonbank financial companies. Another problem with the ex-post funding of the Orderly Liquidation Fund is that when the OLA process is actually implemented, absent large-scale

fraud at the failed financial company, it will likely be a time of widespread distress across the entire U.S. financial sector. This would be the least opportune time for FDIC to impose a potentially large, unexpected Fund assessment on even comparably healthy financial companies. Credit unions suffered from a similar timing exposure in 2009 as a result of the widespread distress at several large corporate credit unions. Given these various uncertainties, FDIC will need to issue regulations with reasonable dispatch if eligible and large financial companies are to understand and quantify their potential liability under Title II and ensure that they have adequately accrued for such liability.

Resolution of a Covered Financial Company – Purpose and General Principles. In general. Upon FDIC’s appointment as receiver of a covered financial company, all matters related to the company are governed exclusively by the OLA resolution process set forth in Title II of the Act. Provisions of the Bankruptcy Code no longer apply. They are superseded by Title II in a covered financial company OLA receivership. Unlike a proceeding under the Bankruptcy Code, which allows for the reorganization of companies if possible, the only outcome for a covered financial company under Title II is liquidation. The only protection for a financial company is the legal requirement that Treasury first determine, among other things, that there are no private sector alternatives to receivership and liquidation and that resolution of such financial company under the Bankruptcy Code would have serious adverse effects on U.S. financial stability. Section 204 of Title II sets forth the general principles which are to guide FDIC as receiver in the liquidation of a covered financial company. In general, FDIC as receiver in an OLA resolution must conduct itself in a manner that mitigates any risk to financial stability in the United States and minimizes moral hazard. This focus differs from a bankruptcy proceeding, where the protection of creditors’ rights is emphasized. Under Title II,

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creditors and shareholders are to bear any losses attributable to the failure of a covered financial company. Management responsible for the company’s insolvent condition is to be removed. All parties having responsibility for the covered financial company’s condition are to be made accountable consistent with their legal responsibility through actions for damages, restitution, and recoupment of compensation and other gains not compatible with such responsibility. While Title II establishes general principles that FDIC is to follow in liquidating a covered financial institution, it does not establish a plan for FDIC to follow in liquidating any particular company. It is up to FDIC, as receiver, to develop an orderly liquidation plan. But FDIC has no experience liquidating nonbank financial companies. To help bridge this gap, Title I of the Act rather ingeniously provides that the Federal Reserve must require certain financial companies (bank holding companies with at least $50 billion in assets and nonbank financial companies that are supervised by the Federal Reserve) to develop and submit plans to the Financial Stability Oversight Council, FDIC and the Federal Reserve for the company’s “rapid and orderly resolution” in the event of material financial distress or failure (so-called “living wills”). Living wills generally must include full descriptions of the company’s ownership structure, assets, liabilities, and contractual obligations, an identification of cross-guarantees tied to different securities, an identification of major counterparties, and a process for determining to whom the collateral of the company is pledged. The living wills required to be submitted by certain financial companies under Title I will provide FDIC with a blueprint for their liquidation in an OLA receivership. No bailouts permitted; company must be liquidated. Title II intends to end the “too big to fail” doctrine and taxpayer bailouts of large financial institutions. Although FDIC is authorized to take over large, systemically significant nonbank financial companies and administer their liquidation, the federal government is not supposed to foot the bill. Specifically, Section 214 requires that covered financial companies put into FDIC receivership be liquidated. No taxpayer funds may be used to prevent the liquidation of a covered financial

company. Any funds expended by the government in administering the liquidation are to be recovered in the first instance from the disposition of the failed company’s assets. If they are not, the other systemically significant financial companies are to be charged the costs of the liquidation through assessments. In carrying out an OLA liquidation of a covered financial company, FDIC is to determine that all actions it takes are necessary for purposes of the financial stability of the United States, and not for the purpose of preserving the covered financial company. FDIC is expressly prohibited from taking an equity interest in or becoming a shareholder of any failed financial company. Liquidation of brokers and dealers. The liquidation procedures applicable to a covered financial company which is a “covered broker or dealer”8 differ from those applicable to other types of covered financial companies. For one, FDIC, as receiver, must appoint the Securities Investor Protection Corporation (“SIPC”) to act as trustee for the liquidation of the covered broker or dealer under the Securities Investor Protection Act of 1970 (15 U.S.C. §78aaa et seq.) (“SIPA”). In general, the powers and duties afforded to the SIPC as trustee, and the rules and procedures applicable to the liquidation of a covered broker or dealer, are governed by SIPA, rather than Title II. Treatment of Subsidiaries. Once appointed the receiver of a covered financial company, FDIC may seize, and appoint itself as receiver of, any U.S. subsidiary of such company (other than a bank or insurance company) if FDIC and the Treasury Secretary jointly determine that: (i) the subsidiary is in default or in danger of default; (ii) the action would avoid or mitigate serious adverse effects on U.S. financial stability or economic conditions; and (iii) the action would facilitate the orderly liquidation of the covered financial company. As receiver of a covered subsidiary, FDIC has the same powers and rights with respect to the subsidiary as it does with respect to the covered financial company.

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Administration of the Receivership Estate by FDIC. In general. The rules applicable to the resolution of a covered financial company under Title II are largely but not completely patterned after those applicable to the resolution of a bank under the FDI Act. In a number of places, provisions of the Bankruptcy Code have been retained for OLA proceedings (e.g., to generally allow recovery of preferences). Upon appointment, FDIC as receiver succeeds to all rights, titles, powers, and privileges of the failed financial company, and has the general authority to operate the company’s business, exercise all of its corporate powers, and liquidate and wind up its affairs. In liquidating the company, FDIC must recognize all legally enforceable and perfected security interests and all legally enforceable security entitlements in respect of the company’s assets. FDIC can utilize resolution procedures it deems appropriate to administer an orderly liquidating authority receivership, including sale of the company’s assets, merging it with another company or transferring its assets and/or liabilities to an existing company or a new “bridge financial company” established for such purpose. FDIC can take such actions without obtaining any judicial or other approval or consent, but subject to any Federal agency approval and Federal antitrust review. In disposing of receivership assets, FDIC is directed to choose the course of action that, to the greatest extent possible, maximizes the net present value return from the sale or disposition of those assets, minimizes the amount of any loss, mitigates the potential for serious adverse effects to the financial system, ensures timely and adequate competition and fair and consistent treatment of offerors and prohibits discrimination on the basis of race, sex, or ethnic group in the solicitation and consideration of offers. Authority to establish bridge financial companies. FDIC, as receiver, is authorized to organize bridge financial companies to hold assets of a covered financial company until they can be liquidated. This authority tracks to the power FDIC has to establish

bridge banks to facilitate the disposition of a failed bank’s assets in a bank receivership. Notice of receivership and determination of claims. After its appointment as receiver, FDIC is charged with notifying creditors and potential claimants to file claims by a bar date which must be at least 90 days after the date on which notice is published. Notice is to be published three times, at monthly intervals. FDIC is also required to mail notice directly to any creditor shown on the books and records of the covered financial company. Section 210(a)(3) of Title II gives FDIC the power to allow or disallow claims in a receivership and sets out the exclusive process by which unsecured claims in the receivership are to be presented and determined. A potential claimant must generally file a proof of claim with FDIC within 90 days after notice is published. FDIC has 180 days to allow or disallow the claim. FDIC can disallow any claim which is not proved to its satisfaction. If the claim is disallowed, the creditor has 60 days to file suit or seek administrative review in the district or territorial court of the United States for the district within which the principal place of business of the financial company is located. If FDIC, as receiver, does not determine a claim within 180 days of filing, it is automatically deemed disallowed. Creditors in an orderly liquidated authority proceeding who do not follow the statutory claim process set forth in section 210(a) will have their claims barred and have no further recourse against FDIC. Expedited processing of claims is available to certain secured creditors if the ordinary claims procedure would cause irreparable injury. Claims are allowed if they are timely filed and proved to the satisfaction of FDIC as receiver. The statutory superpowers granted FDIC as receiver of a failed financial company may make it quite difficult to successfully assert a claim against the receivership estate. Further, even where a claim is allowed, damages are generally limited. Moreover, given the provisions governing the priority and payment of claims, discussed below, a general unsecured creditor will be unlikely to recover its entire allowed claim.

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Payment of allowed claims. FDIC may, in its discretion and to the extent funds are available, pay allowed, authorized or judicially recognized claims. All claimants of a covered financial company that are similarly situated under the priority of claims set forth below are to be treated in a similar manner unless FDIC determines that (i) other treatment is necessary to maximize the value of the company’s assets and (ii) all claimants that are similarly situated receive not less than the amount that they would have received in a Chapter 7 bankruptcy proceeding, or any similar provision of state insolvency law applicable to the covered financial company. FDIC can also make additional payments to any claimant or category of claimants if it determines that such payments are necessary or appropriate to minimize losses to FDIC as receiver; provided that no claimant may receive more than the face value of its claim. Claimants receiving additional funds pursuant to these sections are subject to “recoupment assessments,” described above. Priority of expenses and unsecured claims. Expenses and allowed unsecured claims in an OLA proceeding are paid in the following order of priority, to the extent funds are available:

i) Repayment of post-receivership financing obtained by FDIC as receiver on behalf of the financial company (to be obtained only if unsecured credit is not available from commercial sources);

ii) Administrative expenses of the receiver;

iii) Any amounts owed to the United States, unless the United States agrees or consents otherwise;

iv) Wages, salaries, or commissions, including vacation, severance, and sick leave pay earned by an individual (other than a senior executive or director) in an amount up to $11,725 per person (adjusted for inflation) earned not later than 180 days before the appointment of FDIC as receiver;

v) Contributions owed to employee benefit plans arising from services rendered not later than 180 days before the date of appointment of FDIC as receiver, in an amount up to $11,725 per employee covered by each such plan (adjusted for inflation) less the aggregate amount paid to such employee under subparagraph (iv), plus the aggregate amount paid by the receivership on behalf of such employee to any other employee benefit plan;

vi) Any other general or senior liability of the covered financial company other than those described below (i.e., allowed claims of general, unsecured creditors);

vii) Any obligation subordinated to general creditors that is not described below;

viii) Any wages, salaries, or commissions, including vacation, severance, and sick leave pay earned, owed to senior executives and directors of the covered financial company; and

ix) Any obligation to equity holders of the covered financial company arising as a result of their status as equity holders.

Unsecured claims of the United States shall, at a minimum, have a higher priority than liabilities of the covered financial company that count as regulatory capital.

“Special Powers” Granted to FDIC as Receiver. Title II grants FDIC a number of special powers as receiver in an OLA proceeding which can be used to limit or defeat both affirmative claims and defenses asserted by counterparties to the failed financial company or FDIC as its receiver. In large part, these powers are similar to those granted to FDIC when acting as receiver of a failed bank under the FDI Act. A number of powers, however, such

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as those applicable to the avoidance of preferential transfers and related transferee rights and defenses, are instead modeled after provisions of the Bankruptcy Code. Some of the most significant powers granted to FDIC under Title II are discussed below. Repudiation of contracts. One of the most important powers granted to FDIC is the authority to repudiate contracts or leases to which the company is a party. FDIC can repudiate such agreements within a “reasonable period” following its appointment if it: (i) deems performance of the contract or lease to be “burdensome”; and (ii) determines that repudiation or disaffirmance of the contract or lease would promote the orderly administration of the company’s affairs. In general, the damages recoverable against FDIC for repudiating a contract are limited to the counterparty’s actual direct, compensatory damages. Consequential damages for lost profits, punitive damages and pain and suffering are barred. Special rules apply in the case of damages arising from the repudiation of qualified financial contracts, debt obligations, certain contingent obligations and leases to which the covered financial company is a party. The broad power granted to FDIC to repudiate contracts does not authorize it to set aside (i) any legally enforceable or perfected security interest in any of the assets of any covered financial company, except for certain avoidable fraudulent and preferential transfers, or (ii) any legally enforceable interest in customer property, security entitlements in respect of assets or property held by the covered financial company for any security entitlement holder. Enforcement of contracts. The Act would grant FDIC power to enforce most contracts (other than a qualified financial contract) notwithstanding a so-called “ipso facto” clause allowing the counterparty to the covered financial company to terminate or accelerate the contract or exercise any other right solely by reason of the company’s insolvency or receivership. FDIC is also entitled to enforce contracts of subsidiaries or affiliates of a covered financial company. No third party is permitted to enforce a contract against FDIC, as receiver, during the first 90 days of the

receivership. As under the FDI Act, special rules apply to the enforcement of qualified financial contracts. Avoidance of fraudulent and preferential transfers. FDIC, as receiver, would have the ability to avoid a transfer or obligation made or incurred by the company within two years prior to FDIC’s appointment if (i) the transfer was made or the obligation was incurred with the intent to hinder, delay, or defraud the company or the company did not receive a reasonably equivalent value in exchange for such transfer or obligation, and (ii) at the time the transaction occurred, the company was or became insolvent, was significantly undercapitalized or would not be able to pay its debts when due, or the transaction was for the benefit of an insider under an employment contract not in the ordinary course of business. As receiver, FDIC could avoid certain preferential transfers made (i) to or for the benefit of a creditor, (ii) for or on account of an antecedent debt owed by the company, (iii) while the company was insolvent, (iv) within the 90 days preceding the appointment of FDIC (or within one year where the creditor was an insider), and (v) that enable the creditor to receive more than the creditor would receive if the transfer had not been made, the company had been liquidated under the Bankruptcy Code and the creditor received payment of such debt to the extent provided by the Bankruptcy Code. The power to avoid preferential transfers is a significant addition to FDIC’s powers in an OLA receivership. FDIC has no similar power to avoid preferences when acting as the receiver of a failed bank under the FDI Act. Improperly documented side agreements. No agreement which tends to defeat or diminish FDIC’s interest in an asset is valid unless it: (i) is in writing; (ii) was executed by an authorized officer or representative of the financial company, or confirmed in the ordinary course of business; and (iii) has been continuously from time of execution an official record of the company or the party claiming under the agreement provides documentation, acceptable to FDIC, of such agreement and its authorized execution or

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confirmation by the financial company. This rule is similar to the so-called D’Oench, Duhme doctrine which is available to FDIC under the FDI Act; however, the variation set forth in Title II is not as protective to FDIC.

Unanswered Questions. By preempting the application of the Bankruptcy Code, Title II changes the rules governing the insolvency of covered financial companies. But the special OLA resolution process will apply to the insolvency of only a handful of “covered financial companies.” The resolution of most financial company insolvencies will continue to be determined under the federal Bankruptcy Code. Moreover, any reorganizations of covered financial companies would have to take place under the Bankruptcy Code, as opposed to an FDIC conservatorship process. The uncertainty as to how and when Title II will apply to a financial company insolvency may leave many unanswered questions for financial companies and their counterparties. Title II directs FDIC, in consultation with the Financial Stability Oversight Council, to promulgate regulations implementing Title II with respect to the rights, interests, and priorities of creditors, counterparties, security entitlement holders, or other persons doing business with a covered financial company. To the extent possible, FDIC is directed to harmonize these regulations with the existing insolvency laws that would otherwise apply to a covered financial company. FDIC regulations will undoubtedly help rationalize the broad resolution powers authorized by Title II to end “too big to fail” with existing law. Whether Title II will effectively end “too big to fail” may not be answered for many years. Many commenters, including former FDIC Chairman William Isaac, continue to believe that the U.S. government will, as a practical matter, prefer to support a “too big to fail” financial company rather than risk the economic consequences of utilizing an insolvency OLA process that inflicts prompt and severe distress upon the many counterparties dealing with that company. Certainly, the Act’s failure to provide a funding mechanism to pay for the anticipated cost of an OLA resolution of a “too big to fail” company until the financial system is at considerable risk indicates that Title II’s solution to

“too big to fail” may not have effectively mitigated the problem. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.


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1 Title I of the Act allows the Financial Stability Oversight Council to require, by a two-thirds vote, any nonbank financial company to be supervised by, and registered with, the Federal Reserve if it determines, based on certain enumerated criteria, that material financial distress at the company or the nature, scope, size, scale, concentration, interconnectedness or the company’s mix of activities could pose a threat to U.S. financial stability. A “nonbank financial company” is any company (other than a BHC or a Farm Credit System institution or a national securities exchange (or parent thereof), clearing agency (or parent thereof, unless the parent is a BHC), security-based swap execution facility, or security-based swap data repository registered with the SEC, or a board of trade designated as a contract market (or parent thereof), or a derivatives clearing organization (or parent thereof, unless the parent is a BHC), swap execution facility or a swap data repository registered with the CFTC) that is predominantly engaged (i.e., 85% of revenues or assets) in financial activities. Upon the Council’s determination, any such company is a “nonbank financial company supervised by the Federal Reserve” for purposes of Title II. Once made, the Council’s determination is to be reevaluated annually and can be rescinded by a two-thirds vote. 2 For this purpose, no company is considered to be predominantly engaged in activities that are financial in nature or incidental thereto if the consolidated revenues of the company from such activities (including those from the ownership of a depository institution) constitute less than 85% of the company’s total consolidated revenues. 3 A “financial company” without a designation as a “covered financial company” by the Treasury Secretary is not subject to the OLA resolution process and can seek protection and reorganize under the Bankruptcy Code. A company with the designation, however, cannot and must be liquidated by FDIC. 4 In the case of a covered financial company which is an insurance company, or any insurance company subsidiary of a covered financial company, the Treasury Secretary’s determination does not cause the insurance company to be

put into a FDIC receivership. Instead, its liquidation is conducted in accordance with applicable state law. If, however, within 60 days of the Treasury Secretary’s determination, the applicable state regulator has not taken appropriate judicial actions to commence the liquidation proceedings, FDIC has backup authority to stand in the regulator’s place and file the appropriate judicial action in state court. 5 The Secretary is also likely to require that the company also be a bank holding company with more than $50 billion in consolidated assets or found to be “systemically important” by the Financial Stability Oversight Council under Title I. 6 The Secretary must also provide written notice to Congress within 24 hours of any determination to invoke the OLA process and the reasons for taking such action. 7 Proposals for an Orderly Liquidation Fund to be prospectively funded with $50 billion in premium assessment were politically controversial and were removed from the Act prior to approval. 8 A “covered broker or dealer” is a financial company which is a broker or dealer and is registered with the SEC under section 15(b) of the Securities Exchange Act of 1934 (15 U.S.C. §78o(b)) and is a member of the Securities Investor Protection Corporation.


July 19, 2010 Authors: Nanci L. Weissgold [email protected] +1.202.778.9314 Kerri M. Smith [email protected] +1.202.778.9445 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

HVCC’s Sunset and Other Appraisal Reforms on the Horizon K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. Congress is poised to eliminate the contentious Home Valuation Code of Conduct, (the “HVCC”), and with the HVCC set to sunset, more expansive (and expensive) appraisal reforms are on the horizon. Tucked within the massive Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) are provisions that will strengthen appraiser independence and enforcement, regulate the use of broker price opinions (“BPOs”), set standards for pricing of appraisals and appraiser valuation model products (“AVMs”), and subject appraisal management companies (“AMCs”) to potential federal and state oversight. The Mortgage Reform and Anti-Predatory Lending Act (the “Mortgage Reform Act”), Title XIV to the Dodd-Frank Act, will create enforceable federal appraisal independence standards within the Truth in Lending Act (“TILA”) and amend existing appraisal requirements contained in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”). Other K&L Gates client alerts will describe the abundant other provisions in the Mortgage Reform Act and the larger Dodd-Frank Act relating to residential mortgage lending, including the creation of the new Consumer Financial Protection Bureau (the “Bureau”), the imposition of new mortgage loan origination and servicing requirements, the dilution of federal preemption of state laws for national banks (and the remaining entities with federal thrift charters) and their operating subsidiaries, and the consequences of the new “skin in the game” requirements under the new risk retention rules. In addition, other alerts from K&L Gates will address other aspects of financial reform in the Dodd-Frank Bill on the K&L Gates web site specially dedicated to Financial Services Reform. The new TILA appraisal independence standards, similar to the HVCC’s restrictions, will prohibit the parties involved in residential real estate transactions from influencing the independent judgment of an appraiser through collusion, coercion, and bribery, among other activities. Unlike the HVCC, however, the Mortgage Reform Act does not expressly bar mortgage loan originators from ordering appraisals, although it preserves the ability for regulators to do so by regulation. While the HVCC may be fading into the sunset, don’t expect the same fate for AMCs, AVMs, and BPOs. If you recall, the HVCC originated from an executed settlement among New York Attorney General Andrew Cuomo, the Federal Housing Finance Agency, Fannie Mae, and Freddie Mac (collectively the “GSEs”), that codified an appraiser code of conduct by contract.1 The HVCC, effective May 1, 2009, applies to mortgage lenders that sell residential mortgage loans, i.e. conventional loans to the GSEs. 2





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To avoid violating the HVCC’s ban on relying on appraisers “selected, retained, or compensated in any manner” by mortgage brokers, real estate agents or any other third party, lenders have continued their use of appraisals from AMCs, in part because these companies act as intermediaries between the lender and appraiser. Critics of AMCs suggest that appraisals are being performed by people who do not have geographic proximity to the property to be appraised, lack the detailed, “hands on” knowledge of the geographic areas to conduct a quality appraisal, and that AMCs are forcing appraisers to accept less than the reasonable market value for their work. As a result of the Mortgage Reform Act, AMCs, subject to certain exceptions, will be subject to registration and state and federal oversight (with similarities to the Nationwide Mortgage Licensing System (“NMLS”) established for loan originators), and fee appraisers must be paid “reasonable and customary” fees by AMCs, reflecting what the appraiser would typically be paid for the assignment absent the involvement of an AMC, with violations subject to harsh penalties under TILA.

I. Appraisal Independence Currently, creditors, mortgage brokers and their affiliates engaged in mortgage origination of residential mortgage loans secured by the consumer’s principal dwelling are subject to the appraisal standards of the Federal Reserve Board (“FRB” or “the Board”), found in a final rule (“FRB Rule”) implementing TILA, effective on October 1, 2009.3 The FRB Rule was promulgated not pursuant to specific authority under TILA to regulate appraisals but pursuant to TILA’s broad authority to adopt regulations that prohibit, in connection with residential mortgage loans, acts or practices that the Board finds unfair or deceptive.4 In addition, federally regulated institutions are also subject to the appraisal standards in FIRREA, and the banking agency regulations and guidelines prescribing rules on appraisals. Presumably, the current regulations and Interagency Appraisal and Evaluation Guidelines5 (“Interagency Guidelines”) will be modified in response to the joint rulemaking mandate of the Mortgage Reform Act. The Mortgage Reform Act provides new appraiser independence standards in a stand-alone section within TILA, Section 129E. Their purpose is to strengthen the independence of appraisers from any

improper, coercive influences of loan transaction insiders, and to establish standards governing conflicts of interest. The FRB is charged with issuing interim final regulations further specifying acts or practices that violate appraisal independence and defining any term in Section 129E no later than 90 days after the Mortgage Reform Act’s enactment. Presumably, the current FRB Rule will be modified in response to this mandate. Significantly, civil penalties are available against “each person” who violates Section 129E. For a first violation, a person would be subject to a civil penalty of $10,000 for each day the violation continues. For any subsequent violations, a person would be subject to a civil penalty of $20,000 each day the violation continues. These civil penalties are in addition to the “enforcement provisions referred to in section 130 [of TILA].” The Mortgage Reform Act also adds several appraisal related provisions which apply only to “higher-risk mortgages,” found in another new section of TILA, 129H, described in more detail below. Both sections 129E and 129H would be considered “enumerated consumer laws” and would be assigned to (or transferred to) the new Bureau. (For more information on the Bureau’s enforcement authority, see our earlier client alert, Consumer Financial Services Industry, Meet Your New Regulator.) According to the new legislation, the HVCC will sunset and “have no force and effect” when FRB prescribes its interim final regulations on appraisal independence due within 90 days of enactment. Further, the FRB, OCC, FDIC, NCUA, FHFA and the Bureau (hereinafter, the “federal agencies”) may:

• jointly issue regulations, interpretative guidelines, and general statements of policy with respect to acts and practices that violate appraisal independence.

• jointly issue regulations that would make appraisals portable between lenders for a consumer credit transaction secured by a 1-4 unit single family residence that is the principal dwelling of the consumer.


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A. Applicability Section 129E of TILA would make it unlawful in extending credit or in providing any services for a consumer credit transaction secured by the principal dwelling of the consumer to engage in any act that violates the appraisal independence standards, as set forth below. Section 129E of TILA does not expressly restrict lenders’ use of appraisals from certain sources. For that matter, these new appraisal requirements also do not expressly require or prevent lenders to accept an appraisal from a mortgage broker, loan originator, or other interested party. While a matter of contention in the Conference Committee, the insertion of language requiring lenders to accept appraisals ordered by mortgage brokers and loan officers was rejected. Through silence, Section 129E arguably permits lenders and the GSEs to continue to rely on AMCs as a means to provide independent appraisals, regardless of the HVCC’s elimination. Further, Section 129E preserves the ability of the Board to impose such restrictions between appraisers and loan officers, as prescribed by regulation. However, when promulgating the FRB Rule on appraisal standards, the Board expressly rejected the request to restrict lenders’ use of appraisals from certain sources. The preamble to that rule stated: “[a] few large banks and a financial services trade association suggested that the Board prohibit mortgage brokers from ordering appraisals, as the GSE Appraisal Agreements do. The Board declines to determine that any particular procedure for ordering an appraisal necessarily promotes false reporting of value.”6 B. Requirements and Prohibitions Under the new section 129E, the following violates appraisal independence:

Any appraisal of a property offered as security for repayment of the consumer credit transaction [] in which a person with an interest in the underlying transaction compensates, coerces, extorts, colludes, instructs, induces, bribes, or intimidates a person, appraisal management company, firm or other entity

conducting or involved in an appraisal, or attempts, to compensate, coerce, extort, collude, instruct, induce, bribe, or intimidate such a person, for the purpose of causing the appraised value assigned, under the appraisal, to the property to be based on any factor other than the independent judgment of the appraiser.

This “catch-all” provision, which closely resembles the parallel provision in the HVCC, prohibits a wide range of enumerated conduct toward not only a person “conducting” an appraisal, but anyone “involved in an appraisal.” The FRB Rule, by contrast, is narrower, as the catch-all provision only prohibits attempting to “coerce, influence or otherwise encourage” an appraiser. The FRB Rule is less inclusive because it directs the appraisal coercion provisions against certain specific parties (creditors, mortgage brokers or their affiliates), whereas the prohibitions found in the new TILA section apply more broadly to any person “extending credit” or “providing any services” in connection with the consumer credit transaction. The new TILA section also imposes a conflict of interest standard by prohibiting an appraiser conducting, and an AMC procuring or facilitating, an appraisal in connection with a consumer credit transaction secured by the principal dwelling of the consumer from having a direct or indirect interest, financial or otherwise, in the property or transaction involving the appraisal. The Interagency Guidelines for financial institutions is narrower than Section 129E, as it does not permit an appraiser to appraise any property in which the appraiser has an interest, direct or indirect, financial or otherwise, but is silent with regard to AMCs. Hopefully, the Board will confirm in its interim final regulations that an AMC affiliate of a lender does not have an indirect interest in the transaction merely as a result of its common ownership. Similar to the FRB Rule and the HVCC before it, the legislation attempts to address some of the vagueness concerns about what types of activities are prohibited, by providing examples of specific

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allowable and prohibited conduct. Compared to the HVCC, which lists ten examples of prohibited practices,7 the new TILA section provides three, in addition to the general “catch-all” provision above. Under the new appraisal independence requirements, the following actions are prohibited: (1) mischaracterizing or suborning a mischaracterization of the appraisal value of the securing property; (2) seeking to influence the appraiser or otherwise to encourage a targeted value to facilitate the making or pricing of the transaction; and (3) withholding or threatening to withhold timely payment for an appraisal report or for appraisal services rendered. The FRB Rule, on the other hand, enumerates five prohibited actions, with slightly more specificity than the new TILA section.8 Section 129E of TILA includes three examples of permitted activity already stated in the FRB Rule, although it would allow “any person with an interest in the real estate transaction,” including, but not limited to, a mortgage lender, mortgage broker, mortgage banker, real estate broker, AMC, or an employee of an AMC, to engage in the permitted behavior.9 For example, under the new TILA rule, a consumer may ask an appraiser to consider additional comparables, provide further detail, or correct errors. Overall, the legislation reiterates similar examples of allowable and prohibited conduct, but requires the Board to promulgate interim final regulations specifying acts or practices that violate appraisal independence within 90 days of the Mortgage Reform Act’s enactment. C. Mandatory Reporting of USPAP Noncompliance Section 129E would mandate that any “mortgage lender, mortgage broker, mortgage banker, real estate broker, AMC, employee of an AMC, or “any other person involved in a real estate transaction involving an appraisal in connection with a consumer credit transaction secured by the principal dwelling of a consumer” who has “a reasonable basis to believe” that an appraiser has failed to comply with the Uniform Standards of Professional Appraisal Practice (“USPAP”), is violating applicable laws, or is otherwise engaging in unethical or unprofessional conduct must report the matter to the applicable state appraisal boards. The Interagency Guidelines provide that financial institutions are “encouraged” to make referrals

directly to state appraisal board when an appraiser violates USPAP, or applicable state law, or engages in other unethical or unprofessional conduct. Upon the issuance of the Board’s interim final regulations, federally regulated institutions will need to follow the stricter requirements of TILA. Further, in these interim final regulations, hopefully the Board will clarify the meaning of the phrase “involved in a real estate transaction,” but it appears reasonable to interpret that provision to be limited to those who are directly involved with the origination of the transaction (and not, for example, an investor or other party who becomes connected with the transaction principally after the closing of the loan). This duty to tattle is subject to the remedies discussed below. D. Fees for Appraisers In addition to establishing appraisal standards, Section 129E requires that lenders and their agents must compensate fee appraisers10 (as opposed to staff appraisers) at a “customary and reasonable” rate for appraisal services in the market area of the property being appraised. The issue of “reasonable and customary” appraisal fees came to the forefront a few months ago when the Federal Housing Administration changed how appraisals must be ordered and required that appraisers’ fees should be reasonable and customary. According to Section 129E, evidence of a fee’s “reasonableness” may be established by objective third-party information, such as government agency fee schedules, academic studies, and independent private sector surveys, but not by assignment orders by known AMCs. Some contest that it is misleading to calculate “customary” fees by intentionally excluding AMCs from the analysis, as it omits approximately two-thirds of all of the appraisals done in the United States. In other words, how does one calculate bona fide market value when excluding comparables—rather ironic when talking about appraisers. The new law also suggests that the customary and reasonable fee may reflect the increased time, difficulty, and scope of the work required for a complex assignment. E. Penalties and Duty of Care Extending Credit While the new Section 129E does not explicitly impose a duty of care on appraisers with respect to consumers, it does prohibit a creditor from

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extending credit if the creditor “knows” at or before loan consummation of a violation of the appraisal independence requirements in connection with a transaction secured by the consumer’s principal dwelling, unless the creditor documents that it has acted with “reasonable diligence” to determine that the appraisal does not materially misstate or misrepresent the value of the dwelling. This is not a new requirement as the FRB Rule currently provides the same prohibition. Under the Commentary to the FRB Rule (which may inform how TILA’s prohibition will be interpreted), “reasonable diligence” means that the creditor must obtain a new appraisal. The FRB Commentary also states that a misstatement or misrepresentation about a dwelling’s value is not material if it does not affect the credit decision or the terms on which credit is extended. Civil penalties also are available against “each person” who violates Section 129E; they are not limited to creditors. For a first violation of Section 129E, a person would be subject to a civil penalty of $10,000 for each day a violation continues. Further, for subsequent violations the penalty increases to $20,000 per day. The assessment of these fees will be imposed by a federal banking agency under section 108(a) of TILA (until the enforcement authority is transferred to the Bureau), as applicable, or by the FTC under Section 108(c) (against those individuals not under the supervision of the entities named in Section 102(a)). The penalty provisions assert that these civil penalties are in addition to the “enforcement provisions referred to in Section 130,” which would appear to limit the applicability of other provisions referred to in Section 130. F. Effective Date for Section 129E The FRB is charged with issuing interim final regulations specifying acts or practices that violate appraisal independence and otherwise defining terms used in Section 129E no later than 90 days after the Mortgage Reform Act’s enactment. The Mortgage Reform Act generally states that a section of the Act will take effect when any required rulemaking process is complete and final regulations implementing the pertinent section become effective.

With respect to Section 129E, the FRB is charged with promulgating interim implementing regulations, and since this rulemaking authority may cover any aspect of Section 129E, arguably the section in its entirety will become effective upon the FRB’s promulgation of the interim final regulations. G. Higher-Risk Mortgages Section 129H of TILA is added to impose additional appraisal requirements in connection with the origination of “higher-risk” mortgages. A “higher-risk mortgage” is a residential mortgage loan secured by a principal dwelling that is: (1) not a qualified mortgage (as defined in Section 129C);11 and (2) a loan with an annual percentage rate that exceeds the average prime offer rate for a comparable transaction, as of the date the interest rate is set: (a) by 1.5 or more percentage points, in the case of a first-lien residential mortgage loan having an original principal obligation amount that is equal to or less than the Freddie Mac conforming loan amount for a residence of the applicable size, as of the date the interest rate is set; (b) by 2.5 or more percentage points, in the case of a first-lien residential mortgage loan having an original principal obligation amount that is more than the Freddie Mac conforming loan amount for a residence of the applicable size, as of the date the interest rate is set; and (c) by 3.5 or more percentage points, in the case of a subordinate-lien residential mortgage loan. A higher-risk mortgage does not include a reverse mortgage loan that is a “qualified mortgage.” Given the limitations on non-qualified mortgages in the ability to repay requirements of the Mortgage Reform Act and the risk retention provisions in the larger Dodd-Frank Act, a “higher-risk mortgage” could be aptly renamed a “higher likelihood of never being made mortgage.” Section 129H effectively prohibits BPOs or AVMs for the origination of a higher-risk mortgage by requiring a licensed or certified appraiser to conduct an appraisal by visiting the interior of the mortgage property. Further, if a higher-risk mortgage is used to finance the purchase of a mortgage property from a person within 180 days of that person’s purchase of the property at a price that was lower than the current sale price, the creditor must obtain a second appraisal from a different licensed or certified appraiser at no cost to the applicant. In addition to any other liability to any person under TILA, a

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creditor found to have willfully failed to obtain an appraisal as required by this section will be liable to the applicant or borrower for $2,000. A creditor must provide one copy of each appraisal in connection with a higher-risk mortgage to the applicant without charge, at least three days prior to the transaction closing date. Section 129H also indicates that a creditor must provide a disclosure to the applicant at the time of the initial loan application that the appraisal is for the sole use of the creditor, and given its placement in the statute, it appears limited to higher-risk mortgages, but this conclusion is not free from doubt. Further confusing the matter is that this disclosure may be inconsistent with forthcoming rules on portability. The federal agencies would be required to jointly prescribe regulations to implement the appraisal requirements for higher-risk mortgages and may jointly exempt, by rule, a class of loans if the federal agencies determine that the exemption is in the public interest and promotes the safety and soundness of creditors. According to the Mortgage Reform Act, a section or provision of the Act will generally not take effect until any required rulemaking process is complete, and final regulations implementing the pertinent section or provision are final. The rulemaking process must be finalized within 18 months of the “transfer date” (when the functions are transferred to the Bureau), and the final regulations must take effect within a year of their issuance. Since implementing regulations are required, it appears that Section 129H will take effect when the regulations are finalized.

II. Changes to FIRREA and Guidance on use of BPOs, AVMs, and Appraisal Reviews A. Background Twenty-one years ago, Congress enacted FIRREA in response to the S&L crisis.12 FIRREA instituted appraisal reforms designed to enhance the quality of appraisals. Title XI of FIRREA requires federal banking agencies to establish appraisal standards for “federally related transactions,” which are defined as those real estate-related financial transactions that a federal banking agency engages in, contracts for, or regulates and requires the services of an appraiser.13

Subsequent banking agency regulations and Interagency Guidelines prescribe rules concerning the selection and monitoring of appraisers, approaches that an appraiser should use, and which transactions do not require an “appraisal,”14 but do require at least an “evaluation.”15 For example, according to the federal banking agencies, the requirements to obtain a full appraisal are not required for residential mortgage loans that are less than $250,000, HUD- or VA-insured loans, and residential mortgage loans whose appraisals conform to Fannie Mae or Freddie Mac appraisal standards for that category of real estate.16 While the federal banking agencies already suggest when an “evaluation” rather than an “appraisal” is required, Congress wades in by proposing a set of circumstances where an “evaluation” by a broker is insufficient. B. Limitations on Broker Price Opinions FIRREA will be amended to provide that “in conjunction with the purchase of a consumer’s principal dwelling, broker price opinions [“BPOs”] may not be used as the primary basis to determine the value of a piece of property for the purpose of a loan origination of a residential mortgage loan secured by such piece of property.” The Mortgage Reform Act defines “broker price opinion” to mean “an estimate prepared by a real estate broker, agent, or sales person that details the probable selling price of a particular piece of real estate property and provides a varying level of detail about the property’s condition, market, and neighborhood, and information on comparable sales, but does not include an automated valuation model . . .” While the requirements of FIRREA are generally applicable to “federally related transactions,” the BPO restriction, on its face, applies more broadly to transactions involving “residential mortgage loans” secured by a “consumer’s principal dwelling.” While the Mortgage Reform Act would essentially prohibit the use of BPOs as the primary basis for determining market value for certain mortgage originations, BPOs would not be prohibited entirely. For example, it appears that BPOs could be used in refinancings, establishing home equity lines of credit, and in connection with loss mitigation and collection efforts, to the extent not prohibited by state law.

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C. Standards for AVMs The Mortgage Reform Act also adds a section to Title XI of FIRREA regarding quality control of AVMs. Advances in technology have prompted increased use of AVMs to derive values for residential transactions without resort to, or to supplement, an appraisal. The Home Affordable Mortgage Program, for example, authorizes AVMs (and BPOs) in lieu of appraisals to determine if a loan qualifies for a modification. Notably, the Mortgage Reform Act defines AVM to mean “any computerized model used by mortgage originators and secondary market issuers to determine the collateral worth of a mortgage secured by a consumer’s principal dwelling,” and obligates the federal agencies, in consultation with the Appraisal Subcommittee and the Appraisal Standards Board of the Appraisal Foundation to promulgate regulations to implement the quality control standards for AVMs. Such standards must, at a minimum: (i) achieve a high level of confidence in the estimates produced by AVMs; (ii) protect against the manipulation of data; (iii) seek to avoid conflicts of interest; and (iv) require random sample testing and reviews of AVMs (but the sampling does not expressly have to be carried out by a certified or licensed appraiser). Since the provision requires implementing regulations, it would appear that this provision would become effective upon the effective date of those future regulations. Interestingly, the federal agencies are responsible for enforcing compliance with the future quality control regulations for those entities they regulate, and the FTC, the Bureau and the state Attorneys General are responsible for enforcing compliance with the future quality control regulations for all other participants in the market for appraisals of “1-4 unit single family residential real estate.” Similar to the BPO provisions above, it appears that this section of FIRREA applies beyond “federally related transactions.” D. Appraisal Reviews The provision of FIRREA that requires federal banking agencies to prescribe appropriate standards for appraisals in connection with federally related transactions will be amended by the Mortgage Reform Act to add another minimum standard – that “the appraisal be subject to appropriate review for compliance with [USPAP].” During the Conference

Committee, additional language was stricken from this requirement, which previously conferred that all appraisal reviews for compliance with USPAP “including [an] appraisal review by a lender, AMC, or other third party organization, shall be performed by an appraiser who is duly licensed or certified by a State appraisal board.” The deletion leaves open the possibility that professionals who are not certified or licensed appraisers in the state where the property is located may participate in appraisal reviews, although the type of review may be relevant. This is a contentious issue among state regulators, and getting attention by investors. For example, the Fannie Mae Selling Guide currently allows a desk review by a non-licensed or certified appraiser for quality control purposes. But that will change as Fannie Mae recently issued a policy change effective September 1, 2010, that a desk review which results in a change of the opinion of market value for something other than a mathematical error must be completed by an appraiser licensed in the state in which the property is located, and he or she must have access to the appropriate data sources and must possess the knowledge and experience to appraise the subject property with respect to both the specific property type and geographical location.17

III. Appraisal Subcommittee’s New Role and Oversight of Appraisal Management Companies Title XI of FIRREA will be amended to establish a real estate appraiser regulatory system involving an interrelationship among the federal government, the states, and the Appraisal Subcommittee of the Federal Financial Institutions Examination Council (“Appraisal Subcommittee”). Each state has a certifying and licensing agency (“state appraisal board”) that is responsible for supervising their appraisers’ appraisal-related activities. The Appraisal Subcommittee generally has the authority to: (1) ensure that the state appraisal boards meet requirements to certify/license appraisers and enforce appraisal standards in connection with federally related transactions; (2) ensure that the federal banking agencies implement appraisal standards for federally related transactions; and (3)

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maintain a national registry for state certified and licensed appraisers. A. Appraisal Subcommittee’s New Role By amending FIRREA, the Mortgage Reform Act would bolster the authority of the Appraisal Subcommittee by giving it broad new powers and responsibilities to implement a regulatory framework to supervise the appraisal industry, including AMC’s. The Mortgage Reform Act would also add a representative from the FHFA and the Bureau to the board of the Appraisal Subcommittee. The legislation greatly expands the scope of the Appraisal Subcommittee’s responsibilities by authorizing it to:

• Monitor State Appraisal Boards. (1) Monitor the states’ registration and supervision of the operations of AMCs; (2) Determine whether the state completes investigations, appropriately disciplines sanctioned appraisers and AMCs, and reports complaints to the national registries on a timely basis; and (3) Determine whether the state has adopted effective laws aimed at maintaining appraiser independence.

• Maintain National Registry for AMCs. Impose an annual registry fee for AMCs, and may impose a minimum registry fee to protect against AMC underreporting.

• Take Disciplinary Action. (1) Remove an appraiser or a registered AMC from a national registry on an interim basis pending state action; and (2) Impose sanctions against state appraisal boards that fail to have “effective appraiser regulatory programs.”18

• Issue Regulations. Prescribe regulations on topics such as temporary practice, national registry, information sharing and enforcement.

• Establish Complaint Hotline and Encourage Appraiser Education. (1) Encourage states to accept pre-approved courses; (2) Establish an appraisal complaint hotline if it determines within 6 months that no national hotline exists; and (3) Follow up complaint referrals to state appraisal boards and federal regulators.

B. Oversight of Appraisal Management Companies AMCs – the business entities that administer networks of independent appraisers to procure real estate appraisal assignments on behalf of lenders - will soon become subject to a national registry and may become subject to supervision of state appraisal boards. The legislation would define the term “appraisal management company” to mean “in connection with valuing properties collateralizing mortgage loans or mortgages incorporated into a securitization, any external third party authorized either by a creditor of a consumer credit transaction secured by a consumer's principal dwelling or by an underwriter of or other principal in the secondary mortgage markets, that oversees a network or panel of more than 15 certified or licensed appraisers in a State or 25 or more nationally within a given year: (A) to recruit, select, and retain appraisers; (B) to contract with licensed and certified appraisers to perform appraisal assignments; (C) to manage the process of having an appraisal performed, including providing administrative duties such as receiving appraisal orders and appraisal reports, submitting completed appraisal reports to creditors and underwriters, collecting fees from creditors and underwriters for services provided, and reimbursing appraisers for services performed; or (D) to review and verify the work of appraisers.” We have started to see the enactment of state AMC registration laws. Currently, approximately 18 jurisdictions (12 of which were enacted in 2010) have enacted AMC registration laws and an additional eight or so jurisdictions currently have legislation pending. The definition of AMC in the federal law is similar to those found in state laws, although there are differences. For example, certain state laws may provide a de minimis exemption for AMCs (e.g. those that manage less than ten appraisals in a calendar year). Further, unlike the federal law, some of the state laws may not impose an exemption for AMCs that have less than a de minimis number of certified or licensed appraisers in their network. As described below, states must apply certain minimum standards in their registration of AMCs. Will the Appraisal Subcommittee consider a state that defines AMCs more narrowly than the Mortgage Reform Act to meet those minimum standards? A state appraisal

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board can face sanctions for failing to have “effective” appraiser regulatory programs. 1. National Registry of AMCs

In addition to new minimum requirements for AMCs, as set forth below, the legislation amends FIRREA to require the Appraisal Subcommittee to maintain a new national registry of AMC’s that includes AMCs that either are registered with and subject to supervision by a state appraiser or licensing agency or are subsidiaries owned and controlled by a federally regulated financial institution and regulated by a federal financial institution regulatory agency. This registry is in addition to the one for individual appraisers. To carry out the new functions of the Appraisal Subcommittee, the legislation provides authority for it to impose an annual registry fee on AMCs, in addition to the fees imposed on individual appraisers of federally regulated transactions.19 AMCs, both a state registered entity or a subsidiary of a federally regulated institution, would be required to pay an annual registration fee. For a company that has been in existence for more than one year, the AMC must pay $25 (which amount may be increased to $50 at the discretion of the Appraisal Subcommittee) multiplied by the number of appraisers working for or contracting with such company in such state during the previous year. For a newer AMC, the Appraisal Subcommittee would use a similar calculation, but would determine the appropriate multiple (rather than base it on the number of employees). It appears that the AMC, regardless of whether it is registered with the state or a subsidiary of a federally regulated entity, would pay this fee to the state for transmittal to the Appraisal Subcommittee. It is unclear how AMCs would have to report the number of appraisers working for or contracted by the AMC, in particular when appraisers may be licensed in multiple jurisdictions. What is clear is that this registry may impose a significant financial burden on AMCs. The legislation provides authority for further increases to these registry fees, upon approval if needed, and to adjust for inflation. Moreover, these registry fees may be in addition to those registration fees imposed under state AMC laws.

2. Minimum Requirements for AMCs

Under the new regulatory framework for AMCs, the federal agencies must jointly by rule establish minimum requirements to be applied by a state in its AMC registration. At a minimum, they must require that the AMC: (1) register with and be subject to supervision by a state appraisal board in each state where the company operates; (2) verify that only licensed or certified appraisers are used for federally related transactions; (3) require that appraisals coordinated by the AMC comply with the USPAP; and (4) require that appraisals are conducted independently and free from inappropriate influence any coercion pursuant to the appraisal independence standards under Section 129E of TILA. These requirements are the floor – states are not prohibited from establishing requirements beyond the minimum standards promulgated by the federal agencies. AMCs that are subsidiaries of a financial institution are subject to the above minimum requirements, although the Mortgage Reform Act expressly states that they would not need to register with the state appraisal boards. By inference, it appears, although it is not clear, that subsidiaries of federally regulated institutions would be subject to the supervision of their federal regulator, whereas non-federally regulated AMCs would be subject to the supervision of state appraisal boards. The legislation suggests that a state must implement a regulatory scheme for AMCs within three years of the federal agencies finalizing their rules establishing minimum requirements, subject to an extension by the Appraisal Subcommittee. In this regard, the legislation provides that no AMC may perform services related to a federally related transaction in a state after 36 months from final rulemaking implementing the minimum standards “unless such company is registered with such state or subject to oversight by a federal financial institution regulatory agency.” It appears that the Mortgage Reform Act contemplates two registration “tracks” – one for those subject to federal supervision and one subject to state supervision. While the Mortgage Reform Act describes a state appraisal board’s regulatory responsibilities with

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respect to AMC registration, which includes processing complaints, completing investigations, disciplining and sanctioning AMCs and reporting complaints of the AMC to the national registry, there is no parallel requirement in place for those AMCs not subject to state registration. Because the Mortgage Reform Act does not clearly establish any requirements on the federal agencies to enforce or supervise those AMC subsidiaries, there is an apparent gap in the statute. By contrast, in the loan originator context under the SAFE Act, the federal agencies are expressly charged with developing and maintaining a system for registering employees of federally regulated institutions with the NMLS. The Mortgage Reform Act indicates that subsidiaries of federally regulated entities would be subject to the national registry, but does not indicate how those entities would register. If they were registered with the state appraisal board, the board would be obligated to provide that information to the Appraisal Subcommittee. The federal agencies could, by regulation, create parallel requirements to ensure that AMCs are subject to uniform oversight. In addition to the minimum requirements noted above, the Mortgage Reform Act also imposes a restriction that an AMC cannot be registered by a state or included on the national registry if the company, in whole or in part, directly or indirectly is owned by any person who has had an appraisal license or certificate refused, denied, cancelled, surrendered in lieu of revocation, or revoked in any state. Owners of more than 10 percent of the company are subject to background investigations, and must be of good moral character, as determined by the state appraisal board, although it is unclear if this restriction applies to owners of AMCs that are not subject to state registration. Overall, it appears that the Mortgage Reform Act would attempt to ensure that those who commit appraisal fraud or those who lose their licenses or certificates cannot turn around and establish AMCs.

IV. Miscellaneous Changes The Mortgage Reform Act also makes changes to the Equal Credit Opportunity Act (“ECOA”) and an amendment to the Real Estate Settlement Procedures Act of 1974 (“RESPA”) regarding the disclosure of appraisal-related fees on the HUD-1 Settlement Statement (“HUD-1”).20

A. ECOA and Copies of Appraisal Reports Section 701(e) of ECOA currently requires a creditor to furnish an applicant for credit with a copy of the “appraisal report” used in connection with the applicant’s application for a loan, upon the applicant’s request. The Mortgage Reform Act amends this provision to make the furnishing of “any and all written appraisals and valuations” developed in connection with the application for a first-lien loan mandatory, rather than at the consumer’s request. It would also impose a specific time frame within which the copy must be provided (no later than three days prior to the closing of the loan, whether the creditor grants or denies the applicant’s request for credit or the application is incomplete or withdrawn). It would require a creditor to provide notification, at the time of application, to the applicant of the right to receive a copy of each written appraisal and valuation, and the creditor could not charge the applicant a fee for providing the copy. The Mortgage Reform Act would expand the statutory requirement to provide an “appraisal report” to cover “any and all written appraisals and valuations.” The definition of “appraisal report” under the current regulations of ECOA is arguably broad enough to include valuations, but the Mortgage Reform Act would clarify that such valuations, defined as “any estimate of the value of a dwelling developed in connection with a creditor’s decision to provide credit, including those values developed pursuant to a policy of a government sponsored enterprise or by an automated valuation model, a broker price opinion, or other methodology or mechanism,” would need to be provided to the borrower even if it is in addition to an appraisal. The requirement that a creditor provide an applicant with a copy of an appraisal report promptly or no later than three days prior to closing is similar to the timing requirements on higher-risk mortgages under Section 129H of TILA. Moreover, these amendments are nearly identical to the requirements regarding appraisal reports under the HVCC. According to the Mortgage Reform Act, a section or provision of the Act will generally not take effect until any required rulemaking process is complete, and final regulations implementing the pertinent section or provision are final. The amendments to

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ECOA do not expressly require that an agency issue implementing regulations, and thus the effective date is unclear.21 B. RESPA and HUD-1 Settlement Statement The legislation adds a new subsection to Section 4 of RESPA that permits the HUD-1 form to include, in the case of an appraisal coordinated by an appraisal management company, a clear disclosure of (i) the fee paid directly to the appraiser by the appraisal management company; and (ii) the administration fee charged by such appraisal management company. Prior to the House and Senate Committee meeting, the itemization of the fees paid by a borrower and the disclosure of the persons or entities receiving the fees were mandatory.

V. Conclusion With the HVCC set to sunset, more expansive (and expensive) appraisal reforms are on the horizon. Although Congress has paved the way for substantial appraisal reform, the full extent of Congress’ changes will not likely be known until the regulations on appraisal independence and the registration of AMCs are finalized and implemented. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.



San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d’Alene Taipei Tokyo Warsaw Washington, D.C. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. K&L Gates is comprised of multiple affiliated entities: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), in Tokyo, and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong; a Polish limited partnership (K&L Gates Jamka sp. k.) maintaining an office in Warsaw; and a Delaware limited liability company (K&L Gates Holdings, LLC) maintaining an office in Moscow. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners or members in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. ©2010 K&L Gates LLP. All Rights Reserved



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1 Laurence E. Platt, Lorna M. Neill, NYAG Leapfrogs Feds in Targeting Appraisals, Mortgage Banking Alert, March 10, 2008, available at: http://www.klgates.com/newsstand/Detail.aspx?publication=4375. 2See “Home Valuation Code of Conduct,” Federal Housing Finance Agency, available at http://www.ofheo.gov/media/news%20releases/HVCCFinalCODE122308.pdf. For more on the revised final Home Valuation Code of Conduct; see Phillip L. Schulman, Holly Spencer Bunting, Appraisal Industry Remains Intact: FHFA Announces Revised Home Valuation Code of Conduct, Mortgage Banking & Consumer Credit Alert, by January 13, 2009, available at: http://www.klgates.com/newsstand/Detail.aspx?publication=5218. 3 The rule was published in the Federal Register on July 30, 2008. 73 Fed. Reg. 44,522. To read more about the FRB Rule more generally, see Kristie D. Kully, Laurence E. Platt, Satisficing Subprime: New HOEPA Rules Might Just Be Good Enough, Mortgage Banking and Consumer Credit Alert, August 5, 2008, available at: http://www.klgates.com/newsstand/Detail.aspx?publication=4809. 4 See 15 U.S.C. § 1639 (l)(2). 5 See, e.g., Interagency Appraisal and Evaluation Guidelines (Oct. 27, 1994) (issued jointly by the OCC, FRB, FDIC, and OTS) found at: OCC: Comptroller’s Handbook, Commercial Real Estate and Construction Lending (1998) (Appendix E). 6 73 Fed. Reg. 44,522, 44566. 7 The Home Valuation Code of Conduct (“Code”) provides a lengthy and expressly non-exhaustive list of specific examples of prohibited conduct. See “Home Valuation Code of Conduct,” Federal Housing Finance Agency, available at http://www.ofheo.gov/media/news%20releases/HVCCFinalCODE122308.pdf. 8 The FRB Rule also presents “examples” of violations, which appear to be non-exhaustive: (1) Implying to an appraiser that retention of the appraiser depends on the amount at which the appraiser values the consumer’s home; (2) Excluding an appraiser from consideration for future engagement because the appraiser reports a value of consumer’s principal dwelling that does not meet or exceed a minimum threshold; (3) Telling an appraiser a minimum reported value of a consumer’s principal dwelling that is needed to approve the loan; (4) Failing to compensate an appraiser or to retain the appraiser in the future because the appraiser does not value a consumer’s principal dwelling; and (5) Conditioning an appraiser’s compensation on loan consummation. 9 Under section 129E of TILA, it is permitted to ask an appraiser to provide one or more of the following services: (1) Consider additional, appropriate property information, including the consideration of additional comparable properties to make or support an appraisal; (2) Provide further detail, substantiation, or explanation for the appraiser’s value conclusions; and (3) Correct errors on the appraisal report. Under the FRB Rule, a creditor, mortgage

broker, or its affiliate may also: (1) Obtain multiple appraisals of a consumer’s principal dwelling, so long as the creditor adheres to a policy of selecting the most reliable appraisal, rather than the appraisal that states the highest value; (2) Withhold compensation from an appraiser for breach of contract or substandard performance of services as provided by contract; and (3) Taking action permitted or required by applicable federal or state statute, regulation, or agency guidance. 10 Section 129E provides that the term “fee appraiser” means a person who is not an employee of the mortgage loan originator or AMC engaging the appraiser and is: (1) a state licensed or certified appraiser who receives a fee for performing an appraisal and certifies that the appraisal has been prepared in accordance with the USPAP; or (2) a company not subject to the requirements of FIRREA that utilizes the services of state licensed or certified appraisers and receives a fee for performing appraisals in accordance with the USPAP. 11 A “qualified mortgage” means any closed-end residential mortgage loan for which all the following apply: (i) The regular periodic payments for the loan may not: (I) Result in an increase of the principal balance; or (II) Except for certain balloon loans, described below, allow the consumer to defer repayment of principal; (ii) The terms of the loan do not result in a balloon payment (i.e., a scheduled payment that is more than twice as large as the average of earlier scheduled payments), except under certain circumstances; (iii) The income and financial resources relied upon to qualify the obligors on the loan are verified and documented; (iv) In the case of a fixed rate loan, the underwriting process is based on a payment schedule that fully amortizes the loan over the loan term and takes into account all applicable taxes, insurance, and assessments; (v) In the case of an adjustable rate loan, the underwriting is based on the maximum rate permitted under the loan during the first 5 years, and a payment schedule that fully amortizes the loan over the loan term and takes into account all applicable taxes, insurance, and assessments; (vi) The loan complies with any guidelines or regulations the Board establishes relating to ratios of total monthly debt-to- income or alternative measures of ability to pay regular expenses after payment of total monthly debt, taking into account the borrower’s income levels and such other factors the Board establishes; (vii) The total points and fees payable in connection with the loan do not exceed 3 percent of the total loan amount (the Board is required to prescribe a points and fees threshold for “smaller loans” to meet the requirements of this presumption, considering the potential impact on rural areas and other areas where home values are lower); and (viii) The loan term does not exceed 30 years, except as such term may be extended under certain circumstances, such as in high-cost areas. 12 Pub. L. No. 101-73, 103 Stat. 183 (1989). 13 12 U.S.C. § 3350(4). 14 “Appraisal” is defined as “a written statement independently and impartially prepared by a qualified appraiser setting forth an opinion as to the market value of an adequately described property as of a specific date(s), supported by the presentation and analysis of relevant market information.” 12 C.F.R. §§ 225.62(a), 323.2(a), 34.42(a), 564.2(a). 15 The federal banking agencies have determined that “[a] formal opinion of market value prepared by a State licensed or certified appraiser is not always necessary.” See, e.g., 12 C.F.R. §§ 225.63(b), 323.3(b), 34.43(b), 564.3(b).


http://www.ofheo.gov/media/news%20releases/HVCCFinal



http://www.ofheo.gov/media/news%20releases/HVCCFinal

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16 See 12 C.F.R. §§ 225.63(a), 323.3(a), 34.43(a), 564.3(a). 17 See Fannie Mae Ann. SEL-2010-09: Selling Guide Updates and Additional Guidance on Appraisal-Related Policies (6/30/2010); see also 2010 Fannie Mae Selling Guide/B4-1.4-21, Appraisal Report Review: Valuation Analysis and Final Reconciliation (06/30/2010); 2010 Fannie Mae Selling Guide/D1-3, Lender Post-Closing QC Mortgage Review. 18 A program’s effectiveness would be based on “an analysis of the licensing and certification of appraisers, the registration of appraisal management companies, the issuance of temporary licenses and certifications for appraisers, the receiving and tracking of submitted complaints against appraisers and appraisal management companies, the investigation of complaints, and enforcement actions against appraisers and appraisal management companies.” 19 The Mortgage Reform Act also raises the annual registry fee for individual appraisers from a fee not to exceed $25 to a fee not to exceed $40. 20 The Mortgage Reform Act also tasks the Government Accounting Office with the conduct of two studies, one involving the improvements in the appraisal process and the effects of the changes to the appraisal requirements of the Home Valuation Code of Conduct on the industry, and, the second involving the ability of the Appraisal Subcommittee to monitor and enforce state and federal certification requirements and standards. The Government Accounting Office must provide a report on the first study within 12 months of the enactment of the Mortgage Reform Act, as well as a report on the second study within an 18-month period. 21 On the one hand, the Mortgage Reform Act says that any section of the Mortgage Reform Act “for which regulations have not been issued on the date that is 18 months after the designated transfer date shall take effect on such date.” This would seem to say that those provisions of the Mortgage Reform Act that do not specifically require the applicable regulator to adopt implementing regulations do not become effective until 18 months after the designated transfer date, unless the applicable regulator decides to adopt regulations to implement the provisions anyway, and specifies an earlier effective date in those regulations. On the other hand, others have asserted that the foregoing effective date applies only to those provisions of the Mortgage Reform Act for which the applicable regulator is required to issue regulations. This would mean that the provisions for which a regulator is not required to issue regulations (either because regulations are authorized, but not required, or the section is silent with respect to implementing regulations) would be subject to the Dodd-Frank Act’s default effective date - which is the day after the President signs the bill. This would be an alarming and unreasonable result given the time it would take to implement the many statutory requirements in an orderly manner.

Originally Published July 20, 2010 Updated July 22, 2010 Authors: Rebecca H. Laird [email protected] +1.202.778.9038 Sean P. Mahoney [email protected] +1.617.261.3202 Collins R. Clark [email protected] +1.202.778.9114 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

A New Era: Depository Institutions and Their Holding Companies Face a Deluge of Regulatory Changes K&L Gates originally published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. On July 21, 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act” or “Act”), which restructures the regulatory framework for most banking organizations. Although the full impact of the Dodd-Frank Act cannot be assessed until implementing regulations are released, depository institutions and their affiliates face new regulators, increased activities restrictions and capital requirements, and numerous other fundamental changes in how they are regulated. The most significant changes promised by the Dodd-Frank Act that directly affect most depository institutions are the abolition of the Office of Thrift Supervision (“OTS”) with reallocation of supervisory responsibilities among the remaining regulators and the Volcker Rule. The Volcker Rule imposes new limitations on proprietary trading and permissible private equity fund and hedge fund activities of regulated organizations. The Dodd-Frank Act also provides for many more less significant changes to affiliations among commercial and non-commercial firms, expansionary activities, lending limits, capital rules, deposit rules, stress test requirements, and modification of savings and loan holding company rules.

Abolition of the OTS and Changes to Supervisory Authority The transfer of OTS powers will take place within one year to 18 months after enactment of the Dodd-Frank Act, and the OTS will be officially abolished 90 days after the transfer.1 Consequently, supervisory responsibilities for depository institutions and their holding companies will be reordered to reflect a simpler, more logical scheme. The Board of Governors of the Federal Reserve System (“Federal Reserve”) will become the federal regulator of all holding companies—financial holding companies, bank holding companies, and savings and loan holding companies.2 All depository institutions chartered under federal law (i.e., national banks and federal thrifts) will be regulated by the Office of the Comptroller of the Currency (“OCC”), where a Deputy Comptroller will be appointed to oversee federal thrifts.3 All state thrifts and state non-member banks will be regulated by the Federal Deposit Insurance Corporation (“FDIC”).4 1 Sections 311 and 313. 2 Section 314. 3 Section 312. 4 Id. The FDIC will have supervisory authority over state-chartered savings associations but the regulatory authority of the OTS, with regard to state-chartered savings associations, will be transferred to the OCC.





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The Federal Reserve will retain regulatory and supervisory authority over state-chartered banks that are members of the Federal Reserve System. All existing OTS regulations and orders will remain in effect, until modified, terminated or superseded, but they will be enforceable by the agencies regulating the affected institutions.5 The Dodd-Frank Act also provides increased authority and autonomy for the remaining federal bank regulators. The OCC will have discretion to set fees and keep the revenues, which are not subject to the appropriation process.6 The FDIC will no longer have to obtain the agreement of the other federal banking agencies in order to require reports from insured institutions. Instead, the FDIC will only have to consult with the other agencies prior to requiring such reports. The Federal Reserve will have increased supervisory powers over financial holding companies, bank holding companies, and savings and loan holding companies, including increased examination and reporting authority over all subsidiaries.7 If the Federal Reserve fails to conduct examinations of a nonbank subsidiary, the federal bank regulator with supervisory authority over the lead depository institution of the organization has back-up authority to examine and take enforcement action against the nonbank subsidiary. Thus, activities of bank affiliates that have previously been subjected only to the umbrella regulation of the Federal Reserve may now become subject to more stringent supervision and examination. In order to pay for its additional supervisory authority over large holding companies, the Federal Reserve will be required to assess fees from holding companies having assets of $50 billion or more, as well as systemically significant nonbank financial companies.8 5 Id. 6 Section 318. 7 Section 605 requires the Federal Reserve to conduct examinations of holding company subsidiaries that are not insured depository institutions (excluding functionally regulated entities) that are engaged in activities permissible for insured institutions. Section 604 authorizes the Federal Reserve to take a more active role in examining functionally regulated subsidiaries. 8 Section 318.

Volcker Rule The “Volcker Rule,” which refers to a new Section 13 of the Bank Holding Company Act (“BHCA”),9 is perhaps one of the most discussed reforms governing banking organizations in the Act. These provisions place significant limitations, including capital requirements, on proprietary trading, sponsoring or investing in hedge funds, private equity funds or similar funds by “banking entities” and other systemically significant organizations regulated by the Federal Reserve. Banking Entities The Volker Rule’s restrictions are styled as general prohibitions on “banking entities” and additional capital requirements and possible quantitative limits for systemically significant organizations regulated by the Federal Reserve. Banking entities are defined broadly to include FDIC-insured institutions, any entity that controls an FDIC-insured institution, entities treated as bank holding companies (i.e., certain foreign banks), or any affiliates of the foregoing. FDIC-insured institutions include not only commercial banks, savings banks, cooperative banks and thrifts, but also industrial loan companies and credit card banks. Non-depository trust companies, which are not FDIC-insured, or those FDIC-insured trust companies that comply with the trust company exemption under the BHCA, are not included within the definition, unless they are affiliated with a banking entity. In addition, a “banking entity” includes any company that controls an insured institution. Thus along with bank and savings and loan holding companies, the parent holding companies of industrial loan companies and credit card banks are included within the definition of “banking entity.”

9 See Section 619 of the Dodd-Frank Act, which contains the Volcker Rule provisions. The Volcker Rule provisions generally apply as well to systemically important nonbank financial companies, as designated under the Dodd-Frank Act. Under the Act, the authority of the Federal Reserve with respect to a non-U.S. nonbank financial company generally includes only its U.S. activities and subsidiaries.

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Any company that “is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978” also is a “banking entity.” This includes any foreign banking organization with a U.S. branch, agency, commercial lending company or depository institution subsidiary. It would not include a foreign banking company with only a representative office in the United States. Finally, a “banking entity” includes any affiliate or subsidiary of any of the foregoing entities, which means that all subsidiaries and affiliates of any of the “banking entities” are themselves “banking entities.” Proprietary Trading Restrictions The Volcker Rule would generally prohibit “engaging as a principal for the trading account of the banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or other security or financial instrument that the appropriate agencies have determined, by rule, to be covered instruments.” For purposes of this prohibition, a “trading account” is defined as “any account used for acquiring or taking positions in the securities and instruments (described above) principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements) and any such other accounts as the appropriate agency may determine by regulation.” Nonbank financial companies that engage in proprietary trading will be subject to additional capital requirements and quantitative limits to be determined by regulation. Given the breadth of the regulatory discretion and scope of regulatory interpretation, it will be some time before the full impact of the proprietary trading rules will be known. Notwithstanding this prohibition on proprietary trading, and subject to certain conflict of interest rules (described below), certain limited proprietary trading is allowed. More specifically, to the extent otherwise authorized under federal or state law, a banking entity may:

• Purchase, sell, acquire and dispose of:

o obligations of the United States or any agency thereof,

o obligations, participations, or other instruments of or issued by a Federal Home Loan Bank, Farmer Mac, Farm Credit System institution, Ginnie Mae, Fannie Mae, or Freddie Mac (including mortgage-backed securities issued by any of these entities), or

o obligations of a state or of any political subdivision thereof;

• Purchase, sell, acquire or dispose of securities or other instruments in connection with underwriting or market-making related activities, to the extent that any such activities are designed not to exceed the reasonably expected near-term demands of clients, customers, or counterparties;

• Engage in risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of the banking entity that are designed to reduce specific risks;

• Purchase, sell, acquire, and dispose of securities and instruments on behalf of customers; and

• Invest in one or more small business investment companies as defined in the Small Business Investment Act of 1958, investments designed to promote the public welfare, of the type permitted for national banks, or instruments that are qualified rehabilitation expenditures with respect to historic properties. It appears that the investments permitted under this exception pertain to domestically-chartered small business investment companies, and U.S. public welfare and historic preservation.

In addition, a banking entity may engage in such other activity as the appropriate federal banking agencies, the Securities and Exchange Commission (“SEC”), and the Commodity Futures Trading Commission (“CFTC”) may determine by rule to promote and protect the safety and soundness of the banking entity. An insurance company that is affiliated with a banking entity (and is therefore a banking entity)

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and is directly engaged in the business of insurance and any affiliate may, for the general account of the company, purchase, sell, acquire, or dispose of securities and other instruments if such activities are conducted in compliance with the insurance law of the state in which the company is domiciled and the appropriate federal banking agencies have not jointly determined that the insurance law of the state is insufficient to protect the safety and soundness of the banking entity or financial stability of the United States. Notwithstanding the general prohibition, proprietary trading may be conducted by certain foreign banking entities as permitted by the BHCA if the trading occurs solely outside of the United States and if the banking entity is not directly or indirectly controlled by a U.S. banking entity.10 Hedge Funds and Private Equity Funds (“Private Funds”) The Volcker Rule generally prohibits banking entities from sponsoring or investing in hedge funds or private equity funds (collectively referred to as “Private Funds”), and subjects other systemically significant organizations regulated by the Federal Reserve to increased capital requirements and quantitative limits for engaging in such activities, subject to exemptions. The terms “hedge funds” and “private equity funds” that are the object of Volcker Rule restrictions are defined to mean any issuer that would be an investment company under the Investment Company Act of 1940, but for Sections 3(c)(1) or 3(c)(7) thereof,11 or “such similar funds” as certain federal agencies may determine by rule. These definitions 10 Section 4(c)(9) of the BHCA exempts from the BHCA’s nonbanking prohibitions shares held or activities conducted by a foreign company, the greater part of whose business is conducted outside of the United States. Under Section 4(c)(13) of the BHCA, shares of, or activities conducted by, companies that do no business in the United States, except as incidental to their international or foreign business, are exempted from the BHCA. 11 Section 3(c)(1) of the Investment Company Act of 1940 generally exempts from the definition of “investment company” funds beneficially owned by not more than one hundred persons, and Section 3(c)(7) generally exempts funds beneficially owned by qualified purchasers, in each case if such fund is not making and does not propose to make a public offering of securities.

are potentially broader than the colloquial meanings of the terms “hedge funds” and “private equity funds” because of the absence in the statutory definition of any qualitative criteria (e.g., redemption structure, investment policies, etc.) often implied in the colloquial meanings, and the authority of the agencies to define “similar funds” as Private Funds. Notwithstanding the regulatory agencies’ authority to define “similar funds,” it seems clear that funds exempt from the definition of “investment company” under other sections of the Investment Company Act of 1940, such as bank common and collective investment funds organized under Sections 3(c)(3) and 3(c)(11), respectively, should not be covered as Private Funds subject to the restrictions under the Volcker Rule. “Sponsoring” a Private Fund would include: (1) serving as a general partner, managing member or trustee of a Private Fund; (2) selecting or controlling in any manner a majority of the directors, trustees or management of a Private Fund; or (3) sharing with the Private Fund the same name or variant of a name, which is used for corporate, marketing, promotional, or other purposes. Permissible Private Fund Sponsorship and Investments While the Act contains a general prohibition on a banking entity acquiring or retaining any equity, partnership, or other ownership interest in, or sponsoring any Private Fund, a banking entity, to the extent permitted by any other provision of federal or state law and any restrictions or limitations that the appropriate federal regulators may determine, may organize and offer a Private Fund, and sponsor it, if all of the following conditions are met:

• The banking entity provides bona fide trust, fiduciary, or investment advisory services;

• The Private Fund is organized and offered only in connection with the provision of bona fide trust, fiduciary or investment advisory services and only to customers of such services of the banking entity;

• The banking entity does not, directly or indirectly, guarantee, or assume or otherwise insure the obligations or performance of the

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Private Fund or of any other Private Fund in which the Private Fund invests;

• The banking entity does not share the same name, or variation thereof, with the Private Fund;

• No director or employee of the banking entity takes or retains an equity interest, partnership interest or other ownership interest in the Private Fund, except for any director or employee who is directly engaged in providing investment advisory or other services to the Private Fund;

• The banking entity discloses to prospective and actual investors in the Private Fund, in writing, that any losses in such Private Fund are borne solely by investors in the Private Fund and not by the banking entity, and otherwise complies with any additional regulatory requirements; and

• The banking entity does not acquire or retain an equity interest, partnership interest or other ownership interest in the Private Fund, other than:

o A seed investment, in connection with establishing a Private Fund, for a period of up to one year, which may be up to 100 percent of the ownership interests;12 and

o De minimis longer-term investments, which after one year are reduced to an amount that is not more than 3 percent of the total ownership, and the investment is “immaterial” to the banking entity.

In no case may the banking entity’s seed and de minimis investments in Private Funds exceed 3 percent of the banking entity’s tangible common equity.

The de minimis exception has generally been reported as permitting investments in Private Funds as to which the banking entity has no sponsorship role, i.e., a pure investment, as well as in Private Funds sponsored by the banking entity. However, under the actual wording of the Act, it appears that the de minimis exception is available only for

12 A banking entity is required to seek unaffiliated investors to reduce or dilute its seed investment.

investments in Private Funds organized and offered by the banking entity and sold only to customers subject to the limitations listed above. However, no transaction, class of transactions or activity may be deemed to be a permitted activity if it would:

• Involve or result in a material conflict of interest (to be defined by the appropriate regulatory agencies) between the banking entity and its clients, customers or counterparties;

• Result directly or indirectly in an unsafe and unsound exposure (to be defined by the appropriate regulatory agencies) by the banking entity to high-risk assets or high-risk trading strategies;

• Pose a threat to the safety and soundness of such banking entity; or

• Pose a threat to the financial stability of the United States.

Offshore Funds The Volcker Rule provisions also contain an exception for the acquisition or retention of any equity, partnership, or other ownership interest in, or sponsorship of, a Private Fund by certain foreign banking organizations if the Private Fund is located solely outside of the United States and no ownership interest in such Private Fund is offered for sale or sold to a resident of the United States. This exemption would be available only to banking entities that are (a) foreign companies, the greater part of whose business is conducted outside of the United States or (b) companies that do no business in the United States, except as incidental to their international or foreign business.13 Further, the banking entity may not be directly or indirectly controlled by a U.S. banking entity. This exemption will not be of use to sponsors of offshore funds that have both U.S. and non-U.S. investors. Moreover, foreign banking entities may still be restricted in dealing with Private Funds by the rules governing transactions with affiliates discussed below.

13 See Sections 4(c)(9) and 4(c)(13) of the BHCA.

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Transactions with Affiliates Restrictions Applicable to Private Funds Application of the restrictions on transactions with affiliates to Private Funds appears to reflect a desire to create a firewall around Private Funds, in the same manner such limitations were originally enacted to create a firewall around insured depository institutions, albeit for slightly different purposes. In the case of Private Funds, the firewall appears intended to completely isolate risk associated with Private Fund activities and not allow it to infect a banking organization, whereas in the case of banks, the firewall is intended to limit insured depository institutions’ exposure to risks arising out of nonbanking activities of affiliates. The rule is stated as a prohibition on any banking entity that serves, directly or indirectly, as the investment manager, investment adviser of a Private Fund, or organizes and offers a Private Fund under the rules described above, and any affiliate of such banking entity, from entering into a transaction with such Private Fund (or any other Private Fund controlled by such Private Fund) that would be a “covered transaction” under Section 23A of the Federal Reserve Act. A “covered transaction” in this context would include (1) a loan or extension of credit to the Private Fund, (2) a purchase of, or an investment in, securities issued by the Private Fund, (3) a purchase of assets, including assets subject to repurchase, from the Private Fund, (4) the acceptance of securities issued by the Private Fund as collateral security for a loan, or (5) the issuance of a guarantee, acceptance, or letter of credit on behalf of the Private Fund. Under the provisions of the Volcker Rule noted above, it is permissible for a banking entity to make an investment in a Private Fund in the form of a seed or de minimis investment. This provision is inconsistent with a prohibition against entering into a transaction that would be a prohibited Section 23A covered transaction, which includes investing in securities issued by an affiliate. Still, Congress’s clear intent was to permit seed and other de minimis investments, which should supersede the application of Section 23A. Nevertheless, we may need to wait for the federal regulatory agencies’ interpretation of these provisions.

In addition, any banking entity that serves, directly or indirectly, as the investment manager or investment adviser—but not sponsor—of a Private Fund, or that organizes and offers a Private Fund as a permissible activity, will be subject to Section 23B of the Federal Reserve Act. Section 23B of the Federal Reserve Act generally requires that all transactions between a member bank and its affiliates be conducted on terms that are at least as favorable to the bank as those prevailing at the time for comparable transactions with unaffiliated companies. This could mean, for example, that, when a banking entity is serving as investment adviser to a Private Fund that uses bank affiliated service providers for the Private Fund, the Private Fund would have to pay the bank affiliated adviser and other service providers no less than market rates. Banking entities might also be restricted in the extent to which they could provide waivers of service fees. The Federal Reserve may grant an exemption from the transactions with affiliates rules found in Section 23A of the Federal Reserve Act to allow a banking entity to enter into a prime brokerage transaction with a Private Fund managed, sponsored, or advised by such banking entity if the banking entity is in compliance with the permissible activities provisions, the banking entity enters into an enforceable undertaking that the transaction will not be used to avoid losses to any investor in a Private Fund, and the Federal Reserve has determined that such transaction is consistent with the safe and sound operation of the banking entity. Capital The appropriate federal bank regulatory agencies, the SEC, and the CFTC are also obligated to adopt rules imposing additional capital requirements and quantitative limitations on permissible activities as necessary to protect the safety and soundness of banking entities and systemically significant nonbank financial companies that are supervised by the Federal Reserve. For purposes of determining compliance with any such rules, the aggregate amount of outstanding investment in seed capital and de minimis investments in a Private Fund must be deducted from the assets and the tangible capital of the banking entity.

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Nonbank financial companies supervised by the Federal Reserve may engage in activities that would be subject to the Volcker Rule’s general prohibitions if conducted by a banking entity, but will be subject to capital requirements and quantitative limits. These too will be determined by regulations issued by the federal regulatory agencies. Nonbank financial companies supervised by the Federal Reserve that engage in activities in which a banking entity may engage (i.e., activities not subject to the Volcker Rule’s general prohibition) will be subject to the same capital requirements and quantitative limits applicable to banking entities. Exceptions and Anti-Evasion The federal regulatory agencies may determine that other activities are permissible that would “promote and protect” the safety and soundness of banking entities and the financial stability of the United States. The federal regulatory agencies must issue rules regarding internal controls and recordkeeping to insure compliance with the Volcker Rule. In addition, the federal regulatory agencies are required to order termination of an investment or activity that functions as an evasion of the rules. Effective Date, Rulemaking and Transition Regulations implementing the Volcker Rule must be promulgated by the appropriate federal banking agencies (with regard to insured depository institutions), the Federal Reserve (with regard to holding companies and affected nonbank financial companies), the SEC (with respect to any entity for which the SEC is the primary regulatory agency) and the CFTC (with respect to entities for which the CFTC is the primary federal agency), after coordination among the agencies and with the intent of adopting comparable regulations. In addition, the Chair of the Financial Stability Oversight Council (the “FSOC”) has responsibility for coordinating the regulations issued by the agencies. The agencies are required to act within nine months after the completion of a six-month study by the FSOC on implementation of the Volcker Rule. In any event, the Volcker Rule provisions will take effect on the earlier of 12 months after the issuance of final rules implementing the legislation, or two years after the date of enactment.

Within two years after the effective date of the requirements, banking entities must bring their investments and activities into compliance with the statute. The Federal Reserve may extend the two-year period for not more than one year at a time for a total of three years in the aggregate. With regard to divestiture of illiquid Private Funds, the Federal Reserve may extend the transition period for up to a maximum of five years on a case-by-case basis. An illiquid Private Fund is a Private Fund that, as of May 1, 2010, was principally invested in and contractually committed to principally invest in illiquid assets, such as portfolio companies, real estate investments and venture capital investments, and that makes all investments pursuant to and consistent with an investment strategy to invest in illiquid assets.

Other Reforms in the Dodd-Frank Act New Barriers between Financial and Commercial Activities The Dodd-Frank Act addresses the potential for mixing of financial and commercial activities at both grandfathered unitary savings and loan holding companies and certain depository institutions that are not treated as banks for purposes of bank holding company registration. The Dodd-Frank Act addresses commercial activities conducted by grandfathered unitary savings and loan holding companies by permitting the Federal Reserve to require them to create intermediate holding companies, through which all financial activities are conducted.14 This would force grandfathered unitary savings and loan holding companies to segregate financial activities from non-financial ones. Most internal financial activities, such as treasury, investment, and employee benefit functions, may remain outside of the intermediate holding company. Although intermediate holding companies are permitted, not required, under the Dodd-Frank Act, it is likely that the Federal Reserve’s implementing regulations will require their creation generally. Additionally, the Federal Reserve could prohibit internal financial activities of grandfathered unitary

14 Section 626.

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savings and loan holding companies if they present undue risk. The Federal Reserve may also restrict, by regulation, transactions with the intermediate holding company as necessary to prevent unsafe and unsound practices. The Federal Reserve’s “source of strength” doctrine will not only be codified, but will also be applied to grandfathered unitary savings and loan holding companies. Consequently, the ultimate parent of the grandfathered unitary savings and loan holding company would be able to continue to engage in any commercial activities in which it was previously engaged, notwithstanding the BHCA limitations on nonbank activities, but would have to serve as a source of strength, would have to file reports with the Federal Reserve, and would be subject to enforcement action by the Federal Reserve.15 The Dodd-Frank Act also addresses the potential for mixing financial and commercial activities by subjecting proposals by commercial firms to charter or acquire industrial loan companies, credit card banks, and trust companies that are FDIC-insured to a three-year moratorium.16 During that time, the FDIC is prohibited from approving applications for deposit insurance or change in control for these types of institutions if they are, or will be, controlled by companies that receive less than 15 percent of their gross revenues from activities that are banking or “financial in nature,” as that phrase is defined in the BHCA.17 During the moratorium, a study will be conducted to determine whether companies owning these types of institutions (including thrifts that are not among the BHCA exempt organizations) should be subjected to the restrictions of the BHCA. Meanwhile, credit card bank power is expanded slightly by allowing credit card banks to issue credit cards to small businesses.18

15 In addition, under Section 606, a unitary thrift holding company could become a financial holding company if it meets the criteria. However, there seems to be little reason to do so because, unlike a financial holding company, at the ultimate parent level such a holding company presumably is not subject to any limitations on activities. 16 Section 603. 17 Section 4(k) of the BHCA defines activities that are “financial in nature” broadly to include lending, exchanging, insuring, providing financial and investment services, offering pooled investments, underwriting, providing insurance, and securities services. 12 U.S.C. § 1843(k). 18 Section 628.

Acquisitions and Expansionary Activities The Dodd-Frank Act will also reconfigure the framework for expansionary activities by imposing new concentration limits based upon liabilities, imposing new approval requirements on certain acquisitions by financial holding companies, liberalizing de novo interstate branching, and limiting charter conversions by institutions subject to regulatory orders. The Dodd-Frank Act imposes a general concentration limit on all financial companies (defined similarly to “banking entities” under the Volcker Rule) prohibiting any acquisition that would result in a financial company having more than 10 percent of the aggregate consolidated liabilities of all financial companies.19 Liabilities are defined as risk-weighted assets less regulatory capital.20 The Federal Reserve can permit exceptions for acquiring failed banks, FDIC-assisted transactions, and de minimis increases in a financial company’s liabilities. The FSOC will study the impact of the concentration limit and must recommend modifications to the limit within six months of enactment. The Federal Reserve is required to promulgate regulations within nine months of the study’s completion. The concentration limits under existing law with respect to insured deposits are retained by the Dodd-Frank Act and enlarged.21 Interstate merger transactions involving depository institutions and interstate acquisitions by holding companies, including an acquisition of a savings association by a bank holding company, will generally be prohibited if they would result in the applicant having more than 10 percent of all deposits held by insured institutions in the United States. Exceptions are made for the acquisition of failed banks and for FDIC-assisted transactions. Financial holding companies will have to seek prior Federal Reserve approval for transactions involving the acquisition of a company engaged solely in

19 Section 622. 20 For foreign financial companies, risk-weighted assets will include only U.S. assets, and regulatory capital will be that generated from U.S. operations. 21 Section 623.

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financial activities if the assets of the acquired company would exceed $10 billion or more.22 In addition, financial holding companies would have to be well managed and well capitalized, not just at the depository institution level but also at the holding company level, to engage in or acquire companies engaged in nonbanking activities.23 The Dodd-Frank Act will permit national banks and state banks to open de novo branches in any state that permits its in-state banks to branch.24 Previously, interstate de novo branching was permitted only into states that had opted into interstate branching by passing laws that expressly permitted out-of-state banks to open de novo in-state branches. This section also permits foreign banks to branch outside of their home state since foreign banks have the same authority under the International Banking Act as domestic banks to branch interstate. Under present bank regulatory policy, charter conversions involving institutions with supervisory problems are generally not favored. Under the Dodd-Frank Act, charter conversion would generally be prohibited for institutions subject to enforcement orders, such as cease and desist orders or memoranda of understanding, although an exception will allow conversion if both regulators agree.25 All conversions will require the existing and prospective regulators to communicate about any ongoing supervisory proceeding likely to result in an enforcement order. Additional Lending Limits and Restrictions on Transactions with Affiliates Any credit exposure deriving from a derivative transaction, repurchase or reverse repurchase agreement, or a securities lending transaction will be treated as a loan or extension of credit for purposes of the transactions with affiliates restrictions and the lending limits applicable to national banks, state banks, and insiders.26 Insured depository institutions

22 Section 604. 23 Section 606. 24 Section 613. 25 Section 612. 26 Section 610. In addition, state-chartered banks will not be permitted to engage in derivatives transactions under state law

may not purchase an asset from or sell an asset to an insider unless the transaction is on market terms, and if in excess of 10 percent of the institution’s capital, is approved by the disinterested members of the board of directors.27 Other changes to Sections 23A and 23B of the Federal Reserve Act will (i) amend the definition of a “covered transaction” to include securities borrowing or lending, and all derivative transactions with an affiliate to the extent that the transaction causes a depository institution or its affiliate to have credit exposure, (ii) require repurchase agreements to be secured by adequate collateral at all times, rather than just at the time of the transaction, (iii) cap all covered transactions between a bank and its financial subsidiary at 10 percent of the bank’s capital stock and surplus, and (iv) treat as transactions with an affiliate all transactions with “investment funds” advised by a bank or its affiliate.28 Although the scope is somewhat unclear, the term “investment funds” likely includes at least Private Funds. Further, in the future, exceptions to Sections 23A and 23B will have to be agreed upon by the federal banking agencies and the Federal Reserve, meaning that the Federal Reserve can no longer create exemptions by its order alone. Capital and Leverage Requirements The Dodd-Frank Act imposes stricter capital requirements on all depository institutions, bank holding companies, financial holding companies, and savings and loan holding companies. All bank holding companies, financial holding companies, and savings and loan holding companies must remain at least “well capitalized” and “well managed.”29 Subject to the recommendations of the FSOC, the federal banking agencies may also develop additional capital requirements for systemic unless the state has considered the impact of derivatives transactions for purposes of state lending limits. Section 611. Section 610 affects foreign banks with branches and agencies in the United States because branches and agencies are also subject to the transactions with affiliates rules and lending limits. 27 Section 615. 28 Sections 608 and 609. These provisions will be effective one year after the transfer date under Title III, affecting the transfer of OTS functions. 29 Sections 606 and 607.

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risk purposes. Bank holding companies with assets of more than $50 billion will face additional, increased capital requirements and leverage limits.30 Significantly, trust-preferred securities (“TruPS”) will no longer qualify as tier 1 capital for holding companies.31 A grandfather provision benefiting holding companies with less than $15 billion in assets will allow tier 1 capital treatment for existing (but not future) TruPS. Larger bank holding companies have three years to phase out existing TruPS, with the phase-out beginning on January 1, 2013. Larger savings and loan holding companies and certain bank holding company subsidiaries of foreign banking organizations will have five years before they are required to comply, but they do not benefit from an explicit phase-out period. There are also some exceptions, one of which is for small bank holding companies with assets of $500 million or less. Furthermore, the Dodd-Frank Act calls for a study on the potential impact of prohibiting the inclusion of all hybrid capital instruments in tier 1 capital.32 In addition, federal regulators are required to “seek to make” capital standards countercyclical so that the amount of capital required to be maintained by an insured depository institution or holding company increases in times of economic expansion and decreases in times of economic contraction. It remains to be seen how such provisions will be implemented.33 Stress Tests and Reporting Requirements In addition to increased capital and leverage requirements, depository institutions and their holding companies face additional restrictions relating to systemic risk. All depository institutions or holding companies with assets of over $10 billion are required to conduct annual stress tests and report the results to their primary federal regulator and the Federal Reserve. Holding companies with assets over $50 billion must conduct the stress tests semiannually, and submit to an additional, annual stress test conducted by the Federal Reserve. Bank 30 Section 165. 31 Section 171. 32 Section 174. 33 Section 616.

holding companies with assets over $50 billion that pose a grave threat to financial stability may face even greater restrictions, including FSOC authority to order cessation of certain activities or divestiture of certain assets.34 All bank holding companies with assets over $50 billion may, and most likely will, be required to comply with additional reporting requirements established by the FSOC.35 All publicly traded bank holding companies with assets over $10 billion must establish risk committees to oversee risk management practices. The Federal Reserve has been granted the discretion to require risk committees at smaller publicly traded bank holding companies.36 Deposits The Dodd-Frank Act makes permanent the temporary increase in the standard deposit insurance amount from $100,000 to $250,000.37 This increase is made retroactive from January 2008, benefiting the depositors of IndyMac Bank and other institutions that failed prior to the temporary increase. Unlimited insurance on all non-interest bearing transaction accounts has been extended through the end of 2012, despite considerable efforts to make such insurance permanent.38 The Dodd-Frank Act also authorizes insured depository institutions to pay interest on transaction accounts, effective one year after enactment of the Act.39 Despite the interest bearing-nature of the account, it is likely that such transaction accounts will continue to be subject to reserve requirements. The Dodd-Frank Act raises the deposit insurance fund’s minimum reserve ratio from 1.15 percent to 1.35 percent.40 The FDIC is required to “offset the effect” of any related increase in assessments on institutions with assets of less than $10 billion.

34 Section 165. 35 Section 335. 36 Section 165. 37 Section 335. The Dodd-Frank Act also increases the insurance limits for credit unions insured by the National Credit Union Administration to $250,000. 38 Section 343. 39 Section 627. 40 Section 334.

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For insured institutions of all sizes, insurance premiums will no longer be based on the amount of deposits, but rather an assessment base defined as total assets minus tangible equity. The requirement that insurance premiums collected beyond a certain level of reserve be paid out in the form of dividends has been repealed, giving the FDIC sole discretion to determine when to suspend or limit dividend payments. Additional Restrictions on Certain Savings Banks and Savings Bank Holding Companies Savings associations that fail to meet the qualified thrift lender test will no longer have the possibility of becoming a bank.41 Instead, they will immediately be subjected to branching, activities, and dividend restrictions. The dividend restrictions have been further amended to require advance approval by the OCC. Thrift subsidiaries of mutual holding companies will be required to notify the Federal Reserve and the OCC or FDIC at least 30 days prior to declaring a dividend.42 Mutual holding companies that have previously waived the right to receive dividends may continue to do so, subject to restrictions such as prior Federal Reserve approval.

The Road Ahead Most of the significant reforms will not take effect until at least one year after enactment, and in many cases, significantly later. Regulators are given a multitude of rule-making tasks. In most cases, the rule-making will provide detail and substance to the broad mandates set forth in the Act. Institutions that are affected by the Act’s provisions should stay tuned during the rule-making process and be prepared to comment on proposals that would hinder their operations without advancing the Act’s purposes. The passage of the Act is only the beginning of what promises to be a long process to reorder financial services regulation. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.

41 Section 624. 42 Section 625.


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July 2010 Authors: Kristy T. Harlan [email protected] 206.370.6651 Vincent J. Pisano [email protected] 212.536.4810 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Dodd-Frank Act Includes Immediate Change to “Accredited Investor” Definition for Natural Persons On July 21, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Among the many provisions of the Dodd-Frank Act is a change to the definition of “accredited investor” under the Securities Act of 1933, which takes effect immediately and may impact issuers currently engaged in private offerings.

Revisions to Accredited Investor Definition Issuers raising capital in private offerings often rely on the accredited investor definition in determining whether the offering is exempt from the registration requirements of the Securities Act. The definition of accredited investor contained in Rule 215 and Regulation D currently includes, among other categories, any natural person:

• who had an individual income in excess of $200,000 in each of the two most recent years or joint income with his or her spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year; or

• whose individual net worth, or joint net worth with his or her spouse, at the time of his purchase exceeds $1 million (such calculation includes the value of an investor’s primary residence).

The Dodd-Frank Act revises the accredited investor definition as it relates to natural persons to exclude the value of a person’s primary residence from the $1 million net worth test. This change will effectively increase the net worth requirement for many investors that are natural persons. The other provisions of the accredited investor definition, including the net income test for natural persons, remain unchanged at this time. It is anticipated that the Staff of the Securities and Exchange Commission (SEC), in applying the $1 million net worth test, will allow investors to exclude any mortgage or any other debt secured by the investor’s primary residence that does not exceed the fair market value of the residence. If, however, the amount of such debt exceeds the fair market value of the residence and the lender has recourse to the investor personally for any deficiency, investors would be required to deduct the excess liability from the net worth calculation. Changes Immediate The revision to the accredited investor definition as it applies to natural persons is effective immediately, with no transition period or grandfathering for private offerings that are already in progress but have not yet been completed.

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With the passage of the Dodd-Frank Act, private funds and other issuers relying on the accredited investor definition in connection with ongoing private offerings that may involve investors who are natural persons should revise disclosure and subscription documents now to reflect this modification of the net worth test. To the extent subscription materials have already been received from investors who are natural persons, private funds and other issuers should consider whether new accredited investor representations are required to ensure the availability of an exemption from the registration requirements of the Securities Act. Additional Changes May Be Coming The Dodd-Frank Act also lays the following groundwork for potential future changes to the accredited investor standards:

• The SEC is authorized to review the definition of accredited investors as it applies to natural persons and make adjustments, by notice and comment rulemaking, as it deems appropriate for the protection of investors, in the public interest, and in light of the economy. However, the SEC cannot, during the first

four years after enactment, modify the net worth standard.

• After four years from the date of enactment, and not less than once every four years thereafter, the SEC must review the accredited investor definition as it applies to natural persons, including both the net worth and income tests, and may make such adjustments, by notice and comment rulemaking, as it deems appropriate for the protection of investors, in the public interest, and in light of the economy.

• The U.S. Comptroller General is required to conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and must submit a report on the results of such study to Senate and House committees, within three years after the enactment of the Dodd-Frank Act.





July 21, 2010 Authors: Steven M. Kaplan [email protected] +1.202.778.9204 Sean P. Mahoney [email protected] +1.617.261.3202 Anthony R.G. Nolan [email protected] +1.212.536.4843 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

“Originate-to-Distribute” Lives on in Securitizations of Plain Vanilla Residential Mortgages: The Securitization Reform Provisions of the Dodd-Frank Act Introduction The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”) constitutes the most sweeping financial reform package since the 1930s. Title IX of the Dodd-Frank Act (“Title IX”), entitled the “Investor Protection and Securities Reform Act of 2010” enacts a grab bag of substantial changes to capital markets regulation and practices in the hope of putting back in their bottles the twin genies of moral hazard and lax regulation that are widely viewed as the tinder that sparked the great credit conflagration of 2008. Subtitle D of Title IX, entitled “Improvements to the Asset-Backed Securitization Process” (“Subtitle D”), has been of particular interest to capital markets participants both because practices in securitization markets are widely credited with contributing uniquely to the credit crisis and because of the sense of many that the resuscitation of robust securitization markets is one of the key predicates to an economic recovery. The reforms to the asset-backed securitization process contained in Subtitle D and elsewhere in Title IX are essentially intended to remove incentives embedded in the “originate-to-distribute” model that has been discredited during the financial crisis. The most significant change is the introduction of a requirement that sponsors of nearly all securitizations and/or originators of loans sold into securitizations retain a portion of the credit risk inherent in the pool of assets securitized. However, these risk retention requirements will not apply to securitizations of assets issued or guaranteed by the United States, any state, or any agency of the foregoing, or securitizations consisting solely of qualified residential mortgage loans that conform to parameters established by regulation. The result may be the continued viability of originate-to-distribute with respect to plain vanilla residential mortgages – that is, residential mortgages insured, guaranteed or designed by the government. Residential lenders that do not wish to retain risk or do not have capital to do so may be left with an originate-to-distribute business consisting of plain vanilla mortgages. This ultimately may limit consumer choice, restrict the availability of consumer credit and stifle innovation in the residential mortgage market. Subtitle D is not the end of the game on securitization reform because it grants broad authority to regulators, who will determine the final score based on guidelines contained in Title IX of the Dodd-Frank Act. The Securities and Exchange Commission (the “SEC”) has already issued its blueprint for many of the regulations required in its proposed amendment of Regulation ABi (the “Regulation AB Proposal”) and the Federal Deposit Insurance Corporation (the “FDIC”) has also weighed in with its thoughts on reform of the rules governing securitizations by depository institutions in a rulemaking exercise (the “FDIC Proposal”).ii

http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf

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This Alert will discuss principal themes of reform embedded in Title IX, with special reference to Subtitle D. These themes are risk retention, new disclosure and reporting requirements, regulation of the use of representations and warranties and regulation of conflicts of interest. It will then discuss the timing and process for regulatory implementation. Other K&L Gates client alerts address other aspects of financial reform in the Dodd-Frank Act. Additional information is available on the K&L Gates web site specially dedicated to Financial Services Reform.

Substantive Provisions Applicability Subtitle D applies to all “asset-backed securities” other than securities issued in a securitization in which the only investors are affiliates of the sponsor of the securitization. The Dodd-Frank Act amends the Securities Exchange Act of 1934 (the “Exchange Act”) to define the term “asset-backed security” to include many categories of securitizations and structured products that were not previously subject to registration. The definition will now include collateralized mortgage obligations, collateralized debt obligations, collateralized bond obligations, and any other securities that the SEC determines are asset-backed securities – but will exclude any securities issued to affiliates by a finance subsidiary that issues securities only to its affiliates. Risk Retention General Subtitle D mandates a rulemaking process (described below) to require that “securitizers” retain at least a five percent economic interest in a portion of the credit risk in each asset held in a securitization, subject to certain exclusions and exceptions discussed below. The term “securitizer” is defined to mean the issuer of asset-backed securities or the sponsor of a securitization. In apparent conflict with this mandate is a requirement that retained risk be allocated between securitizers and originators that deliver into securitizations for particular categories of assets, as determined with reference to the credit risk of the assets, the characteristics of securitization transactions involving those assets (e.g., form and volume), and the potential impact of a risk retention requirement on the availability of credit to consumers and

businesses. Subtitle D generally prohibits securitizers and originators from hedging any retained risk directly or indirectly, subject to exemptions promulgated by the SEC and the Board of Governors of the Federal Reserve System (the “FRB”), the FDIC and the Office of the Comptroller of the Currency (the “OCC,” and, together with the FRB and OCC, the “Bank Regulators”) iii, and with respect to exemptions for residential mortgage securitizations, the U.S. Department of Housing and Urban Development (“HUD”) and the Federal Housing Finance Agency (“FHFA”). The mandate of risk retention represents not only a sense that the financial crisis resulted in material part from an “originate-to-distribute” business model for residential mortgages, but also an expectation that requiring securitizers and originators to retain “skin in the game” (providing an incentive for them to monitor underwriting standards and obligor credit quality) will help rein in the excesses of that model. A risk retention requirement may be too blunt an instrument to be fully effective, particularly in light of the increased costs it implies that likely would be passed on to borrowers, assuming loans subject to the risk retention requirements would be made at all. The Act adopts a compromise position. It focuses risk retention on higher risk and unconventional products, while at the same time creating incentives for lenders, in the form of exemptions from, or reductions in, risk retention requirements, to originate and distribute loans that fit parameters established by Congress and the regulators. Exclusion of Qualified Residential Mortgages from Risk Retention Requirements Subtitle D excludes single-tranche securitizations of pools consisting solely of qualified residential mortgages from risk-retention requirements. By doing so, it creates a class of mortgage products – likely plain vanilla products – for which no risk retention is required and for which an originate-to-distribute business model will likely remain viable. These mortgage products would effectively be designed by the SEC, the Bank Regulators, HUD and FHFA when they jointly define the term “qualified residential mortgage,” subject only to general guidance from Congress. This guidance establishes minimal base line requirements relating


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to the breadth of the definition as well as features relevant to default rates. The definition of “qualified residential mortgage” may be no broader than the definition of “qualified mortgage” inserted into the Truth in Lending Act by the Dodd-Frank Act.iv Under that definition, a qualified mortgage must satisfy all of the following criteria:

• No negative amortization and limited deferrals of principal payments;

• Limitations on balloon payments;

• Verified and documented financial resources of the borrower;

• Underwriting takes into account level amortization and payments of required taxes and insurance;

• Underwriting, with respect to adjustable rate mortgage loans, takes into account borrower’s ability to pay highest allowed rate during first five years;

• Complies with guidelines or regulations established by the FRB (or the Bureau of Consumer Financial Protection) related to debt to income;

• Points and fees of less than three percent of the total loan amount; and

• Term of thirty years or less.

In addition, Subtitle D provides that the definition of qualified residential mortgages in applicable regulations must take into account “underwriting and product features that historical loan performance data indicate result in a lower risk of default” and also requires regulators to restrict or prohibit in qualified residential mortgages any feature “demonstrated to exhibit a higher risk of borrower default.” Examples of relevant features include some of the features contained in the above definition, such as balloon payments and negative amortization. They also require the regulators to look at a broader range of underwriting practices or loan features based on historical experience with default rates, such as, among other things, documentation and verification of the obligor’s

assets and income, maximum debt-to-income ratios, features that may mitigate the potential for payment shock on adjustable rate mortgage loans, and the presence of mortgage guarantee insurance or other credit enhancements. These requirements assume an availability of uniform historical data from which the regulators could assess the risk of default associated with specific underwriting and product features and thus likely preclude a newly designed product from qualifying. Subtitle D would require an issuer of asset-backed securities collateralized exclusively by qualified residential mortgages to certify that it has evaluated the effectiveness of its internal controls for ensuring that the pool consists solely of qualified residential mortgages. The Act would delegate enforcement of the regulations to both Bank Regulators (for securitizers that are insured depository institutions) and the SEC (for other securitizers). The exemption from risk retention for qualified residential mortgages is necessary as originators may be reluctant to retain risk in mortgages they originate for a variety of reasons unrelated to the quality of the asset or soundness of underwriting. These may include capital constraints, questions about the accounting treatment of loan sales with retained risk, an institution’s policy for managing interest rate risk and liquidity concerns. The exemption for qualified residential mortgages serves to push mortgage lenders with such concerns towards qualified residential mortgages for distribution in securitizations. Unfavorable treatment in securitizations of certain products may make it difficult for all but the largest institutions to fund loans that contain provisions allowing for greater borrower flexibility. An institution would need sufficient size to appropriately manage the risks retained for these products, regardless of underwriting standards. New products or features, for which historical information on the risk of default is not available, likely will be subject to higher risk retention requirements versus conventional products. In sum, the push towards increased standardization of residential mortgages may come at the price of innovation.

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Exclusion of Agency Guaranteed Loans from Risk Retention Requirements Subtitle D of the Dodd-Frank Act contemplates additional exemptions from the risk retention requirements with respect to loans insured or guaranteed by government agencies or at the discretion of the regulators. It provides exemptions for securitizations of assets issued or guaranteed by the United States, any state, or any agency of the foregoing, as determined by the SEC and Bank Regulators. It also contains language excluding from its scope: (1) assets made, insured, guaranteed or purchased by an institution, that is subject to the supervision of the Farm Credit Administration, or (2) residential, multifamily, or health care facility mortgage loan assets, or securitizations based upon such assets, which are insured or guaranteed by the United States or any agency thereof. Exemptions for government insured loans – such as FHA-insured or VA-guaranteed loans that are included in Ginnie Mae securities – make sense, as it would be unclear how one could retain risk on an insured asset. For purposes of these exemptions, neither Fannie Mae nor Freddie Mac is considered an agency of the United States, although conforming loans separately may be exempt as qualified residential mortgages. Other Exemptions The SEC and the Bank Regulators, acting jointly, will have broad authority to grant any other exemptions for classes of institutions or assets from the risk retention requirements or the prohibitions on hedging retained risk, so long as those exemptions help ensure high underwriting standards and encourage appropriate risk management practices by securitizers and originators. This authority may be very useful to the SEC and Bank Regulators, as future market developments may vitiate the justifications for risk retention. However, neither the Regulation AB Proposal nor the FDIC Proposal contemplates any exceptions to the risk retention rules. Form and Extent of Risk Retention For securitizations in which risk retention is required, regulations must specify permissible forms of risk retention and the minimum duration of that risk retention. This could range from maintaining an interest in specific assets or in securities of the issuer of the asset-backed securities. Subtitle D itself does

not specify whether the retained risk must be first loss position, or a portion of each tranche of securities issued in the securitization. By comparison, the Regulation AB Proposal specified a portion of each tranche or “vertical slice” of the securitization. The duration of risk retention could present some complexity, because neither the Regulation AB Proposal nor the FDIC Proposal specifies a period of time during which risk must be retained. The intent of the legislation appears to be to encourage more disciplined underwriting and pooling of securitized assets. Thus, the duration of any required risk retention should be related to a period during which defaults would be a function of underwriting, as opposed to other risks, such as interest rate risk, that materialize over the life of an asset. Subtitle D charges regulators with allocating risk retention among securitizers and originators that deliver into securitizations. More specifically, it directs regulators to reduce the percentage of risk retention obligations required of the securitizer by the percentage required of the originator, and to promulgate rules considering factors such as: (1) whether the assets have low credit risk characteristics, (2) whether the form and volume of transactions in the marketplace create incentives for poor underwriting, and (3) how risk retention may impact the availability of credit. In many cases, these considerations would weigh in favor of allocating more risk to securitizers and less to originators. Originators in many lending businesses have historically not been capital intensive. Unless these originators are able to raise significant additional capital, pushing risk retention requirements to such originators would almost certainly have a negative impact on the availability of credit. Thankfully, unlike the corresponding provision in the bill that was originally passed by the House of Representatives, the risk retention provisions do not apply to originators that merely sell loans in transactions not involving securitizations. Thus, there is no statutory risk retention for originators that sell loans to other institutions to be held in portfolio. However, regulations may be needed to address circumstances in which loans are sold

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without the originator knowing or intending that such loans are to be securitized. With respect to commercial mortgages, the Dodd-Frank Act authorizes regulators to allow a securitizer of commercial mortgage loans to transfer the first loss position retained risk subject to certain conditions. More specifically, regulations promulgated under the Act would require any transferee of the first loss position in a commercial mortgage securitization to: (1) hold adequate financial resources; (2) provide due diligence on all individual assets in the pool prior to securitization; and (3) meet the same standards for risk retention as the securitizer. Additional requirements on commercial mortgage securitizations would include a determination by the SEC and the Bank Regulators that the “underwriting standards and controls for the asset are adequate,” and specifications for representations, warranties, and remedies for breach thereof. Changes to Disclosure and Periodic Reporting Rules The Act’s securitization provisions also require more granular and extensive disclosures than are required under existing rules. For instance, the Act creates an obligation to disclose the nature of the due diligence review of underlying assets and enhance disclosure of contingent repurchase obligations through representations and warranties or otherwise. The Act also requires the SEC to adopt regulations setting forth the standards for disclosure in all issuances of asset-backed securities. The regulations would have to prescribe a standardized format for disclosures and require asset-level or loan-level disclosures. The asset- and loan-level disclosures would allow inventors to perform independent due diligence by tracking brokers or originators of loans, determining the nature and extent of their compensation, and identifying the amount of risk each has retained in the securitized assets. The SEC has already commenced revising the disclosures required in a registered offering through its Regulation AB Proposal. Of particular significance to sponsors, the Act eliminates for asset-backed securities the ability of issuers or depositors to suspend reporting obligations under the Exchange Act, when the number of investors in a securitization falls below a

specified threshold, typically three hundred persons. This may not materially affect the amount of information required to be provided in connection with asset-backed security transactions where the information reporting requirements of the transaction documents generally mirror what is required of issuers of publicly held asset-backed securities. However, the loss of suspension of reporting increases the risk that asset-backed security sponsors may lose eligibility to use shelf registration statements for certain asset-backed securities owing to non-compliance with the reporting obligations imposed by the Exchange Act. This change in the law may encourage the continuation of private placements of asset-backed securities, notwithstanding required compliance with the same risk retention and disclosure obligations governing securities issued in public offerings. The Act also eliminates the exemption from registration for mortgage-related securities that had been included in the Securities Act of 1933 by the Secondary Mortgage Market Enhancement Act. This change will likely effect a substantial reduction in unregistered offerings of asset-backed securities backed by mortgage-related assets. Representations and Warranties Subtitle D also would require the SEC to prescribe regulations on the use of representations and warranties in the securitization markets. The regulations would require each credit rating agency to include in its rating report a description of representations, warranties, and remedies in a securitization, along with a comparison with other securitization transactions. The regulations also would require securitizers to disclose the level of repurchase requests made, both fulfilled and unfulfilled, across all securitizations sponsored by such securitizer. Conflicts of Interest The Act also prohibits an underwriter, placement agent, initial purchaser, or sponsor with respect to any asset-backed security, or any of their respective affiliates, from engaging in any transaction that presents a conflict of interest with investors in the asset-backed securities for a period of one year from and after the first closing of the offering of such

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securities. Exceptions exist for risk-mitigating hedging activities, commitments to provide liquidity, and bona fide market making activities. As with most other provisions of the Act, regulations will be required to give color to the general rule and exceptions. In this case, the regulations are to be promulgated by the SEC.

Required Rulemaking The Dodd-Frank Act takes an indirect approach to securitization reform by delegating many decisions to regulators and authorizing them to create exemptions and otherwise limit the effect of many provisions of the Act to specified issuer types and asset classes. This approach could result in a more nuanced treatment of many difficult issues than Congress could have created through legislation. Coordinated rulemaking also mitigates the possibility of having different requirements depending upon the nature of the entity sponsoring a securitization or originating receivables. It also means that the full effect of the legislative provisions will not be felt for quite a long time. Subtitle D requires that the applicable regulators issue implementing regulations within 270 days after enactment of the Dodd-Frank Act. Those regulators are the SEC, the Bank Regulators, HUD and the FHFA. The regulations will have to take effect within one year (in the case of residential mortgage securitizations) or two years (in the case of securitizations of other assets) after publication in the Federal Register. The provisions of the Act generally require regulators – in most cases, two or more regulators working together – to adopt regulations, which, in turn, implement the desired reform. It will be at least 270 days after the enactment of the Act before regulators promulgate most of the required regulations. In addition to a large number of mandated rulemaking exercises, the regulators are also tasked with completing a significant number of studies. These demands and capacity constraints, together with the need to coordinate concerted action by a number of regulators, may complicate the process and extend the time needed to promulgate regulations. The effective time of the regulations varies from one year after promulgation (for securitizations of asset-backed securities backed by residential mortgages) to two years (for

securitizations of all other classes of asset-backed securities), leaving a window of close to three years before the date on which certain reforms are required to become effective. Subtitle D requires two sets of regulations governing securitizations: one of universal application, and one governing residential mortgages only. The SEC and Bank Regulators will promulgate the former set of regulations alone and the latter set in concert with HUD and FHFA. The Chairman of the newly created Financial Stability Oversight Council will coordinate all of this rulemaking activity. Subtitle D requires the promulgation of regulations that establish asset classes and specifically govern securitizations of each of those asset classes.v Specifically, these rules will have to incorporate underwriting guidelines established by the Bank Regulators “that specify the terms, conditions, and characteristics of a loan within the asset class that indicate a low credit risk with respect to the loan.” Thus, these regulations could subject originators that sell loans into securitizations to bank underwriting standards. Moreover, because the underwriting guidelines may dictate the level of risk retention required, these regulations would likely require sponsors of securitizations comprising higher credit risk assets to retain additional credit risk. That higher threshold would apply regardless of whether investors in such asset-backed securities would otherwise voluntarily contract to assume all of such risk in exchange for a higher return. Additionally, the Chairman of the Financial Services Oversight Council is required to conduct a study of the macroeconomic effects of risk retention requirements (and deliver a report to Congress on the conclusions of that study) within 180 days of enactment of the Act into law. The risk retention study must include the following features:

• An analysis of the effects of risk retention on real estate bubbles, including an assessment of whether (and to what extent) a risk retention requirement would have avoided real estate-related losses in recent years,

• An analysis of whether real estate bubbles could be prevented by proactively adjusting risk

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retention levels or mortgage origination requirements based on market conditions,

• An assessment of whether such proactive adjustments are properly made by an independent regulator or set by formula, whether independently or in concert with monetary policy, and

• Recommendations with respect to proper implementation and the contents of enabling legislation.

The regulatory exercise will come against the backdrop of regulatory approaches to asset-backed securitization reform that have already been in the works. As discussed above, the SEC’s Regulation AB Proposal covers many of the same issues that are the subject of the Act and may serve as a head start for some of the required rulemaking. Separately, the FDIC Proposal would significantly alter a safe harbor from the exercise of FDIC receivership powers relied upon in securitizations by insured depository institutions, although the significant shortcomings of the FDIC Proposal may lead one to question whether it will be adopted as a final rule. vi

Conclusion While Subtitle D promises some form of risk retention, regulators will determine the final form of that requirement. Some asset classes, residential mortgages that conform to the regulators’ specifications for low risk mortgages, for example, will be exempt from any risk retention requirements. The only certainty for participants in securitization markets coming out of the Dodd-Frank Act is the need to monitor and review proposed regulations as they are published. The key question is whether there will be anything left other than plain vanilla mortgages.



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i Notice of Proposed Rulemaking: Asset Backed Securities, 75 Fed. Reg. 23328 (May 3, 2010). ii See Advanced Notice of Proposed Rulemaking: Treatment by the Federal Deposit Insurance Corporation as Conservator or Receiver of Financial Assets Transferred by an Insured Depository Institution in Connection With a Securitization or Participation After March 31, 2010, 75 Fed. Reg. 934 (January 7, 2010); Notice of Proposed Rulemaking: Treatment by the Federal Deposit Insurance Corporation as Conservator or Receiver of Financial Assets Transferred by an Insured Depository Institution in Connection With a Securitization or Participation After September 30, 2010, 75 Fed. Reg. 27471 (May 17, 2010). iii The Dodd-Frank Act eliminates the Office of Thrift Supervision and moves to the OCC many of the functions and powers relative to federal savings banks that had previously accrued to that agency. These provisions are discussed in the K&L Gates Alert entitled “A New Era: Depository Institutions and Their Holding Companies Face a Deluge of Regulatory Changes,” by Rebecca H. Laird, Sean P. Mahoney, and Collins R. Clark. iv The provisions of the Act related to qualified mortgages are discussed in more detail in the K&L Gates Alert entitled “Hope You Like Plain Vanilla! Mortgage Reform and Anti-Predatory Lending Act (Title XIV)” by Kristie D. Kully and Laurence E. Platt. v The asset classes contemplated by the Act include residential and commercial mortgages, commercial loans, auto loans, and any other asset classes deemed appropriate by regulators. vi A critique of an early stage of the FDIC Proposal is contained in the K&L Gates Alert entitled “FDIC Proposes Far-Reaching Changes to the Legal Isolation Safe Harbor: New Requirements May Affect Securitization Sponsors, Servicers, and Investors,” by Sean P. Mahoney and Anthony R.G. Nolan.


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July 2010 Authors: Edward G. Eisert [email protected] +1.212.536.3905 Charles R. Mills [email protected] +1.202.778.9096 Anthony R.G. Nolan [email protected] +1.212.536.4843 Lawrence B. Patent [email protected] +1.202.778.9219 Gordon F. Peery [email protected] +1.617.261.3269 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Congressional Overhaul of the Derivatives Market in the United States I. Introduction On July 15, 2010, the U.S. Senate passed by a 60-39 vote the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), following earlier passage of the legislation by a 237 to 192 vote in the U.S. House of Representatives on June 30, 2010. On July 21, 2010, President Obama signed Dodd-Frank into law. Dodd-Frank constitutes the most sweeping financial reform package since the 1930s. Title VII of Dodd-Frank, the Wall Street Transparency and Accountability Act of 2010 (“Title VII”), brings about a complete overhaul of the OTC derivatives market in the United States. The primary objectives of Dodd-Frank are to bring about greater transparency and to enable U.S. regulators to better manage individual counterparty and broader systemic risks that are inherent in the OTC derivatives market. The enactment of Dodd-Frank will not be the final word on the reform of derivatives. Regulators will promulgate several dozen regulations to implement Dodd-Frank, and Congressman Barney Frank (D-MA) recently stated that a subsequent bill will be considered in early 2011 to make technical amendments to Dodd-Frank and to clarify, inter alia, an important exception for certain end-users from the requirement to centrally clear certain derivatives that are currently traded over-the-counter (“OTC”)1. The principal ways in which the drafters of Dodd-Frank intend for these objectives to be accomplished include:

• Imposing substantial requirements on the most active OTC derivatives market participants, major swap participants (“MSPs”) and swap dealers (“SDs”), including reporting, capital and margin requirements;

• Subjecting many derivatives that are currently traded OTC to central clearing and exchange trading in regulated trading systems; and

• Establishing more clearly the jurisdiction of the key regulators of derivatives, the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”), and repealing exemptions and exclusions that stood in the way of their regulation of the multi-trillion dollar OTC market.

1 Congressman Frank made this statement on the record during the final day of Congressional conference committee deliberations on June 29, 2010. See Section VI below for a discussion of the term “end-user” and the exception available to such parties.

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Title VII will mark the beginning of an intensive regulatory process to implement its provisions. While some of these provisions will become effective immediately, Congress has designed Dodd-Frank so that its parts will become effective in several stages. Congress has also delegated significant regulatory authority to regulatory agencies, with a mandate to adopt rules or conduct studies within prescribed times from enactment. Unless otherwise provided, Title VII becomes effective on a date that is the later of: (a) 360 days following the enactment of Dodd-Frank into law; or (b) to the extent that a provision thereof requires rulemaking, not less than 60 days after publication of the applicable final rule or regulation. A separate two-year phase-in period permits derivatives providers that now receive certain forms of federal assistance, including access to the discount window of the Federal Reserve, to divest themselves of certain derivative-related activities and investments. For brevity, most of the following discussion is based primarily upon Title VII’s amendments to the Commodity Exchange Act (“CEA”), but there are parallel amendments to the securities laws in almost all cases.

II. Regulatory Agencies’ Authority Title VII grants the CFTC extensive new authority over commodities derivatives markets as well as over swaps (“Swaps”), SDs and MSPs. Title VII also grants the SEC corresponding authority over security-based Swaps (“SBS”), security-based SDs (“SBSDs”) and major security-based swap participants (“MSBSPs”).2 Swaps and SBS are differentiated within Title VII by the asset class or underlier of the trade. Generally, SBS are defined as Swaps that are based on equities, bonds, or narrow-based security indices of these instruments,3 and are

2 See Sections III and IV below for a discussion of the meaning of these terms. 3 The term “narrow-based security index” is generally defined as an index: (i) that has nine or fewer component securities; or (ii) in which a component security comprises more than 30 percent of the index’s weighting; or (iii) in which the five highest weighted component securities, in the aggregate, comprise more than 60 percent of the index’s weighting; or (iv) in which the lowest weighted component securities

to be subject to the jurisdiction of the SEC. All other Swaps are to be regulated by the CFTC, with certain exceptions discussed below. Both the CFTC and SEC are granted extensive authority throughout Title VII to define which products come within their exclusive jurisdiction, which products are to be centrally cleared and which market participants must comply with the mandates of Title VII. SDs and MSPs are generally required to execute Swap transactions through an exchange facility and to clear these transactions through a derivatives clearing organization or agency (“DCO”). SDs and MSPs must comply with capital and margin requirements, as well as business conduct standards. A. Demarcation of Jurisdiction of SEC and CFTC; “Mixed Swaps”; “Credit Default Swaps” and “Identified Banking Products” The demarcation between the jurisdiction of the CFTC and the SEC was a point of some controversy in the legislative process for derivatives regulation, and some material jurisdictional ambiguities remain in Dodd-Frank. Dodd-Frank generally grants the CFTC jurisdiction over Swaps (other than SBS), participants in the markets for Swaps (such as SDs and MSPs and their associated persons) and swap execution facilities. The CFTC also is granted jurisdiction over foreign exchange Swaps and foreign exchange forwards unless the Secretary of the Treasury makes a written determination that either or both instruments: (i) should not be regulated as Swaps; and (ii) are not structured to avoid the purpose of the legislation. (See discussion in Section III below.) Unlike security futures (which include futures on a single security or loan or a narrow-based index of securities), where the CFTC and the SEC have joint jurisdiction, the SEC will have sole jurisdiction over

comprising, in the aggregate, 25 percent of the index’s weighting, have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with 15 or more component securities, $30 million), with special ranking rules for certain securities that have an equal weighting.

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SBS and participants in SBS markets such as SBSDs and MSBSPs and their associated persons, as well as security-based swap execution facilities. It is not clear how the agencies are to exercise their jurisdiction over dealers and major participants that transact in both Swaps and SBS, but these firms are required to register with both agencies. While the CFTC will generally have jurisdiction over Swaps and the SEC will generally have jurisdiction over SBS, Title VII addresses in a particular way the peculiarities of derivatives instruments that have features of both Swaps and SBS, referred to as “Mixed Swaps.” A Mixed Swap has some elements of a SBS, and also is based upon the value of one or more interest or other rates, currencies, commodities, instruments of indebtedness, indices, quantitative measures, other financial or economic interest or other property of any kind (except for a single security or a narrow-based security index), or the occurrence, non-occurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence (again, except for an event relating to a single security or a narrow-based security index). Mixed Swaps will be jointly regulated by the CFTC and the SEC, in consultation with the Federal Reserve Board. The definitions of Title VII suggest a few ways in which products may be regulated by the SEC, the CFTC, or both regulators:

• An equity swap that is structured as an option to purchase emissions credits would come within the jurisdiction of the CFTC;

• An equity swap that is an option to purchase shares of an equity security would come within the jurisdiction of the SEC;

• An equity swap with payments that depend on the movement of an equity security and the price of a mineral such as gold would likely be deemed a “Mixed Swap,” in which case both the SEC and CFTC would share jurisdiction and both would jointly regulate that equity swap.

While there are straightforward examples of how products would likely be regulated under Title VII, ambiguity remains, including in the division of

jurisdiction over derivatives such as credit default Swaps (“CDS”) and equity Swaps (“ES”). If a CDS or ES is tied to the securities issued by a publicly-traded company, or of a narrow-based index of publicly-traded companies, that CDS or ES will be under SEC jurisdiction. Conversely, if a CDS or ES is tied to a broad-based index of publicly-traded companies, that CDS or ES will be under CFTC jurisdiction. Nonetheless, some CDS or ES may be subject to joint CFTC-SEC jurisdiction. For example, if a CDS or ES is based upon the debt of governmental entities, or is tied to mortgage-backed or asset-backed securities, it is not clear upon which side of the jurisdictional divide the instrument belongs. It is to be hoped that the agencies will clarify this issue so that market participants are not subject to duplicative or inconsistent regulation. Certain “identified banking products” are excluded from the jurisdiction of the CFTC and the SEC (and the definitions of “security-based swap” and “security-based swap agreement”).4 However, an appropriate federal banking agency that has jurisdiction over a SD is authorized to make an exception to the exclusion for any particular identified banking product that it determines, in consultation with the CFTC and the SEC: (i) would meet the definition of Swap or SBS; and (ii) is known to the trade as a “swap” or “security-based swap” or otherwise has been structured to evade the CEA or the Securities Exchange Act of 1934, as amended (the “Exchange Act”). If the bank is not under the jurisdiction of an appropriate federal bank regulatory agency,5 the “identified banking

4 “Identified banking products” consist of: (1) deposit accounts, savings accounts, certificates of deposit, or other deposit instruments issued by a bank; (2) banker’s acceptances; (3) letters of credit issued or loans made by a bank; (4) debit accounts at a bank arising from a credit card or similar arrangement; and (5) participations in a loan which the bank or affiliate of the bank (other than a broker or dealer) funds, participates in, or owns, that is sold to certain persons. The exclusion from jurisdiction and from the definitions of swap and security-based swap does not extend to agreements that would otherwise qualify as identified banking products under Section 206 of the Gramm-Leach-Bliley Act. 5 Dodd-Frank defines this term by reference to the Federal Deposit Insurance Act (i.e., the Comptroller of the Currency, the Director of the Office of Thrift Supervision, the Board of Governors of the Federal Reserve System, or the Federal Deposit Insurance Corporation), the Federal Reserve Board in


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products” exclusion will not apply even if the above conditions are satisfied. B. Extraterritoriality Dodd-Frank amends the CEA to provide that the CEA “shall not apply to activities outside the United States” unless those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or contravene CFTC rules promulgated to prevent the evasion of Dodd-Frank. With respect to SEC jurisdiction, Dodd-Frank generally provides that no provision of the federal securities laws added by Dodd-Frank or any rule there under shall apply to any person that transacts a business in “security-based swaps” outside the jurisdiction of the United States” unless the person “transacts such business in contravention of SEC rules promulgated to prevent evasion of any provision” of the provisions added by Title VII. Dodd-Frank also provides, however, that it shall not be construed to limit the SEC’s jurisdiction as in effect prior to the enactment of Dodd-Frank. Dodd-Frank provides for more robust extraterritorial application of the anti-fraud provisions of the Securities Act of 1933, as amended (the “Securities Act”), and of the Exchange Act, by granting jurisdiction to the district courts of the United States to hear an action or proceeding brought or instituted by the SEC or the United States (i.e., the Department of Justice) alleging conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors, provided that the alleged conduct occurring outside the United States has a foreseeable and substantial effect within the United States. C. International Harmonization Title VII requires the CFTC and SEC to consult and coordinate with their counterparts overseas to promote effective and consistent global regulation of derivatives and other products. It is to be hoped that this will help provide a unified, consistent framework for regulation of OTC derivatives

the case of a noninsured state bank, and the Farm Credit Administration for farm credit system institutions.

markets globally in a manner that does not place U.S. market participants at a competitive disadvantage relative to participants in other jurisdictions. In addition, the authority of the CFTC and the SEC to prohibit entities from certain countries from participating in the OTC derivatives markets in the United States in certain circumstances, as described below in Section X, may be used to try to bring about international harmonization of the regulation of Swaps and SBS.

III. Definitions of “Swap” and “Security-Based Swap” A. Generally Title VII defines a “Swap” as any agreement, contract or transaction that: (i) provides for an exchange of payments based upon the value or level of interest or other rates, currencies, commodities, securities, debt instruments, indices, quantitative measures, or other financial or economic interests or property of any kind that transfers financial risk without transferring ownership risk; (ii) is an option on such interests or property; or (iii) provides for any purchase, sale, payment, or delivery that is dependent upon the occurrence, non-occurrence or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence. Examples of Swaps cited in Title VII include, among others, interest rate swaps, currency swaps, credit default swaps, energy swaps, and metal swaps. Title VII defines a SBS as a Swap that is based on a narrow-based security index, a single security or a loan, or the occurrence, non-occurrence or the extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index. It will be important for investment managers to bear this in mind when reviewing trading operations and compliance programs under Dodd-Frank. B. Special Issues Dodd-Frank amends but preserves much of the pre-existing definition of “swap agreement” in Section 206A of the Gramm-Leach-Bliley Act. As

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amended, it would appear materially broader than the new and distinct definition of “swap” in the CEA. Its legal application is not clear in light of that new CEA definition. The definition of a Swap in Title VII excludes any “sale” of a “nonfinancial” commodity or security for “deferred shipment or delivery” so long as the transaction is “intended to be physically settled.” It is anticipated that many commercial entities involved in the purchase and sale of physical commodities will seek to rely on this exclusion for, at a minimum, all forward contracts. Ultimately, what constitutes an intent to physically settle and the proof necessary to establish such intent will be critical to determining the scope of the exclusion. For example, the plain terms of the exclusion could fairly be interpreted to include a sale that the parties intended to settle by physical delivery when the contract was formed, even though they later financially settled it due to changes in their commercial needs or circumstances. But what the CFTC will require to demonstrate the original intent to physically settle will have to await its later rulemakings or case decisions. In applying the existing forward contract exemption under the CEA, the CFTC and many courts have evaluated the legal character of transactions retrospectively, giving weight to such matters as the nature of the parties (commercial or retail investors), the nature of the transaction (commercial or investment), the prior dealings of the parties (what percentage of transactions resulted in deliveries), and a host of other factors.6 The CFTC has said that

6 See, e.g., Andersons, Inc. v. Horton Farms, Inc., 166 F.3d 308, 320 (6th Cir. 1998) (citing seven factors evidencing intent to deliver: (1) the defendant entered into these contracts only with farmers and producers of grain rather than with speculators from the general public; (2) each plaintiff was in the business of growing grain and had the ability to make delivery on the contracts; (3) the defendant was in the business of obtaining grain under contracts for resale and relied on actual delivery of that grain to carry out its business; (4) the defendant had the capacity to take delivery of the grain subject to the contracts; (5) on their faces, the contracts were clearly grain marketing instruments to accomplish the actual delivery of grain in exchange for money; (6) it was undisputed that delivery and payment routinely occurred between the parties in past dealings; and (7) the plaintiffs received cash payment on the contracts only upon delivery of the actual commodity.). See also Characteristics Distinguishing Cash

a transaction must be viewed as a whole with a critical eye toward its underlying purpose and that no bright-line definition or list of characterizing elements is determinative. This precept was criticized by some, however, for failing to provide sufficient prospective legal certainty for commercial dealings.7 The new Swap exclusion provides an opportunity for the CFTC to consider its approach anew. Another issue of significant controversy during the formulation of Dodd-Frank was whether currency derivatives should be outside of the legislative framework considering the special features of the currency derivatives markets and the sheer size of those markets. As enacted, Title VII includes currency derivatives (i.e., foreign exchange forwards and foreign exchange Swaps) in the definition of Swap unless the Secretary of the Treasury makes a written determination, submitted to the House and Senate Agriculture Committees, that these instruments should not be regulated as Swaps. In making this determination, the Treasury Secretary is required to consider, among other matters, whether bank regulators provide adequate supervision of these products and the extent and adequacy of payment and settlement systems. If the Treasury Secretary makes such a determination, foreign exchange forwards and Swaps would still be required to be reported to a Swap repository or the CFTC, and SDs and MSPs that are parties thereto would be subject to business conduct standards. This treatment of OTC currency derivatives thus reflects a compromise position concerning the extent to which such instruments should be subject to regulation. Whether or not foreign exchange forwards and Swaps are traded on exchanges or cleared, they would be subject to statutory anti-fraud and anti-manipulation proscriptions. and Forward Contracts and “Trade” Options, 50 Fed. Reg. 39656, 39657 (Sept. 30, 1985). 7 “It is essential to know beforehand whether a contract” is covered by the CEA because “[c]ontracts allocate price risk, and they fail in that office if it can’t be known until years after the fact whether a given contract was lawful.” Nagel v. ADM Investor Services, Inc., 65 F. Supp. 2d 740, 752 (N.D. Ill. 1999) (Easterbrook, J.), aff’d., Nagel v. ADM Investor Services, Inc., 217 F.3d 436 (7th Cir. 2000). See also, e.g., In re Competitive Strategies for Agric., Ltd., [2003-2004 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 29,635 (CFTC Nov. 25, 2003) (dissent of Commissioner Sharon Brown-Hruska).

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Dodd-Frank repeals provisions of the Commodity Futures Modernization Act and Gramm-Leach-Bliley Act that prohibit the SEC from regulating SBS. Section 762 of Title VII amends Section 2A of the Securities Act and Section 3A of the Exchange Act. In general terms, these provisions excluded Swaps (as defined in Section 206 of the Gramm-Leach-Bliley Act) from the definition of security while subjecting SBS to anti-fraud provisions and to the limited reporting obligations under Section 16 of the Exchange Act. Significantly, these provisions also prohibit the SEC from promulgating, interpreting or enforcing rules or issuing orders of general applicability regarding SBS. Title VII would amend these provisions by making conforming changes to reflect that “security” includes SBS. However, it would not eliminate the limits on the SEC’s regulatory authority. This would appear to be inconsistent with other provisions of Dodd-Frank, such as those discussed above, that specifically call on the SEC to set margin requirements and make other determinations or interpretations with respect to SBS. This is another area of jurisdictional ambiguity that must be clarified through further legislative action, perhaps in a “technical corrections” Dodd-Frank, and subsequent rulemaking. See Section XIII for a discussion of Exchange Act beneficial ownership reporting relating to SBS. Title VII provides for the CFTC and the SEC to conduct a joint study within 15 months of enactment of Dodd-Frank into law to determine whether “stable value contracts” fall within the definition of a Swap and, if so, whether an exemption for stable value contracts from the definition of Swap is in the public interest. Title VII also provides that its provisions do not apply to stable value contracts during the term of that study. This relief was granted after Congress became aware of how the financial services reform legislation could inadvertently do great harm to stable value funds, which are popular investment options under many defined contribution retirement plans such as 401(k) plans and 457(b) plans and are also used outside the retirement plan context, such as in section 529 qualified tuition plans. However, the relief granted only applies to defined contribution plans, deferred compensation plans and qualified tuition plans. This raises the question of whether the CFTC and the SEC have exemptive authority with respect to stable value

contracts in funds that are part of defined benefit plans and also raises the question of whether such funds within defined benefit plans are subject to Title VII.

IV. Definitions of Swap Dealers and Major Swap Participants; Security-Based Swap Dealers and Major Security-Based Swap Participants A. Swap Dealer; Security-Based Swap Dealer Under Title VII, a SD is defined as: “any person who (1) holds itself out as a dealer in Swaps; (2) makes a market in Swaps; (3) regularly enters into Swaps with counterparties as an ordinary course of business for its own account; or (4) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in Swaps.” A person may be designated as a SD for a single type or single class or category of Swap, but not for other types, classes, or categories of Swaps. The term SD, however, does not include a person that enters into Swaps for such person’s own account, either individually or in a fiduciary capacity, but not as part of a regular business. Also, the CFTC is authorized to exempt from designation as a Swap dealer any entity that engages in “de minimis” Swap dealing with or on behalf of customers, and to promulgate regulations to establish factors that would govern such an exemption. Title VII contains similar definitional provisions for a SBSD, but with references to Swaps being to SBS and references to the CFTC being to the SEC. B. Major Swap Participant; Major Security-Based Swap Participant Title VII defines a MSP as a non-Swap dealer that: (1) maintains a “substantial position” in Swaps for any of the major Swap categories as determined by the CFTC (excluding positions held for hedging or mitigating commercial risk); (2) has substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S.

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banking system or financial markets; or (3) is a financial entity (see discussion of this term below) that is highly leveraged relative to the amount of capital it holds, is not subject to the capital requirements of a federal banking regulator, and maintains a substantial position in outstanding Swaps in any major Swap category. Positions maintained by any employee benefit plan for the primary purpose of hedging or mitigating any risk directly associated with the plan’s operation are also excluded from the “substantial position” threshold, thus enabling employee benefit plans to be excluded from the definition of MSP. Title VII contains similar definitional provisions for a MSBSP, but with references to Swaps being to SBS and references to the CFTC being to the SEC. The CFTC and the SEC will separately be required to define the term “substantial position” in the MSP and MSBSP definitions in such a way that is “prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the United States.” Therefore, entities whose Swap transactions are not considered to create systemic risk potentially may be able to avoid designation as a MSP or MSBSP. For example, an entity transacting only in a relatively small niche market among a small number of counterparties could be deemed to pose no systemic risk and thus not come within the MSP or MSBSP definition. The MSP definition also excludes entities whose primary business is to provide financing and that use derivatives to hedge commercial risks related to interest rate and currency exposures, where at least 90 percent of the exposures arise from financing that facilitates the purchase or lease of products, if 90 percent or more of the products are manufactured by the entity’s parent company or another subsidiary of the parent company. As with SDs, a person may be designated as a MSP for one or more categories of Swaps or SBS, as appropriate, without being classified as a MSP for all classes of Swaps.

V. Clearing A. Title VII Requirements It is important to recognize that Title VII does not require that all derivatives in the U.S. OTC derivatives market be centrally cleared. The general rule is that, if the CFTC or SEC determines that a Swap or SBS (as appropriate) must be cleared, then counterparties to that Swap or SBS are prohibited from entering into and settling that instrument unless they submit it to a DCO or clearing agency in the absence of an exception to the clearing requirement. If the CFTC or SEC takes no action, but a DCO accepts for clearing instruments of the relevant type, an end-user may elect that the Swap be submitted to the clearing organization for clearing in accordance with that organization’s rules and procedures or the derivative may be settled OTC, but other requirements (e.g., reporting and recordkeeping) still apply to the trade. In order to be authorized to clear a derivative, a DCO must file an application with the CFTC or SEC, as applicable. The CFTC or the SEC must act on the submission within 90 days, unless the DCO agrees to an extension of time. A DCO must provide for Swaps or SBS to be cleared on a non-discriminatory basis, whether they were executed bilaterally or through an unaffiliated exchange. In addition, if no DCO is requested to clear a particular Swap or SBS otherwise subject to mandatory clearing, that is, neither party thereto qualifies for an exemption from mandatory clearing, the CFTC must conduct an investigation and issue a public report within 30 days, and take such action as the CFTC deems necessary and in the public interest, which may include requiring the parties to retain adequate margin or capital. However, the CFTC could not require a DCO to clear a Swap or SBS if the clearing of that instrument would threaten the financial integrity of the DCO. If a SBS must be cleared under Title VII, the counterparties to the SBS must submit the SBS to a DCO or a clearing agency. 8

8 DCOs and clearing agencies are typically organizations that are either owned by exchanges or are operated separately from exchanges, and for purposes of this discussion, both are referred to as “DCOs.”

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B. Clearing Mechanics, Documentation and Technology DCOs, through a novation by the counterparties to a Swap or SBS, in essence step in between the counterparties and become the buyer to the counterparty that is the seller, and the seller to the counterparty that is the buyer, thereby ensuring the performance of both counterparties’ obligations under the Swap. While the clearing mechanics, documentation and technology are not expressly mandated by the sections within Title VII, a brief discussion of how clearing works in the Dodd-Frank regulatory regime is necessary. To centrally clear those Swaps or SBS that are designated for clearing, a member of a DCO must be designated to submit the Swap to the DCO. Not all Swap counterparties are members of DCOs. DCO membership, which is not prescribed by Title VII or other provisions of Dodd-Frank, is open to parties to Swaps that meet certain prudential and other requirements, which typically include a certain level of assets, as well as other undertakings such as the posting of collateral to a large default insurance fund of the DCO. In the current OTC derivatives market, generally only the largest dealers and end-users are members of DCOs. If neither of the two counterparties that face each other in the derivatives transaction is a member of a DCO, one must “give up” the Swap to a member of a DCO by entering into a contract with a DCO member, which in turn clears the Swap through the DCO. DCO members generally guarantee the performance of the Swap by the original counterparties and employ certain remedies and other mechanisms in the event of a member default. Not all requirements (including documentation and margin arrangements) are the same for all DCOs, and not all members of DCOs use the same technology or margin arrangements. Title VII does not harmonize the divergent clearing arrangements that exist in the market today. Some DCOs allow their members to hold the margin that the DCOs require to secure performance of the derivatives that are cleared. Other DCOs themselves hold the counterparties’ margin.

The documentation that is required to centrally clear a Swap or SBS under Title VII varies according to the DCO that clears the Swap or SBS. In some cases, the DCO adds an annex to the existing ISDA Master Agreement, Schedule and Credit Support Annex documentation; the annex supplements the existing ISDA and incorporates new clearing requirements for “Covered Transactions” that are subject to the DCO rules. Title VII does not prescribe any particular technology to satisfy the clearing requirements imposed by the SEC or the CFTC. Each DCO generally has a clearing platform that is adopted by end-users and members to a cleared trade. Swaps and SBS will not be subject to Title VII clearing (and exchange-trading and margining) requirements if the counterparties entered into the transactions before the enactment of Dodd-Frank or prior to the effectiveness of a clearing requirement that is imposed by the SEC or CFTC, if the end-user exception is met (as described below), or if certain other requirements are satisfied as described below.

VI. The End-User Exception to the Clearing Requirements; Treatment of Eligible Contract Participants There is an exception to the requirement that certain Swaps or SBS be centrally cleared under Title VII, for instruments to which one of the counterparties is a commercial end-user9 that hedges or otherwise manages commercial risk through the Swap. A counterparty that qualifies for this exception: (i) is not a “financial entity”; (ii) uses Swaps to hedge or mitigate “commercial risk”; (iii) notifies the

9 The term “end-user” is not defined in Dodd-Frank, but, in OTC derivatives industry parlance, the term generally refers to the party that faces the SD dealer in the trade. End-users to swaps include those that hedge or mitigate “commercial risk.” Whether an end-user will qualify for the exception to the clearing mandate in Section 723 of Dodd-Frank will turn in large part on whether the end-user is a “major swap participant” or a “financial entity,” as discussed more fully below. The CFTC and the SEC are granted authority to define the term “commercial risk.”

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appropriate regulatory agency how it meets its financial obligations related to non-cleared Swaps; and (iv) is not a SD or MSP. The exclusion of “financial entities” from the commercial end-user exception means that a large swathe of participants in OTC derivatives markets are not eligible for this exemption. The term “financial entity” for this purpose is broadly defined and includes SDs, SBSDs, MSPs, MSBSPs, commodity pools, Private Funds,10 employee benefit plans, and entities predominantly engaged in banking or financial activities.11 However, there are important exceptions to the definition of “financial entity,” particularly for the financing arms of manufacturers. Furthermore, the CFTC and the SEC also may exempt “small” depository institutions, farm credit system institutions, and credit unions with total assets of $10 billion or less. In the case of publicly-traded companies, the commercial end-user exemptions from clearing and exchange-trading of Swaps are available only if an appropriate committee of the board or governing body reviews and approves its decision to enter into OTC derivatives trades. The end-user may use an affiliate to conduct its Swaps activity, provided that the affiliate is not a SD, SBSD, MSP, MSBSP, Private Fund, commodity pool, or a bank holding company with over $50 billion in consolidated assets. However, under Title VII a person that is not an “eligible contract participant” as defined in the CEA12 (an “ECP”) may not enter into a Swap or 10 A “Private Fund” for these purposes is defined in Section 202 of the Investment Advisers Act of 1940, as amended by Dodd-Frank, as a fund that would be an “investment company,” as defined in the Investment Company Act of 1940, as amended, but for the exclusions of Section 3(c)(1) or Section 3(c)(7) thereunder. 11 By covering MSPs and MSBSPs as “financial entities,” Title VII creates a risk that commercial or manufacturing entities with large derivatives trading activity may not be eligible for the exemption from central clearing. 12 Generally speaking, an ECP is a financial institution, an insurance company, investment company, commodity pool, corporation or other legal entity, an employee benefit plan, governmental entity, or certain other types of entities and individuals, in each case having a minimum required total assets, net worth or total amount invested, as applicable, or

SBS except on a board of trade, and SBS are subject to the registration requirement of Section 5 of the Securities Act unless each counterparty to the SBS is an ECP. Title VII also narrows the definition of the term “eligible contract participant”. Subject to the foregoing limitations, it appears that ECPs will continue to be able to enter into non-standard derivatives that are not centrally cleared and exchange-traded, as long as the SEC and the CFTC do not require that the derivatives be centrally cleared. Prior to the passage of Dodd-Frank in the House of Representatives on June 30, 2010, the Congressional conference committee on Dodd-Frank (the “Committee”) reconvened on June 29, 2010 to consider a $19 billion bank tax, which the Committee removed from Dodd-Frank. During its June 29, 2010 meeting, the Committee considered an amendment to re-open Title VII to clarify the end-user exemption, but the amendment failed on a 6-6 vote among the members of the Committee from the Senate. Congressman Frank subsequently stated on the record that he expects that a bill in early 2011 will be necessary not only to make technical corrections to Dodd-Frank but also to make more substantive changes to clarify the end-user exception. Since the final meeting of the Committee, Senators Christopher Dodd and Blanche Lincoln wrote a letter to House leadership (the “Dodd-Lincoln Letter”) stating that the design of the end-user exception (and the scope of the definition of MSPs) is to enable certain classes of end-users that hedge or otherwise manage commercial risk through derivatives to continue to use derivatives for those purposes without having to centrally clear or margin their trades.

VII. Trading Venues Swaps will generally be required to be traded on designated contract markets, or exchanges (“DCMs”), or a type of newly created facility referred to as a “swap execution facility (“SEF”).

meeting other specified requirements. See Section 1a(12) of the CEA.

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Unlike a SEF, a DCM can also serve as a trading platform for futures. Title VII requires that both DCMs and SEFs satisfy certain core principles. In order for cleared swaps to be traded on SEFs, the SEFs must satisfy criteria imposed by Title VII, which includes: (i) prohibiting trading of derivatives that are susceptible to manipulation; (ii) imposing internal controls to monitor the trading of swaps to prevent manipulation, price distortion and disruptions in trade processing; (iii) facilitating information dissemination to regulators; and (iv) implementing rules that are in line with those set by the SEC and CFTC (e.g., rules on position limits).

VIII. Reporting of Transactions Dodd-Frank imposes comprehensive daily recordkeeping requirements on MSPs and SDs, requiring them to maintain daily trading records of trades, along with all recorded communications, electronic mail and instant messages relating to Swaps. Complete audit trails for conducting comprehensive trade reconstruction are mandated and trade details are to be stored under Title VII. In addition, all Swaps or SBS must be reported to a registered trade repository for Swaps or SBS, as the case may be, regardless of whether they are cleared or uncleared and regardless of whether they are entered into by financial entities or commercial end-users. Real-time public reporting of transaction data, including price and volume, is required, which is defined as being as soon as technologically practicable after the Swap transaction is executed. “Real-time public reporting” in Title VII means the reporting of the salient terms of the Swap (e.g., volume, price). For cleared Swaps, Title VII imposes the real-time public reporting obligation. The CFTC or the SEC, as appropriate, is required to adopt regulations to ensure that parties to a transaction are not identified, and to specify criteria to define a large notional Swap transaction (a block trade) and to specify the appropriate time delay for reporting block trades to the public, taking into account whether public disclosure will materially reduce market liquidity. This requirement was intended to address the concerns of market

participants that real-time reporting of block trades could make dealers reluctant to assume the risks of block trades, because other market participants might then be able to trade ahead of the dealers’ transactions to hedge or liquidate the position. Every six months, the CFTC and the SEC are required to issue a written report to the public regarding the trading and clearing in the major categories of Swaps and SBS, and the market participants and developments in new products, on an aggregate basis. For uncleared Swaps, the reporting obligation is imposed upon SDs as long as a SD is a party to the transaction, regardless of whether the counterparty is a MSP or not. If the Swap does not have a SD as one of the parties, and if one party is a MSP, then the MSP must report; otherwise, the parties shall select which one shall report. Even Swaps and SBS that are entered into before the clearing requirement becomes effective13 would have to be reported to a registered Swap data repository or the CFTC or a registered SBS depository or the SEC, as appropriate. Swaps or SBS entered into before the date of enactment must be reported within 180 days after the effective date of Title VII (about a year and one-half after enactment), and Swaps entered into on or after the date of enactment must be reported within 90 days after such effective date or such other time as the CFTC or SEC, as applicable, may prescribe by rule or regulation.

IX. Capital and Margin Requirements A. General The CFTC or the SEC, as appropriate, in consultation with the banking regulators, must 13 Within one year of the President’s signing of Dodd-Frank into law, Dodd-Frank requires the CFTC and the SEC to promulgate rules for DCOs to submit to the regulators certain categories of Swaps that the DCOs seek to accept for clearing. The CFTC and SEC are required by Dodd-Frank to review on an ongoing basis each “swap” or groups, categories or types of Swaps for purposes of determining whether the derivatives must be cleared.

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establish capital requirements as well as requirements for margin on uncleared Swaps or SBS for SDs, SBSDs, MSPs and MSBSPs. DCOs and exchanges will set margin for cleared Swaps and SBS. The margin requirements for uncleared Swaps, to be set by the regulators, are intended to account for the greater risk presented by uncleared Swaps as compared to cleared Swaps, and to ensure the safety and soundness of the SD, SBSD, MSP and MSBSP. It is not clear how the regulators will set margin levels for uncleared Swaps. The regulators will not be able to move as swiftly as the exchanges and DCOs to adjust margin levels, particularly if they wish to increase margin requirements. Presumably, they will establish a certain formula or percentage calculation for parties to use in determining the amount of margin to be posted for uncleared Swaps. The CFTC/SEC margin levels are, therefore, likely to exceed those established by exchanges and DCOs. OTC derivatives are generally collateralized by cash and liquid securities such as U.S. Treasuries, but contractual arrangements also permit letters of credit and other assets as eligible collateral to support out-of-the-money positions and are commonly used by commercial end-users. Many end-users argued during the legislative deliberations that the imposition of cash margin requirements would be financially burdensome and inconsistent with longstanding market practice. The CFTC is directed to permit the use of non-cash collateral as margin for counterparty arrangements of end-users with SDs and MSPs, if it determines that would be consistent with preserving the financial integrity of markets trading Swaps and preserving the stability of the U.S. financial system. The International Swaps and Derivatives Association, Inc. issued on June 29, 2010 a press release, referenced in the final meeting of the Congressional conference committee, which stated that U.S. companies may be faced with $1 trillion in capital and liquidity requirements due to the requirements of Title VII. The Dodd-Lincoln Letter clarifies that Dodd-Frank is intended to exempt certain end-users from clearing and margining requirements and recognizes that imposing the clearing and exchange trading requirement on commercial end-users could contravene public policy by raising transaction costs where there is a

substantial public interest in keeping such costs low in order to protect consumers, promote investments and create jobs.14 Interestingly, by precluding the imposition of margin requirements for commercial end-users, the terms of the Dodd-Lincoln Letter would effectively work against one of the legislative objectives for margin requirements (driven by the perception of AIG’s use of derivatives), which is to prevent SDs and MSPs from engaging in Swaps that could adversely affect their creditworthiness. Title VII does not include a provision that expressly prohibits regulators from applying margin requirements retroactively. However, following the concerns expressed about this issue by, among others, Warren Buffett and the American Bar Association Section on Business Law Derivatives and Futures Law Committee, it appears that margin requirements will not be imposed retroactively on existing Swaps. The Dodd-Lincoln Letter states that Congress did not intend for Title VII to have retroactive effect regarding margin for existing Swaps. In setting the capital requirements, the CFTC must take into account all of the activities of SDs and MSPs, including activities that are not required to be regulated. This raises a question of whether the CFTC would be authorized to impose capital requirements on an entity that is generally treated as a commercial end-user, if the entity is a MSP for a particular type of Swap. Dodd-Frank appears to authorize the CFTC to impose capital requirements based on all of the transactions entered into by a regulated entity. B. Segregation Swap customers providing margin for Swaps that are cleared through a DCO will retain ownership of that margin in much the same way that futures customers retain ownership of collateral pledged to 14 Letter from Chairman Christopher Dodd, Senate Committee on Banking, Housing, and Urban Affairs, United States Senate and Chairman Blanche Lincoln, Senate Committee on Agriculture, Nutrition, and Forestry, United States Senate, dated June 30, 2010 to Chairman Barney Frank, Financial Services Committee, United States House of Representatives and Chairman Collin Peterson, Committee on Agriculture, United States House of Representatives, at 2-3.

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futures commission merchants. Swap customer margin is to be segregated, separately accounted for, and not commingled except in certain specified circumstances. For uncleared Swaps, the SD or MSP will be required to notify its counterparty at the beginning of a transaction, that the counterparty has the right to require segregation of initial (but not variation) margin. Segregated funds may be invested in permissible investments under CFTC regulations, and the parties to the Swap may arrange how to allocate gains and losses on such investments.

X. Registration and Regulation of SDs and MSPs SDs and MSPs will be required to register as such under the CEA, and SBSDs and MSBSPs will be required to register with the SEC under the Exchange Act. Such registration will be required even if the person is a depository institution or is registered with the other regulatory agency in accordance with the provisions of Title VII. Title VII defines an “associated person” of a SD or MSP as a person engaged in the solicitation or acceptance of Swaps or SBS, as the case may be, or the supervision of a person so engaged, unless the person’s functions are solely clerical or ministerial. Although Title VII does not speak specifically to registration of associated persons, regulations promulgated by the CFTC and the SEC will undoubtedly require it, with attendant fitness and proficiency examination requirements. A. Recordkeeping and Reporting Requirements As discussed in greater detail in Section VIII above, all SDs and MSPs will have to maintain daily trading records of Swaps and all related records (including related cash or forward transactions); recorded communications, including electronic mail, instant messages and telephone calls; daily trading records for each customer or counterparty; and a complete audit trail to enable comprehensive and accurate trade reconstructions. The records will have to be maintained for the time period required by the CFTC and the SEC. The CFTC currently requires records to be kept for five years, and

records must be readily available during the first two years. B. Business Conduct Standards Generally. Title VII will impose business conduct requirements on SDs and MSPs. These include requirements (1) to verify that any counterparty is an ECP and (2) to disclose to their counterparties that are not SDs or MSPs (a) information about the material risks and characteristics of the Swap; (b) any material incentives and conflicts of interest associated with the Swap transactions; (c) the DCO’s daily mark for cleared Swaps, if the counterparty requests it; and (d) the SD’s or MSP’s daily mark for uncleared Swaps. In addition, SDs and MSPs will be required to communicate in a fair and balanced manner based on principles of fair dealing and in good faith. Duties of SDs and MSPs to Governmental Entities and Retirement Plans. In addition, under Title VII, SDs, SBSDs, MSPs and MSBSPs will have special duties to governmental entities, pension plans, and endowments, which are referred to as “Special Entities.” If a SD or SBSD acts as an advisor to a Special Entity, it must act in the best interests of the Special Entity and have a reasonable basis for determining that any Swap recommended to the Special Entity is in the best interests of the Special Entity. If a SD, a SBSD, a MSP or a MSBSP acts as a counterparty to a Special Entity, it must have a reasonable basis to believe that the Special Entity has a representative independent of the SD, SBSD, MSP or MSBSP that is capable of evaluating the risks of the transaction, is not subject to a statutory disqualification from registration, and will act in the best interests of the Special Entity. The SD must also disclose in writing before the initiation of the transaction the capacity in which it is acting. In any dealings with Special Entities, SDs and MSPs are prohibited from engaging in fraudulent, deceptive or manipulative acts. This provision of Title VII replaces a proposal in the Senate bill that would have imposed a fiduciary duty on SDs or SBSDs that (1) provide advice regarding, (2) offer to enter into, or (3) enter into a Swap or SBS with a government entity or agency, pension plan, endowment or retirement plan. This provision was highly controversial because of the concerns of state governments and retirement plans that the

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imposition of a fiduciary duty would effectively close the market for Swaps and SBS to Special Entities. C. Conflicts of Interest Under Title VII, SDs, SBSDs and MSPs must implement conflict-of-interest protocols that separate any research and analysis personnel from trading and clearing personnel. Specifically, these entities will be required to separate, by appropriate information barriers within the firm, employees conducting research or analysis of the price or market for any commodity, Swap or SBS, or acting in a role of providing clearing activities or making determinations as to accepting clearing customers, from the review, pressure and oversight of persons involved in pricing, trading or clearing activities. D. Position Limits Title VII grants the CFTC authority to impose aggregate position limits for contracts in non-financial commodities that are traded on designated contract markets and Swap execution facilities, as well as Swaps that are not centrally executed if they perform a significant price-discovery function with respect to exchange-traded contracts. It also will grant the SEC authority to impose aggregate position limits across SBS that may be held by any person, including positions in any SBS and any security or group or index of securities, the price, yield, value, or volatility of which, or of which any interest therein, is the basis for a material term of such SBS. These provisions will significantly expand the authority of the CFTC and the SEC to limit the size of an entity’s overall portfolio by limiting or eliminating the entity’s ability to take positions in the OTC market as it reaches the position limits in the futures market. The CFTC is also directed to seek to ensure that trading on foreign boards of trade in the same commodity will be subject to comparable limits and that any limits imposed by the CFTC will not cause price discovery in the commodity to shift to trading on foreign boards of trade. In addition, if the CFTC or the SEC determines that the regulation of the Swaps or SBS markets in a non-U.S. country undermines the stability of the U.S. financial system, the CFTC or

the SEC, in consultation with the Secretary of the Treasury, may prohibit an entity from that country from participating in any U.S. Swap or SBS activities, as the case may be. This represents a significant expansion of the CFTC’s jurisdictional reach. While this provides a potentially important tool to bring about international harmonization of the regulation of Swaps and SBS, it is unlikely that the regulators would take such action very often because of the severe consequences that such a trading ban could have on a wide range of market participants and relationships.

XI. Prohibition on Federal Assistance to Swaps Entities Incorporating a version of the “Lincoln Rule,” Title VII prohibits, subject to a two-year phase-in period, any “swaps entity” from receiving enumerated types of funding or credit support from the U.S. government with respect to any activity, regardless of whether related to Swaps or SBS.15 However, the prohibition would not apply to Swaps entities whose activities are limited to trading interest rate Swaps, foreign exchange Swaps, government securities, AAA-rated debt instruments or entering into Swaps to hedge their own risk. CDS and ES could only be entered into if cleared by a registered DCO or securities clearing agency, or a DCO or securities clearing agency that is exempt from registration by the CFTC or SEC, respectively. The categories of proscribed assistance (referred to in Title VII as “Federal assistance”) include advances from any Federal Reserve credit facility or discount window that is not part of a program or facility with broad-based eligibility under section 13(3)(A) of the Federal Reserve Act, Federal Deposit Insurance Corporation (“FDIC”) insurance or guarantees for the following purposes: (A) making any loan to, or purchasing any stock, equity interest, or debt obligation of, any Swaps entity; (B) purchasing the assets of any Swaps

15 Dodd-Frank defines the term “swaps entity” generally to include a registered SD, SBSD, MSP, MSBSP and a swap execution facility, designated contract market, national securities exchange, central counterparty, clearing house, clearing agency and derivatives clearing organization.

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entity; (C) guaranteeing any loan or debt issuance of any Swaps entity; or (D) entering into any assistance arrangement (including tax breaks), loss sharing, or profit sharing with any Swaps entity. Swaps entities will be required to “push out” much of their Swap trading activity that is not covered by the safe harbor described above, that is, conduct it through a separately capitalized affiliate in order to insulate these activities from the prohibition on Federal assistance. The prohibition on Federal assistance also precludes the use of taxpayer funds to prevent the receivership of any Swap entity resulting from that entity’s Swap activity if the entity is FDIC-insured or has been designated as systemically important. If a FDIC-insured or systemically important institution is put into receivership or declared insolvent because of Swap activity, then its Swap activity will be subject to termination or transfer in accordance with applicable law. All funds that are expended on the termination or transfer of Swap activity of a Swaps entity must be recovered, either through the disposition of assets of the Swap entity or by assessments, including on the financial sector. Title VII expressly provides that taxpayers are to bear no loss as a result of the exercise of any authority related to winding up the Swap activity of an entity that is FDIC-insured or systemically important, and no taxpayer resources are to be used for the orderly liquidation of any Swaps entity that is not FDIC-insured or systemically important.

XII. Special Considerations Relating to Investment Funds Like many other provisions of Dodd-Frank, Title VII has potentially far-reaching effects on investment funds that are registered under the Investment Company Act of 1940, as amended (the “1940 Act”), as well as those that are not, but engage in OTC derivatives trading as part of their business. Investment companies registered (or that seek registration) under the 1940 Act that use Swaps must reconsider their regulatory status and may need to reconsider their investment strategies. Unregistered funds must consider the implications of possibly being caught up in multiple regulatory schemes.

A. Registered Investment Funds. Dodd-Frank revises the CEA to make all Swaps, generally other than SBS, subject to CFTC jurisdiction by removing the exception for Swaps from the definition of “commodity” under the CEA. As a result, the operators (general partners or managing members) of funds that invest in Swaps will become subject to regulation as commodity pool operators, like their cousins that invest in futures contracts. More important for registered investment companies, Dodd-Frank revises the Securities Act and the Exchange Act to include SBS within the definition of “security.” The new definition of SBS includes only Swaps that reference a narrow-based security index or a single stock. As a result, Swaps based on broad-based securities indices (as well as non-SBS like commodity Swaps) are excluded from the definition of security, but subject to CFTC jurisdiction. This revision creates new uncertainties for funds that want to register as investment companies under the 1940 Act. The definition of “investment company” under the 1940 Act turns on whether a fund invests in securities; before Dodd-Frank, a fund that primarily invested in Swaps based on securities could register as an investment company because of the ambiguous status of these instruments.16 However, under Dodd-Frank, a fund 16 SBS and non-SBS had been specifically excluded from CFTC jurisdiction under law in effect prior to the enactment of Dodd-Frank. Therefore, the operator of a fund that invested only in swaps (as opposed to futures) on securities has not been subject to CFTC oversight as a commodity pool operator. SBS and non-SBS also had been specifically excluded from the definition of “security” under the Securities Act and the Exchange Act prior to the enactment of Dodd-Frank. Nevertheless, the SEC permitted funds that primarily invest in SBS (including Swaps based on broad-based securities indices, narrow-based securities indices, and single stocks) to register as investment companies, despite the argument that such funds may not be engaged in investing in “securities.” Presumably, the rationale for having permitted such funds to register with the SEC as investment companies is based in large part on the argument that the definition of “security” under the 1940 Act is broader than the corresponding definition under the Securities Act and the Exchange Act. The Staff of the SEC has been more tentative as to whether to treat swaps that do not reference securities as securities under the 1940 Act. However, it has allowed funds that primarily invest in currency swaps to register as investment companies under the 1940 Act. It has also permitted funds that primarily invest in commodity swaps to register as investment companies under the 1940 Act,


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that primarily invests in Swaps based on a broad-based securities index, now may be treated as a fund that does not invest in “securities,” and is specifically subject to CFTC jurisdiction. As a result of the new legislation, registered funds and funds seeking to register with the SEC may have to rethink their use of Swaps if they wish to be regulated as investment companies rather than as commodity pools. B. Private Funds A “Private Fund,” or the investment manager of a Private Fund, might be deemed to be a SD, SBSD, MSP or a MSBSP and be required to register as such with the CFTC, the SEC, or both, depending on the degree to which its investment program employs Swaps or SBS. As noted, relevant considerations under Dodd-Frank include the “regularity” with which the fund or its adviser enters into Swaps “in the ordinary course of business” and the degree of leverage employed. Managers also must carefully consider how the instruments they employ in their investment programs might be characterized and regulated.17 The subjective nature of these determinations pose new regulatory risks to Private Fund managers and their counterparties that will not be resolved, if at all, until the rulemaking process is completed or clarifying legislation is enacted. It appears that Dodd-Frank does not affect the ability of a general partner or managing member of a Private Fund to rely upon the exemptions from registration as a commodity pool operator provided by CFTC Regulation 4.13(a)(3) or (4), for certain otherwise regulated entities to rely upon the exclusion from the definition of commodity pool operator provided by CFTC Regulation 4.5, or for such managers to rely upon the exemption from registration as a commodity trading advisor provided by CFTC regulations for advisors to entities that come within the scope of the foregoing regulations.

although, for tax purposes, such funds typically invest in commodity swaps through wholly-owned subsidiaries. 17 E.g., see the discussion regarding the use of Mixed Swaps, forward contracts on securities that, by their terms, are to physically delivered, and CDS/ES in Sections II(A), III and XIII, respectively.

XIII. Exchange Act Beneficial Ownership Reporting and Anti- Fraud Provisions Relating to Security-Based Swaps Title VII includes SBS within the definition of the term “security” under both the Securities Act and the Exchange Act. Furthermore, because SBS is defined to include securities or loans, Title VII may expand the scope of coverage of OTC derivatives as securities beyond those in current law. A. Exchange Act Beneficial Ownership Reporting Title VII provides that, for purposes of Section 1318 and Section 1619 of the Exchange Act, a person is deemed to acquire beneficial ownership of an equity security based on the purchase or sale of a SBS, but only to the extent that the SEC, by rule, determines, after consultation with the prudential regulators and the Secretary of the Treasury, that the purchase or sale of the SBS, or class of SBS, provides incidents of ownership comparable to direct ownership of the equity security, and that it is necessary to achieve the purposes of this section of the Exchange Act – that the purchase or sale of the SBS, or class of SBS, be deemed the acquisition of beneficial ownership of the equity security.

18 The Dodd-Frank Act amends Section 13(d) of the Exchange Act to extend the reporting obligations thereunder to any person who “becomes or is deemed to become a beneficial owner of [more than 5 percent of a class of specified equity securities] upon the purchase or sale of a security-based swap that the [SEC] may define by rule.” The Dodd-Frank Act also amends Section 13(f) of the Exchange Act to extend the reporting obligations thereunder to any institutional investment manager who “becomes or is deemed to become a beneficial owner of any security of a class described in subsection (d)(1) [in excess of specified amounts] upon the purchase or sale of a security-based swap that the [SEC] may define by rule.” 19 Dodd-Frank amends Section 13(g) of the Exchange Act to extend the reporting obligations thereunder to any person who “becomes or is deemed to become a beneficial owner of [more than 5 percent of] any security of a class described in subsection (d)(1) upon the purchase or sale of a security-based swap that the Commission may define by rule.”

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Consequently, Dodd-Frank does not resolve the issues raised by the ruling in CSX Corporation v. The Childrens’ Investment Fund Management (UK) LLP and 3G Fund L.P.20 That court ruling called into question a basic expectation of the equity derivatives market, which is that the long party to a total return swap (“TRS”) does not acquire beneficial ownership of the reference securities absent a supplemental arrangement outside of the TRS that provides a contractual right to vote or dispose of such securities, and therefore does not have reporting obligations under Section 13(d) of the Exchange Act. This result, if upheld, could be unfavorable to Swaps purchasers. It is to be hoped the SEC will resolve this issue through its rulemaking process so that market participants will be able to plan their activities to avoid reporting obligations, and not be subject to potential litigation risk and potentially inconsistent results in different courts. B. Anti-Manipulation Provisions Title VII will expand the anti-manipulation and anti-fraud provisions of the Securities Act and the Exchange Act to include transactions in SBS as defined in Title VII. This means that the law and regulations applicable to insider trading will also apply to SBS transactions.

XIV. Oversight of Carbon Markets Title VII creates an interagency working group comprised of the Chairman of the CFTC, the Secretary of Agriculture, the Secretary of the Treasury, the Administrator of the Environmental Protection Agency and other federal energy officials to conduct a study on carbon market oversight. The study is designed to ensure the development of an efficient, transparent and secure carbon market (including spot and derivatives markets), and the working group is required to issue a report within 180 days of the enactment of Dodd-Frank.

20 562 F. Supp. 2d 511 (S.D.N.Y. 2008), aff’d in part, 292 Fed. Appx. 133 (2d Cir. 2008).

XV. Bankruptcy Treatment Title VII provides that a Swap cleared by or through a DCO shall be considered to be a “commodity contract” under Section 761 of the U.S. Bankruptcy Code. Accordingly, cleared Swaps will be subject to the exclusion from the automatic stay that is applicable to commodity contracts. Uncleared Swaps may qualify for similar treatment, because the definition of commodity contract was also amended to include any other contract, option, agreement, or transaction similar to others described in the commodity contract definition. In addition, Section 761(4)(I) of the U.S. Bankruptcy Code, which refers to master agreements, has been retained. Thus, although there was some discussion during the legislative process about removing Swaps from the exclusion to the automatic stay provision, it appears that Swaps will remain excluded. This result should serve to promote certainty regarding the treatment of Swaps in a bankruptcy proceeding.

XVI. Conclusion Title VII provides the framework for a new landscape of exchange-trading and clearing of Swaps. For those Swap transactions that would still be permitted to be traded bilaterally on an off-exchange basis, transaction reporting will be required, and certain other regulatory requirements, such as capital and margin requirements, might be imposed as well. The regulators are charged with promulgating dozens of rules over the next year, and further legislative action during that time is also possible. Many details of the new regulatory framework remain to be developed, and the focus of the Swaps debate will now shift to the regulatory agencies. * * * In the event that you have any questions concerning the foregoing, please do not hesitate to contact one of the authors of this Alert. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.

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July 2010 Authors: Mary C. Moynihan [email protected] +1.202.778.9058 Anthony R.G. Nolan [email protected] +1.212.536.4843 Clair E. Pagnano [email protected] +1.617.261.3246 Gwendolyn A. Williamson [email protected] +1.202.778.9251 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Financial Reform Bill Strengthens Regulation, Expands Potential Liability of Credit Rating Agencies On July 21, 2010, U.S. President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) following earlier passage of the legislation by a 237 to 192 vote in the U.S. House of Representatives and a 60 to 39 vote in the U.S. Senate. Dodd-Frank represents Congress’s response to what the House Committee on Financial Services calls “years without accountability for Wall Street [and] the worst financial crisis since the Great Depression.” Subtitle C of Title IX of Dodd-Frank – “Improvements to the Regulation of Credit Rating Agencies” (“Subtitle C”) – establishes an almost wholly new framework for governing and regulating credit rating agencies, including nationally recognized statistical rating organizations (“NRSROs”). The overhaul stands to dramatically change the role NRSROs play in the markets, and is based on Congressional findings that “the systemic importance of credit ratings and the reliance placed on credit ratings by individual and institutional investors and financial regulators” makes the activities and performance of NRSROs “matters of national public interest, as credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the United States economy.”

Dodd-Frank imposes new requirements covering key areas of NRSRO function and oversight, including:

• Increased Authority of the Securities and Exchange Commission (the “SEC”): Subtitle C gives the SEC substantial rulemaking authority and establishes an Office of Credit Ratings (the “OCR”) within the SEC.

• Liability Provisions: By lowering pleading requirements, removing safe-harbor protections, and imposing filing and other requirements, Subtitle C heightens the liability that NRSROs face.

• NRSRO Governance: Subtitle C contains many provisions aimed at minimizing the impact of conflicts of interest on the integrity of NRSROs’ issuance of credit ratings.

• Public Disclosure: Under the terms of Subtitle C, NRSROs are required to disclose an array of new information, such as the performance record of their credit ratings and the procedures and methodologies used in the credit ratings process.

• Impact on Existing Federal Securities Laws: Subtitle C removes a wide range of statutory references to NRSROs and, among other matters, calls for the SEC and other federal agencies to develop new standards of creditworthiness.

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• Asset-Backed Securities (“ABS”): Dodd-Frank includes many provisions designed to improve the asset-backed securitization process, including new disclosure requirements and an SEC study to identify the appropriate way to reconstruct the current issuer-pays business model of obtaining credit ratings for ABS (also referred to as structured finance products).

• Looking Forward: In addition to the SEC study on the issuer-pays model, Dodd-Frank, and Subtitle C in particular, requires that the SEC, the Government Accountability Office (the “GAO”) and others conduct studies that may result in additional rules and regulations affecting the role and import of NRSROs and credit ratings in the markets.

Background Credit ratings and the practices of the agencies issuing them are widely regarded to have been factors in the 2008 credit crisis, and, unsurprisingly, NRSROs have been the focus of inquiry and reform efforts by Congress, the Obama Administration, and the SEC for several years. This reform process has brought to light a variety of conflicts of interest inherent in the existing credit ratings structure as well as the impact of those conflicts on the health of the U.S. and global economies. For example, the U.S. House of Representatives Committee on Oversight and Government Reform considered testimony in October 2008 that the credit meltdown occurred to a great extent because of inaccurate and unsound ratings, driven by a variety of factors that included conflicts of interest, competitive pressure to lower standards, and the “cliff risk” in structured products, which could fall from a high rating level to junk status based on relatively small differences in the default and recovery experience of underlying assets. The 2008 credit crisis was not the first time that such concerns had been expressed about the fitness of credit ratings, as evidenced by commentary and hearings after the major rating agencies found Enron Corporation’s debt to be investment grade up to the eve of its bankruptcy.1

1 The history and progress of reforms of credit rating agency practices, including the testimony heard by the U.S. House of Representatives Committee on Oversight and Government

Congressional concerns about credit ratings, as articulated in Subtitle C and throughout Dodd-Frank, also mirror those identified by the SEC in its February 2, 2010 amendments to certain disclosure and conflicts of interest requirements for NRSROs. In adopting those amendments, the SEC “cited concerns about the integrity of NRSROs’ credit rating procedures and methodologies in light of the role they played in the credit market turmoil.”

Increased Authority of the SEC Subtitle C establishes the OCR as a part of the SEC, and requires that the OCR have a staff of experts in corporate, municipal, and structured debt finance. The OCR is tasked with administration of SEC rules covering the credit ratings determination practices of NRSROs, promoting the accuracy of NRSRO credit ratings, and ensuring that credit ratings issued by NRSROs are not unduly influenced by conflicts of interest. To effectuate these goals, the OCR will conduct annual examinations of NRSROs’ compliance with federal statutes and with their own internal controls, policies, procedures, and methodologies, including ethics policies and corporate governance procedures. The OCR will publish its report on “the essential findings” of each annual NRSRO review. Subtitle C gives the SEC broad rulemaking, examination, and enforcement authority, significantly augmenting the SEC’s existing regulatory authority with respect to NRSROs. Among other matters, the SEC is authorized to:

• impose fines and other penalties on non-complying NRSROs;

• issue rules to prevent “the sales and marketing considerations” of an NRSRO from influencing its production of credit ratings;

• temporarily or permanently revoke an NRSRO’s registration with respect to a class or subclass of securities if it is found to be incapable of consistently producing “credit ratings with integrity”;

Reform, was the subject of our Investment Management Alert in October 2009.


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• require NRSRO applications to be formally filed; and,

• under certain circumstances, limit the activities of, censure, suspend, or bar individuals associated with NRSROs.

Each of the new rules and regulations that the SEC must establish pursuant to Subtitle C is required to be issued no later than one year after the enactment of Dodd-Frank.

Liability Provisions The provisions of Subtitle C generally increase an NRSRO’s risk of liability. For example, the requirement that applications for NRSRO status be formally filed, rather than simply furnished to the SEC, subjects NRSROs to the risk of liability under the Securities Exchange Act for making false or misleading statements. This and the other rule amendments discussed below reflect the determination of Congress that NRSROs “perform evaluative and analytical services on behalf of clients, much as other financial ‘gatekeepers’ do [that are] fundamentally commercial in character and should be subject to the same standards of liability and oversight as apply to auditors, securities analysts, and investment bankers.” Subtitle C specifically exposes NRSROs to liability resulting from both public and private litigation. Subtitle C removes the restriction on private actions against NRSROs under Section 15E(m) of the Securities Exchange Act and, by lowering certain pleading requirements, essentially grants investors the right to seek damages stemming from an NRSRO credit rating if they can assert that the NRSRO knowingly or recklessly failed to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. Subtitle C also (i) rescinds the safe harbor provided by Section 21E of the Securities Exchange Act that protected NRSROs from potential SEC enforcement action for statements made regarding credit ratings, and (ii) repeals Rule 436(g) under the Securities Act, which excluded NRSRO ratings from being considered part of a company’s registration statement under the Securities Act and thereby shielded NRSROs from SEC enforcement action for false statements and/or omissions made by an “expert” under Sections 7 and 11 of the Securities

Act. This additional litigation exposure has already led at least one NRSRO to state that it will not allow its ratings to be included in SEC filings.

In addition, Subtitle C creates a duty for NRSROs to report to the appropriate law enforcement or regulatory authorities any credible information received from a third party alleging that an issuer of rated securities has violated or is violating the law.

NRSRO Governance – Internal Controls, Management of Conflicts of Interest Subtitle C establishes a number of requirements regarding the governance and operations of NRSROs. These new standards are rooted in Congress’s finding that inaccurate credit ratings brought to light by the 2008 financial crisis “necessitate increased accountability on the part of credit rating agencies” and that “in certain activities…credit rating agencies face conflicts of interest that need to be carefully monitored and that therefore should be addressed explicitly in legislation.”

• NRSROs are required to establish, maintain, enforce, and document, “an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings, taking into consideration such factors as the [SEC] may prescribe, by rule.”

• In an annual internal controls report to be submitted to the SEC, NRSROs must (i) describe “the responsibility of the management of the [NRSRO] in establishing and maintaining an effective internal control structure,” (ii) assess the effectiveness of that internal control structure, and (iii) provide an attestation of the CEO or equivalent individual regarding the effectiveness of the internal controls.

• NRSROs must consider independent information, “from a source other than the issuer or underwriter,” when making securities credit ratings.

• In accordance with rules to be issued by the SEC, NRSROs are required to ensure that their

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ratings analysts (i) meet “standards of training, experience, and competence necessary to produce accurate ratings for the categories of issuers whose securities [they] rate,” and (ii) are tested for knowledge of the credit rating process.

• Under the so-called “Look-Back Requirement,” each NRSRO must conduct a one-year look-back review when an employee responsible for making credit ratings goes to work for an obligor or underwriter of a security or money market instrument subject to a rating by that NRSRO; the policies and procedures that NRSROs must establish, maintain, and enforce with respect to these reviews must be reasonably designed to identify whether any conflicts of interest of the employee at issue influenced credit ratings issued by the NRSRO and whether the NRSRO should take action to revise any credit rating. Similarly, NRSROs will be required to report to the SEC when certain employees, including senior officers and individuals involved in the credit rating process, go to work for an entity rated by the NRSRO during the preceding 12 months.

• The compliance officers of NRSROs must file with the SEC an annual report on the organization’s compliance with the federal securities laws and its own internal policies and procedures. The report will include a description of any material changes to the code of ethics and conflicts-of-interest policy of the NRSRO as well as a certification that the report is accurate and complete. The SEC will review the code of ethics and conflicts of interest policy of each NRSRO at least annually and following any material revision of such code and/or policy.

• Each NRSRO must have a board of directors, at least half of whom are independent of the NRSRO, and whose compensation is in no way “linked to the business performance” of the NRSRO. In addition to its overall responsibilities, the board will oversee the establishment, maintenance and enforcement of policies and procedures for (i) determining credit ratings, (ii) addressing, managing and disclosing conflicts of interest, (iii) ensuring the

effectiveness of the internal control system for determining credit ratings, and (iv) monitoring the NRSRO’s compensation and promotion policies and practices.

• Compensation of NRSRO compliance officers also may not be linked to the financial performance of the NRSRO. Compliance officers are not permitted to be involved with the ratings, methodologies, or sales of the organization.

Public Disclosures Subtitle C includes a number of new disclosure requirements designed to make credit ratings and the process by which they are generated more transparent.

• NRSROs are required to disclose and publish their “ratings track record” so that “users of credit ratings [may] evaluate the accuracy of ratings and compare the performance of ratings by different [NRSROs].” This record will present “performance information over a range of years and for a variety of types of credit ratings” that is “clear and informative for investors having a wide range of sophistication who use or might use credit ratings.”

• Any credit rating issued by an NRSRO must be accompanied by an attestation “affirming that no part of the rating was influenced by any other business activities, that the rating was based solely on the merits of the instruments being rated, and that such rating was independent of the risks and merits of the instrument.”

• In keeping with rules to be prescribed by the SEC regarding “the procedures and methodologies, including qualitative and quantitative data and models,” NRSROs will be required to disclose to the users of credit ratings: (i) the version of a procedure or methodology used with respect to a particular rating; (ii) when a material change is made to a procedure or methodology, and the likelihood that such change will result in a change to current credit ratings; and (iii) any significant

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error identified in a procedure or methodology that may result in credit rating actions.

• Following a form to be established by the SEC, NRSROs must publish with the issuance of each credit rating detailed information, including: (i) the main assumptions and principles underlying the procedures and methodologies used to determine the credit rating; (ii) the data upon which the credit rating is based, and the reliability of that data; (iii) the existence of conflicts of interest; potential limitations, and risks related to the credit rating; and (iv) the use, if any, of third party research and due diligence. This disclosure is intended to help investors and other users of credit ratings “better understand credit ratings in each class of credit rating issued” by the NRSRO, and must be presented in a format that is “easy to use and helpful for users of credit ratings.”

• With respect to their unique credit rating symbols, NRSROs must establish, maintain, and enforce written policies and procedures (i) clearly defining and disclosing the meaning of all symbols, and (ii) mandating the consistent application of a symbol across all types of securities and money market instruments for which the symbol is used.

Impact on Existing Federal Securities Laws Notably, Subtitle C removes a wide variety of statutory references to credit ratings, credit rating agencies, and NRSROs and, in many cases, requires the development of new standards of criteria to evaluate creditworthiness. These amendments affect the Federal Deposit Insurance Act, the National Bank Act, the Federal Housing Enterprises Financial Safety and Soundness Act, certain World Bank statutory provisions, the Securities Exchange Act, and the Investment Company Act. The amendments to the Securities Exchange Act strike the ratings requirement included in the definitions of “mortgage related security” and “small business related security,” and require that these securities meet creditworthiness standards to be established by the SEC. Similarly, the provision affecting Section 6(a)(5) of the Investment Company

Act, which provided certain exemptions for state-regulated companies that do not issue redeemable securities, replaces references to NRSROs with references to standards of creditworthiness to be adopted by the SEC. These provisions of Dodd-Frank are paralleled by similar regulatory developments, such as the SEC’s April 7, 2010 proposal to remove references to credit ratings from Rule 144A under the Securities Act. It remains to be seen how the SEC will frame a new creditworthiness standard under the directives of Dodd-Frank, which gives the SEC ample discretion. The SEC could replace the current NRSRO ratings standard with a nebulous standard of reasonableness: the creditworthiness of a particular security would be based on what a reasonable person would deem creditworthy under the circumstances regulated by the given law. The SEC might, however, pursue a variety of alternative paths, such as incorporating the creditworthiness standards articulated in (i) the July 1, 2008 proposal to strike references to NRSROs in Rules 2a-7, 3a-7, 5b-3 and 10f-3 under the Investment Company Act, and (ii) the rule amendments it adopted in November 2009 that eliminate certain references to credit ratings issued by NRSROs in (a) rules and forms under the Securities Exchange Act “related to the regulation of self-regulatory organizations and alternative trading systems,” and (b) rules under the Investment Company Act affecting an investment company’s ability to purchase refunded securities and securities in underwritings with affiliated participants.2 Not unlike the goals of Congress with Subtitle C, the SEC’s July 2008 proposal and November 2009 amendments were “designed to address concerns that references to NRSRO ratings in [SEC] rules may have contributed to an undue reliance on those ratings by market participants.” In both the July 2008 and November 2009 rule releases, the SEC endorsed the substitution of NRSRO references with “alternative provisions that require the assessment 2 In November 2009, the SEC also re-opened the comment period for the July 1, 2008 proposal. The SEC proposal to eliminate references to ratings of NRSROs was the subject of our Investment Management Updates in July 2008 and August 2008. See also our October 2009 Investment Management Alert regarding the status of reforms of credit rating agency practices.

http://www.klgates.com/files/Publication/cd755ec7-dd46-422c-a3fd-d7e503878678/Presentation/PublicationAttachment/abab40ad-587c-4af8-8b79-fcdc80a0ec78/Investment_Management_Summer_2008_Newsletter.pdf

http://www.klgates.com/files/Publication/0d59a64a-cc9d-446c-b214-0ccdd2c657b5/Presentation/PublicationAttachment/5d96b80b-8f40-420e-adde-0da8dd7acecd/Invt_Mgmt_August_2008.pdf


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of liquidity and credit risk” by giving fund boards the duty of determining whether a security is (i) “sufficiently liquid that it can be sold at or near its carrying value within a reasonable period of time,” and (ii) subject to no greater than moderate or minimal credit risk, depending on the type of fund making the investment and certain other factors. Subtitle C does not explicitly impact the amendments to the rules governing money market funds under the Investment Company Act that the SEC adopted on February 23 of this year in response to the extreme turbulence experienced by the money fund sector in 2007 and 2008. In those amendments, in the face of strong opposition to its proposal to require money funds to invest only in the highest-quality, “first-tier” securities – a definition based on credit agency ratings3 – the SEC elected to limit the type and amount of assets of second-tier securities in which money funds can invest and to: (i) require money funds’ boards to designate four or more NRSROs, any one or more of whose short-term credit ratings the fund uses to determine whether a security is an eligible security, and determine at least annually that the designated NRSROs issue credit ratings that are sufficiently reliable; and (ii) require money funds to identify the designated NRSROs in the statement of additional information.4

Asset-Backed Securities (Structured Finance Products) Among other measures in Dodd-Frank aimed at the ABS market, Subtitle D of Title IX of Dodd-Frank – “Improvements to the Asset-Backed Securitization Process” – tasks the SEC with creating new disclosure rules as well as “a new mechanism to prevent issuers of asset-backed securities from picking the agency they think will give the highest credit rating, after conducting a study and after submission of the report to Congress.” Within 180 days of the enactment of Dodd-Frank, the SEC will

3 A “first-tier security” is: (i) a rated security that has received the highest short-term rating from the requisite NRSRO(s); (ii) a comparable unrated security, as determined by a fund’s board; (iii) a money market fund; or (iv) a Government security. 4 The SEC’s proposal to amend the money market fund rules was the subject of our Investment Management Alert in July 2009 and our Early Fall 2009 Investment Management Update. The amendments, as adopted, were the subject of our Investment Management Alert in March 2010.

release, among many others, rules requiring that credit rating agencies include with each ABS ratings issuance a report describing (i) the representations, warranties, and enforcement mechanisms related to the rating, and (ii) how the representations, warranties, and enforcement mechanisms may differ from those related to the credit ratings of similar securities.

Additionally, Section 939F of Subtitle C gives the SEC the responsibility of carrying out a two-year study of (i) the credit rating process for structured finance products (i.e., asset-backed securities), “and the conflicts of interest associated with the issuer-pay and the subscriber-pay models,” and (ii) “the feasibility of establishing a system in which a public or private utility or a self-regulatory organization assigns [NRSROs] to determine the credit ratings of structured finance products.” The SEC study required by Section 939F represents the compromise struck between the sponsors of Dodd-Frank and the proposed Franken Amendment, which would have amended the Securities Exchange Act to require that initial structured finance product credit ratings be determined by a centralized “Credit Rating Agency Board” that would prevent seekers of credit ratings from choosing the ratings issuer by assigning pre-qualified NRSROs on a rotating basis.

In assessing the appropriate system for the generation of structured finance product credit ratings, the SEC must consider, among other factors, the extent to which the creation of a new system “would be viewed as the creation of a moral hazard by the Federal Government,” as well as “any constitutional or other issues concerning the establishment of such a system.” Section 939F also mandates that upon completion of the study, the SEC must adopt rules to establish the system of assigning initial credit ratings to structured finance products,” and that the system proposed by the Franken Amendment should be implemented “unless the Commission determines that an alternative system would better serve the public interest and the protection of investors.” The effectiveness of the board contemplated by the Franken Amendment has been a matter of great debate in Congress, as it raises certain logistical impracticalities and potential conflicts of interest related to the rating of debt securities issued by the U.S. government.


http://www.klgates.com/files/Publication/2949740c-0a3c-40cc-9dcd-1a9638919926/Presentation/PublicationAttachment/dd05a503-5f0b-4db3-912c-34261991d6b4/IM_update_0909.pdf


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Looking Forward In addition to rule and regulation changes, Subtitle C requires initiation of the following studies, each of which may result in further rulemaking and other developments affecting the function and role of credit ratings:

• To the extent applicable, each federal agency must conduct a one-year review of agency regulations requiring “the use of an assessment of the creditworthiness of a security or money market instrument and any references to or requirements…regarding credit ratings,” and modify those regulations by removing any reference to reliance on credit ratings and putting in its place a standard of creditworthiness deemed appropriate by the agency issuing the regulation. Under this provision of Subtitle C, it seems that the SEC may be free to implement in full its July 1, 2008 proposal – which was re-opened for public comment in November 2009 – to replace references to NRSROs in rules under the Investment Company Act. It is not yet clear what the SEC and other federal agencies covered by Subtitle C will establish as the appropriate measure of creditworthiness for their rules and regulations. It is of course possible that a broad standard of “reasonableness under the circumstances,” or another similarly malleable standard, could be adopted across the federal government. But pursuant to the language of Subtitle C, which only offers the guidance that each federal agency “shall seek to establish, to the extent feasible, uniform standards of creditworthiness for use by such agency, taking into account the entities regulated by such agency and the purposes for which such entities would rely on such standards of creditworthiness,” it is also possible that the new agency standards could vary significantly. Congress will oversee any amendments to the federal laws, as each federal agency will provide

Congress with a report “containing a description of any modification of any regulation...made pursuant to [Section 939A of Subtitle C].”

• The SEC will conduct a three-year study of the independence of NRSROs and how independence affects their issuance of credit ratings. The study is intended to strengthen the independence of credit rating agencies, and will evaluate the management of conflicts of interest created by the other services, such as risk management or advisory services, that an NRSRO may offer. The SEC study will also consider the potential impact of rules that would prohibit NRSROs from providing such services.

• The GAO will conduct an 18-month study “on alternative means for compensating [NRSROs] in order to create incentives…to provide more accurate credit ratings, including any statutory changes that would be required to facilitate the use of an alternative means of compensation.” Similar to the SEC study on assigned credit ratings, the purpose of this GAO study is to analyze ways to reduce the conflicts of interest intrinsic to the issuer-pays and subscriber-pays models of obtaining credit ratings for structured finance products, including asset-backed securities.

• The GAO also will conduct a one-year study “on the feasibility and merits of creating an independent professional organization for rating analysts employed by [NRSROs] that would be responsible for establishing independent standards for governing the profession of rating analysts; establishing a code of ethics; conduct; and overseeing the profession of rating analysts.”

This client alert is part of a series of alerts focused on monitoring financial regulatory reform

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August 2, 2010 Authors: Stacey H. Crawshaw-Lewis [email protected] +1.206.370.7656 Deanna L. S. Gregory [email protected] +1.206.370.8128 Carol Juang McCoog [email protected] +1.503.226.5717 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

Municipal Securities Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act includes several provisions of potential interest to participants in the municipal bond market. The Dodd-Frank Act will require registration and regulation of previously unregulated swap and other municipal advisors. The Dodd-Frank Act also addresses the composition and authority of the Municipal Securities Rulemaking Board (the “MSRB”) and funding of the Governmental Accounting Standards Board (“GASB”). Finally, the Dodd-Frank Act directs a number of studies regarding the municipal securities market, including a study to address “the advisability of the repeal or retention of” the Tower Amendment.1 Registration and regulation of municipal advisors. Under the Dodd-Frank Act, swap and other municipal advisors are subject to three key requirements: registration, antifraud provisions, and a fiduciary duty to their clients. The Dodd-Frank 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 the municipal advisor is registered.” The Dodd-Frank Act includes an antifraud provision specifically applicable to municipal advisors, and provides that municipal advisors have a fiduciary duty to any municipal entity for whom such municipal advisor acts as a municipal advisor. A municipal advisor is defined to include persons soliciting or providing advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products (including municipal derivatives, guaranteed investment contracts, and investment strategies) or the issuance of municipal securities. The definition includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisors providing such advice. Broker-dealers, underwriters, engineers and attorneys providing legal advice are specifically excluded from the definition of municipal advisor. Changes in Composition of MSRB. The Dodd-Frank Act amends the composition of the MSRB to ensure majority-public membership.

1 The Tower Amendment, a 1975 amendment to the Securities Exchange Act of 1934, prohibits the Securities and Exchange Commission (the “SEC”) or the MSRB from requiring a municipal issuer to make any filing prior to the sale of municipal securities.





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The MSRB is to be composed of at least 15 members including:

• At least eight public representatives (including at least one representative of institutional or retail investors in municipal securities, at least one representative of municipal entities, and at least one member of the public with knowledge of or experience in the municipal industry); and

• At least seven regulated representatives (individuals who are associated with a broker, dealer, municipal securities dealer, or municipal advisor, including at least one broker-dealer representative, at least one bank representative, and at least one advisor representative).

Topics for Future Consideration. The Dodd-Frank Act also directs a number of studies relevant to municipal issuers and the municipal bond market: Municipal Disclosure. The Government Accountability Office (the “GAO”) is directed to conduct a study and review of the disclosure made by municipal issuers. The study is required, among other things, to describe the disclosures provided by municipal issuers; to compare the amount, frequency, and quality of municipal disclosure to that provided by corporate issuers; and to evaluate and make recommendations regarding additional municipal disclosure requirements. The study also is to address “the advisability of the repeal or retention” of the Tower Amendment. This report is required to be completed within two years. Transparency of Trading in the Municipal Bond Market. Within 18 months, the GAO must submit a study of the municipal securities markets to the Committee on Banking, Housing, and Urban Affairs of the Senate, and the Committee on Financial Services of the House of Representatives. The Dodd-Frank Act directs that the study is to include: an analysis of the mechanisms for trading, quality of trade executions, market transparency, trade reporting, price discovery, settlement clearing, and credit enhancements; the needs of the markets and investors and the impact of recent innovations; recommendations for how to improve the transparency, efficiency, fairness, and liquidity of trading in the municipal securities markets; and

potential uses of derivatives in the municipal securities markets. Funding of GASB. The GAO is required to conduct a study that evaluates the role and importance of the GASB in the municipal securities markets. The study also is to address the manner and the level at which the GASB has been funded. The GAO is required to consult with the principal organizations representing state governors, legislators, local elected officials, and state and local finance officers (“state and local government finance constituencies”). The study is required to be submitted within six months to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives.

The Dodd-Frank Act also permits the SEC to require the Financial Industry Regulatory Authority (“FINRA”) to establish an annual fee to fund GASB, together with rules and procedures, in consultation with state and local government finance constituencies, to provide for the equitable allocation, assessment, and collection of the accounting support fee from FINRA members. The Dodd-Frank Act states that the GASB funding provisions are not to be construed to impair or limit the authority of a state or local government to establish accounting and financial reporting standards.

Conclusion. Most of the provisions of the Dodd-Frank Act that relate to municipal securities involve future rulemaking, consultation and study. As these rules are promulgated, and these studies are released, the scope and potential impact of the provisions will become clearer.

Some of the federal legislative priorities of participants in the municipal bond market are beyond the scope of the Dodd-Frank Act. The Dodd-Frank Act does not extend key municipal bond provisions of the American Recovery and Reinvestment Act of 2009 (such as the authority to issue Build America bonds and Recovery Zone bonds, expanded eligibility for “bank qualification” of bonds, and relief from alternative minimum tax treatment for certain private activity bonds).

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August 2010 Authors: Diane E. Ambler [email protected] +1.202.778.9886 Edward G. Eisert [email protected] +1.212.536.3905 Alan P. Goldberg [email protected] +1.312.807.4227 Mary C. Moynihan [email protected] +1.202.778.9058 Stevens T. Kelly [email protected] +1.312.807.4240 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com.

The Impact of the Dodd-Frank Act on Registered Investment Companies

I. Introduction The core provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) for the most part focus on areas of the financial services industry other than the registered fund sector. However, the Dodd-Frank Act’s sweeping expansion of federal regulation in the financial sector will affect investment companies and the investment management industry as a whole, generally in indirect and often subtle ways. Moreover, many of the more controversial issues under consideration during the legislative process were left to be resolved by regulatory studies and rulemakings, and in some cases further remedial legislation, deferring their resolution to a future date. The Dodd-Frank Act will restructure the U.S. financial system by providing widespread regulation of financial institutions (primarily through a broad new regulatory framework designed to protect the financial system from systemic risk), consumer financial products and services, broker-dealers, over-the-counter (“OTC”) derivatives, investment advisers, credit rating agencies and mortgage lending. Of note is the extent to which the Dodd-Frank Act is silent regarding mutual fund1 regulation, other than in the areas of sales practices and investor protection. Nevertheless, because of the overarching influence of the SEC on mutual funds and their management, the Dodd-Frank Act’s restructuring of the regulatory landscape and its impact on the SEC’s management and agenda have the potential to change how the fund industry is regulated. The enactment of the Dodd-Frank Act itself is merely the opening curtain to the first act in a new regulatory era affecting all aspects of financial services and products. Some of the more significant areas broadly affected by the Dodd-Frank Act include those discussed below.

II. General Provisions of the Dodd-Frank Act Impacting the Mutual Fund Industry A. Regulatory Reform Focus on Systemically Significant Financial Institutions The Dodd-Frank Act establishes an interagency council called the Financial Stability Oversight Council (the “Council”)2 that is designed to “identify risks to the financial stability of the U.S.,” “promote market discipline” and “respond to emerging threats to the stability of the U.S. financial system.” Under the Dodd-Frank Act, both bank holding companies and nonbank financial companies, which are companies that are “predominately engaged in financial activities,” may fall under the supervision of the Council. The Council may consider the activity of a pooled investment vehicle, such as a registered investment company, or that of its manager, to fall under the scope of this regulation.

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Board Supervision and Prudential Standards. If the Council concludes that the “material financial distress” at a nonbank financial company or the “nature, scope, size, scale, concentration, interconnectedness, or mix of the activities” of a nonbank financial company could pose a threat to the financial stability of the U.S., the company can be required to (i) be supervised by the Federal Reserve Board of Governors (the “Board”) and (ii) be subject to prudential standards. Whether major fund complexes and their advisers may be deemed systemically important remains unclear. Among the factors that the Council must take into consideration, there are several that may reduce the probability that investment companies could fall under the supervision of the Board, such as:

• the extent of the leverage of the company;

• the extent to which assets are managed rather than owned by the company;

• the extent to which ownership of assets under management is diffuse; and

• the degree to which the company is already regulated by one or more primary financial regulatory agencies.3

While the second, third and fourth factors appear to weigh against deeming a fund complex or its manager to be systemically significant (and indeed were prompted in part by the arguments of the investment company industry), it is possible that the Council could have systemic concerns about large fund complexes and their managers. If a company does fall under the supervision of the Board, the Board can implement stringent prudential standards and reporting and disclosure requirements on the targeted entity. The prudential standards can include the following:

• risk-based capital requirements and leverage limits, unless the Board determines that such requirements are not appropriate for a company subject to more stringent prudential standards because of the activities of such company (such as investment company activities) or structure, in which case, the Board shall apply other standards that result in similarly stringent risk controls; and

• liquidity requirements; overall risk management requirements; resolution plan and credit exposure report requirements; concentration limits; a contingent capital requirement; enhanced public disclosures; short-term debt limits; and such other prudential standards deemed appropriate.4

It seems unlikely that capital requirements would apply to investment companies. While the prudential requirements may have more applicability, the standards are clearly oriented towards the regulation of banks, and unless modified, could impede the normal operations of investment companies and their managers.

B. Investor Protection Provisions The much-publicized Bureau of Consumer Financial Protection created by the Dodd-Frank Act does not have jurisdiction over mutual funds. However, the Dodd-Frank Act establishes within the SEC a new Investor Advisory Committee, created to advise and consult with the SEC on investor protection, the effectiveness of disclosure and other issues. Several other provisions of the Dodd-Frank Act are designed to address general concerns related to investor protection as well as the general functioning of the SEC – including hiring market specialists, sharing information with other agencies, paying compensation to victims, investor testing, and self-examination – and require reports to Congress, including a report by an independent consultant on the internal operations, structure and funding of the SEC. The investor protection provisions of the Dodd-Frank Act will also have a major impact on the SEC’s enforcement agenda. Whistleblowers are being encouraged through potentially lucrative bounties to report suspect activities, and the SEC will benefit from relaxed evidentiary standards of proof in pursuing secondary actors, expanded jurisdiction over activities conducted abroad, the ability to obtain penalty awards in SEC administrative cases, industry-wide bars for securities professionals, and the ability to subpoena trial witnesses nationally. The Dodd-Frank Act also provides for the SEC to impose aiding and abetting liability on persons who “recklessly” provide substantial assistance to someone who violates the antifraud and other provisions of the Securities

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Exchange Act of 1934 (the “Exchange Act”), and it provides for aiding and abetting liability under the Securities Act of 1933, the Company Act and the Investment Advisers Act of 1940 (the “Advisers Act”). The Dodd-Frank Act also permits the SEC to seek civil penalties for aiding and abetting cases under the Advisers Act and for administrative cease and desist proceedings, and it clarifies that the SEC may pursue enforcement actions against so-called “control” persons (those found to “directly or indirectly control” a violator) unless they acted in “good faith” and did not “directly or indirectly induce” the violative conduct. In addition, the Dodd-Frank Act permits the SEC to bring enforcement actions for breach of fiduciary duty against “a person who is, or at the time of the alleged misconduct was, serving or acting” for an investment company. Such persons or entities include former directors, officers, investment advisers, depositors or principal underwriters or members of an advisory board. Together with a newly reorganized enforcement division, increased staffing and “get-tough” statements of senior staff officials, regulation through enforcement can be expected to have a significant impact on the investment company industry. For more information, please see Investor Protection Provisions of Dodd-Frank. C. Changes to the Competitive Landscape; Private Fund Adviser Registration It also is to be expected that the new private fund adviser registration requirements and the significantly more robust recordkeeping, reporting and examination requirements to which private fund advisers will be subject will narrow the gap between the business and regulatory environments in which non-registered advisers to private funds and registered advisers to mutual funds have operated. From the perspective of many investors, the comparative advantages of an investment in a private fund and a mutual fund employing the same investment strategy may merit re-examination.5 An investment in a private fund could now appear to be less risky at the same time as the fund may be subject to higher compliance costs. Moreover, once registered, private fund advisers might more readily consider sponsoring and managing mutual funds.

In addition, under the so-called “Volcker Rule,”6 banking entities will be generally prohibited from acquiring or retaining any meaningful ownership interest in or sponsoring a hedge fund or private equity fund. This could further change the competitive landscape.

III. Specific Provisions of the Dodd-Frank Act Affecting the Mutual Fund Industry A. Changes Affecting the Distribution of Mutual Fund Shares The Dodd-Frank Act empowered the SEC to consider whether to impose fiduciary duties on broker-dealers that charge asset-based fees for providing advice to retail clients. Rather than resolving the issue itself by enacting one of the fiduciary standard provisions included in the House or Senate bills, the Dodd-Frank Act requires the SEC to conduct a study evaluating the standards of care for broker-dealers and investment advisers and comparing the relative regulatory standards for broker-dealers with those for investment advisers. Congress placed a heavy hand on the scale by detailing the issues to be considered by the SEC in the process, requiring the SEC to seek and consider public input and directing the SEC to submit a report – within six months of the Dodd-Frank Act’s passage – covering specific areas, including whether there are regulatory gaps or areas of regulatory overlap in the protection of retail customers relating to the standards of care for broker-dealers and investment advisers providing personalized investment advice about securities. Thereafter, the SEC is authorized to commence a rulemaking to address these standards of care and is given specific detailed authority to establish a fiduciary duty for brokers and dealers. Significantly, the Dodd-Frank Act affirmatively states that there would be no continuing duty of care or loyalty to a customer of a broker or dealer after providing personalized investment advice about securities. How any such duty will specifically impact brokers selling mutual funds, particularly proprietary products, depends on the debate before the SEC and the ultimate terms of the rule adopted.7


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B. Disclosures and Advertising Practices Other rulemakings and studies, required of the SEC over the course of the next several years, number in the hundreds and in many cases involve controversial issues that can be expected to promote heated debate. Many focus on investor protection; among the more important to the public fund industry is the Study Regarding Financial Literacy Among Investors, in which the SEC is to explore the level of financial literacy among retail investors, particularly with regard to the purchase of mutual fund shares. To be completed within two years, the study will include particular focus on the timing, content and format of disclosures, as well as identification of the most useful and understandable relevant information that retail investors need to make informed financial decisions about mutual funds, with particular attention to transparency of expenses and conflicts of interest. In a separate study, the Study Regarding Mutual Fund Advertising, the Government Accountability Office (“GAO”) is charged, subject to a one-year time deadline, with reviewing and recommending improvements to mutual fund advertising, in order to improve investor protection and ensure informed financial decisions by retail investors purchasing mutual fund shares. Without calling for a specific study, the provisions for Clarification of Commission Authority to Require Investor Disclosures Before Purchase of Investment Products and Services authorizes the SEC to issue point-of-sale disclosure rules for brokers or dealers to provide basic information to retail investors before the purchase of an investment product or service. The SEC has already begun to tackle these various statutorily mandated studies and rulemakings by requesting public comment; in doing so, Chairman Schapiro has announced administrative modifications to the SEC’s rulemaking process, including permitting the receipt of comments prior to a Release being issued, a higher degree of disclosures of meetings with SEC staffers and a willingness to call for public hearings on particular issues. Additional changes to the process can be expected as a result of heightened congressional oversight over the rulemaking process as well as the expectation for follow-on legislation addressing any

number of areas. It is worth noting that the SEC is expected to hire more than 800 new employees as a result of the increased funding facilitated by the Dodd-Frank Act. C. Reliance on Credit Rating Agencies The Dodd-Frank Act establishes an almost wholly new framework for governing and regulating credit rating agencies, including nationally recognized statistical rating organizations (“NRSROs”). The overhaul stands to dramatically change the role NRSROs play in the markets, and it could have a significant impact on the mutual fund industry. In particular, the Dodd-Frank Act grants increased authority to the SEC through the establishment of an Office of Credit Ratings (the “OCR”) within the SEC; and a requirement for federal agencies to remove references to NRSROs from their rules, provided there are reasonable alternatives. In addition, the Dodd-Frank Act imposes new requirements covering key areas of NRSRO function and oversight, including:

• lowering pleading requirements, removing safe-harbor protections, and imposing filing and other requirements, which heighten the liability that NRSROs face;

• minimizing the impact of conflicts of interest on the integrity of NRSROs’ issuance of credit ratings;

• requiring disclosure by NRSROs of an array of new information, such as the performance record of their credit ratings and the procedures and methodologies used in the credit ratings process;

• calling for the SEC and other federal agencies to develop new standards of creditworthiness;

• mandating provisions designed to improve the asset-backed securitization process, including new disclosure requirements and an SEC study to identify the appropriate way to reconstruct the current issuer-pays business model of obtaining credit ratings for asset-backed securities; and

• directing the SEC, the GAO and others to conduct studies that may result in additional rules and regulations affecting the role and

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import of NRSROs and credit ratings in the markets.

These changes may especially impact money market funds (which otherwise are not covered directly by the Dodd-Frank Act, perhaps in deference to the SEC’s recent rulemakings tightening standards for these funds) and their boards in reaching judgments regarding the creditworthiness of issuers. For more information, please see Financial Reform Bill Strengthens Regulation, Expands Potential Liability of Credit Rating Agencies. D. Regulation of Derivatives The Dodd-Frank Act completely overhauls the regulation of the OTC derivatives market in the United States. The primary objectives of the Dodd-Frank Act in the derivatives arena are to bring about greater transparency and to enable regulators to better manage individual counterparty and broader systemic risks that are inherent in the OTC derivatives market. In general, the increased transparency and efficiency resulting from these changes should benefit fund managers and facilitate board oversight of derivatives. The principal changes effected by the Dodd-Frank Act include:

• Imposing substantial requirements on the most active OTC derivatives market participants, major swap participants and swap dealers, including reporting, capital and margin requirements;

• Subjecting many derivatives that are currently traded OTC to central clearing and exchange trading in regulated trading systems; and

• Establishing more clearly the jurisdiction of the key regulators of derivatives, the SEC and the Commodity Futures Trading Commission, and repealing exemptions and exclusions that stood in the way of their regulation of the multi-trillion dollar OTC market.

These changes have the potential to significantly change the economics of engaging in hedging transactions and could impact investment strategies in the short and long term. E. Regulation of Short Sales The Dodd-Frank Act places additional regulation on short selling of securities by amending the Exchange

Act to prohibit any “manipulative short sale of any security” and to authorize the SEC to issue rules to enforce this provision. The SEC must issue rules providing for public disclosure at least monthly of short sale activity in each security. Brokers must notify customers that they may elect not to allow their securities to be used in connection with short sales, and brokers must disclose that they may receive compensation for lending their customers’ securities. The SEC may by rule specify the “form, content, time, and manner of delivery” of such customer notifications. F. Securities Lending The Dodd-Frank Act requires the SEC, within two years, to promulgate rules designed to increase the transparency of information available with respect to the lending or borrowing of securities. In addition, the Dodd-Frank Act amends the Exchange Act to make it unlawful to lend or borrow securities in contravention of the new SEC rules. Once effective, these rules should benefit independent directors in discharging their obligations to oversee securities lending. G. Fund Board Oversight and Governance The Dodd-Frank Act also provides for several regulations regarding the corporate governance structure of companies, which may impact investment funds. First, the SEC must establish rules to direct national securities exchanges and national securities associations to prohibit the listing of any equity security of an issuer that does not have an independent compensation committee. Although open-end mutual funds are excluded from this requirement, closed-end funds are not. In addition, the SEC may issue rules permitting the use by a shareholder of proxy solicitation materials supplied by an issuer of securities for the purpose of nominating individuals to membership on the board of directors; such “proxy access” rules might also cover registered funds. For more information, please see New Executive Compensation and Governance Requirements in Financial Reform Legislation. Other measures in the Dodd-Frank Act include expanding Sarbanes-Oxley provisions related to non-U.S. public accounting firms, thereby extending to OTC securities existing prohibitions on market



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manipulation of listed securities. The Dodd-Frank Act includes various other important investor protections and regulatory initiatives, which deal with, among other things, studying reform of self-regulatory organizations, the broker-dealer dispute arbitration process, the asset-backed securitization process, corporate accountability and executive compensation, and municipal securities. For more information, please visit our Financial Services Reform Newsstand. These mandates may add to the oversight responsibilities of the boards of registered investment companies.

* * * * *

IV. Conclusion As the regulators adjust to the new authorities and obligations granted by the Dodd-Frank Act, the true impact on the fund industry will begin to unfold. Now is the time for all industry participants to assess the potential effect of the Dodd-Frank Act on their individual business models and contribute to the dialogue with the SEC and Congress in a way that will assure the most thoughtful and appropriate regulatory outcomes. Although relatively few provisions of the Dodd-Frank Act are directed at the registered fund industry, its potential impact on this industry could ultimately be of great significance. This client alert is part of a series of alerts focused on monitoring financial regulatory reform.




1 Although the term “mutual fund” is not defined in the Investment Company Act of 1940, as amended (the “Company Act”), it is commonly used to refer to “open-end investment companies” that are registered thereunder. 2 The Council, created by the Dodd-Frank Act, is an inter-agency body charged with identifying and monitoring systemic risks to the financial markets, including those posed by U.S. and non-U.S. “nonbank financial companies.” The Council is composed of ten voting members, nine of which are granted a seat ex officio and one independent member appointed directly by the President. The ex officio members include, among others, the Secretary of the Treasury (who serves as chairperson of the Council), the Chairman of the Federal Reserve, the Comptroller of the Currency, the Director of the Bureau of Consumer Financial Protection created under the Dodd-Frank Act, the Chairperson of the SEC, the Chairperson of the CFTC, the Chairperson of the Federal Deposit

Insurance Corporation and other high ranking officials from various governmental and regulatory authorities. The Dodd-Frank Act provides that the Council shall have certain non-voting members serving in an advisory capacity, including a state banking supervisor, a state insurance commissioner and a state securities commissioner. 3 Additional factors that the Council will consider include off-balance-sheet exposures of the company; importance of the company as a source of credit; nature of the activities of the company; nature of the financial assets of the company; nature of the liabilities of the company; and other risks. 4 The Board has several other powers that may impact investment companies and their managers. For example, if the Board deems it appropriate, it may: (i) limit the ability of a company to merge with, acquire, consolidate with, or otherwise become affiliated with another company; (ii) restrict the ability of a company to offer a financial product; (iii) terminate one or more activities; (iv) impose conditions on the company’s conduct; or (v) require the company to sell or transfer assets or off-balance-sheet items to unaffiliated entities.


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5 It must be recognized that under the Company Act it is not possible for all investment strategies to be employed by a manager of a registered investment company, e.g., strategies that are highly dependent on the use of leverage and the use of derivatives. However, this is not necessarily the case for managers of more conservative strategies. 6 Section 619 of the Dodd-Frank Act. Early efforts by former Federal Reserve Chairman Paul Volcker to address concerns over the so-called “shadow banking system,” which might have impacted money market funds in particular, were scaled back significantly during the legislative process. 7 Although developed independently of the requirements of the Dodd-Frank Act, the SEC’s recent rulemaking proposal to rescind Rule 12b-1 under the Company Act in favor of a new Rule 12b-2, with conforming proposals to broaden Section 22(d) of the Company Act, has the potential to dramatically alter how mutual funds are distributed. By unbundling distribution financing from fund management, and removing the process by which fund boards have been required to review and approve 12b-1 plans, the rule proposals, if adopted, will fundamentally affect fund share class structures and distribution platforms. For more information, please see SEC Proposes Reform of Rule 12b-1, Mutual Fund Distribution Payment Framework.


financial services reform client alert series · senator scott brown (r-ma), who had previously...

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