A Summary of Certain Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act
by OTTO SORENSEN
October 6, 2010
Whether Dodd-Frank will prevent or even reduce the likelihood of another financial panic remains to be seen. However, it is clear now that, like the stimulus bill and the healthcare bill, it contains a number of provisions that have little to do with its stated goals.
As described below, these provisions include: growth in the size, power, and cost of the federal government through a number of new agencies and departments, mandated affirmative action in the financial sector, a form of permanent monetary TARP, significant powers in the executive branch to seize and liquidate private companies with limited judicial review, public company proxy access for special interest groups, hedge funds and wealthy individuals, a capital restricting change in the definition of an accredited investor, and whistleblower provisions that will prove to be a boon to trial lawyers.
The following is a summary of certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). It is not a comprehensive summary, in that it does not deal with all aspects of the Act. For example, those parts of the Act dealing with credit rating agencies, the regulation of derivatives and the Volker Rule are beyond the scope of this summary. Moreover, the Act leaves much discretion in the hands of regulators, particularly the SEC and the Federal Reserve, and the full effects of the Act will therefore not be known until those regulators have fulfilled their new responsibilities created by the Act.
1. SEC Enforcement.
The Act contains a number of provisions related to the enforcement of the federal securities laws.
Section 922 specifies that any person who provides the SEC or the CFTC with information regarding a violation of the securities or commodities laws is entitled to between 10% and 30% of the resulting fines and penalties in excess of $1,000,000. This has become known as the “whistleblower provision.” To be eligible for the reward, the whistleblower must make an allegation containing information “derived from the independent knowledge of the whistleblower” that is not already known to the appropriate regulator. The Act also provides for a private right of action on the part of a whistleblower who has been retaliated against by his employer. Under this cause of action the whistleblower can obtain twice his lost wages and his attorneys fees. If whistleblowers wish to remain anonymous, they must provide their information through counsel. At least one plaintiff’s firm has already announced the expansion of its practice to include the representation of Dodd-Frank whistleblowers.
The financial rewards to whistleblowers and their counsel are potentially significant. For example Dell Computer recently agreed to pay a penalty of $100 million to settle accounting fraud charges. Had a whistleblower provided qualifying information to the SEC related to the Dell case, he or she would have been entitled to up to $30 million, and his or her counsel would presumably have earned a significant contingent fee.
The probable consequences of Section 922 are significant. Given the rewards that may be earned and the protection from retaliation, the Enforcement Division of the SEC should experience a significant increase in tips from employees of public companies. Because resolving questions related to securities disclosure, financial reporting, and the raising of capital inevitably involves the exercise of judgment, some of these tips will deal with true malfeasance, some will be based on differences of opinion and some will be based in whole or in part on financial opportunism. As public companies and their counsel and auditors become aware of the new environment, they will become increasingly conservative in their approach to securities matters, resulting in disclosures and financial statements that are even more cumbersome, opaque, and costly than they already are.
The Act also authorizes the SEC to seek civil monetary penalties in administrative actions, as opposed to court actions, against public companies and their officers and directors. Before the passage of the Act, this remedy was limited to brokers and investment advisors. Since administrative proceedings have a number of advantages for the SEC when compared with court actions, this provision, in combination with the whistleblower provision, should result in an increase in the number of administrative actions brought against public companies and their principals.
The Act also amends Section 20(e) of the Securities Exchange Act of 1934 in a way that makes it easier for the SEC to prosecute secondary actors. Previously, to establish aider and abettor liability, the SEC would have to show that the accused acted knowingly. Now the SEC will be required to show that he or she acted “knowingly or recklessly.” Only time will tell what level of diligence on the part of a director of a public company is required to avoid a charge of recklessness by the SEC under the new, less stringent standard, or when the directors will be able to satisfy the new diligence requirement by relying on company counsel as opposed to hiring their own special diligence counsel. The resulting increase in demand for independent director services will probably result in yet another increase in the cost of being a publicly-traded company in the United States.
2. Private Placements.
The Act changes the definition of an accredited investor by excluding the value of an individual investor’s personal residence when determining whether that investor qualifies as an accredited investor by virtue of having a net worth of at least $1,000,000. Because accredited investors have traditionally formed the backbone of most capital raises by new and development stage companies, this change will have the effect of limiting capital flows, and increasing the cost of raising capital, to such companies.
3. Corporate Governance.
The Act requires that all public companies, in their first proxy solicitation for an annual meeting occurring more than six months after passage of the Act, include a provision in their proxy materials for a non-binding shareholder say-on-pay vote.
The Exchanges are mandated by the Act to require listed companies to adopt clawback policies, under which incentive compensation paid to executive officers will be recovered in the event of a financial statement restatement (with a three year look back) if the compensation was based on the error being rectified by the restatement. The Act also requires the Exchanges to require listed companies to have independent compensation committees.
The Act exempts public companies with a market capitalization of less than $75 million from the Sarbanes Oxley requirement that internal controls be audited.
The Act authorized the SEC to adopt its then proposed new proxy access rules. Losing no time, the SEC approved the new rules on August 25, 2010. The rules require a public company to include the names of all board nominees, even those not backed by the existing board or nominating committee of the board, directly on the ballots distributed by the company during its solicitation of proxies for its annual meeting. To obtain the right to nominate, a shareholder or group of shareholders must own at least 3% of the outstanding voting shares and must have held those shares for three years. The new rules will be effective 60 days after they are published in the Federal Register, well in time to be in place for the 2011 annual meeting season. Smaller reporting companies, as defined in SEC Rule 12b-2, will be exempt from compliance with the rules for three years. This new process for soliciting proxies will probably result in a number of issues, including how to determine whether two or more shareholders or groups of shareholders are acting in concert to elect directors, how to describe shareholder nominees in the proxy materials and how to resolve disputes concerning those descriptions, and whether shareholder nominees who are elected will recognize their fiduciary duties to the company and all of the shareholders as opposed to the constituency that nominated them.
4. Too Big To Fail.
The Act creates an orderly liquidation authority, which empowers the FDIC to seize and liquidate any “covered financial company” after a determination that it poses a systemic risk to the financial system as a whole. “Covered financial company” is broadly defined to include any U.S. company that is a bank holding company, a broker dealer, a non-bank financial company subject to supervision by the Federal Reserve, and any company predominantly engaged in activities that the Federal Reserve determines are financial or at least incidental to financial activities. Proceedings under this part of the Act will not be reorganizations. They will only be liquidations and will preempt bankruptcy proceedings. The effect of a seizure and liquidation under this part of the Act on creditors’ rights under the bankruptcy laws is not clear. Once a decision has been reached for the FDIC to seize a company, judicial recourse to oppose the seizure will be extremely limited. A seizure petition can only be rejected by the court if the court finds that the government’s decision to seize was arbitrary and capricious within 24 hours of the filing of the petition to seize. If the court does not act within 24 hours, the petition will be deemed granted. The court’s decision must be appealed, if at all, within 30 days, and the scope of appellate review is limited to whether the company in question is a “covered financial company” and whether the government’s action was arbitrary and capricious. This provision grants the executive branch a powerful weapon with regard to companies involved in a very broad swath of the American economy and severely limits the ability of those companies to protect themselves from abuse of this authority through recourse to the judicial branch. The probable effects of this provision on (i) the willingness of these companies to resist the diktatsof the government, i.e.to exercise their liberty and (ii) the cost of capital to these companies are, to say the least, ominous.
5. Affirmative Action.
Each of the Treasury Department, the FDIC, the Federal Housing Finance Agency, the Comptroller of the Currency, the Federal Reserve, each Federal Reserve Bank, the Bureau of Consumer Financial Protection, the SEC, and the National Credit Union Administration is required by the Act to establish an Office of Minority and Women Inclusion. Each such office is mandated to develop procedures for the inclusion and use of minorities, women and businesses owned by minorities and/or women in the activities of their respective agency. When awarding contracts or hiring service providers, the agencies must consider the diversity of the applicant. Failure on the part of a contractor to make a good faith effort to include women and minorities in its work can result in sanctions, including the termination of its contract. The potential breadth of this policy was demonstrated on August 25, 2010, when Representative Maxine Waters criticized the underwriting syndicate for the General Motors public offering as including too few women and minority owned investment banks and too many investment banks based in foreign countries.
6. Financial Stability Oversight Council.
The Act establishes a Financial Stability Oversight Council (the “Council”), which is required to designate companies systemically important in the financial markets. The Federal Reserve, the SEC, and the CFTC are authorized to impose risk management standards on companies so designated by the Council. A financial institution so designated by the Council will be able to access the Fed’s discount window if it can demonstrate that it is not able to borrow adequate amounts from other financial institutions.
7. Investor Advisory Council.
The Act creates an Investor Advisory Council to advise the SEC. It will consist of senior citizens, representatives of individual and institutional investors, and representatives of state securities regulators.
8. Investor Advocate.
The Act creates an Investor Advocate within the SEC. His principal role will be to protect individual investors.
9. Consumer Protection.
The Act creates a new federal agency called the Bureau of Consumer Financial Protection. Its job will to be regulate the offering of consumer financial products and services by many different types of companies. The Bureau, although an independent agency, it will be funded by the Federal Reserve and will coordinate with the Fed. It will have authority to promulgate rules affecting all entities that sell consumer financial goods or services. It will also supervise the enforcement of federal laws related to equal access to credit, presumably including the Community Reinvestment Act, which contributed to the mortgage and real estate bubble and therefore the financial crisis of 2008. The Act contains complete or limited exemptions from regulation by the Bureau for small businesses, licensed real estate brokers, manufactured and modular home retailers, accountants, tax preparers, attorneys, and automobile dealers.
10. Liability Standards for Broker Dealers and Investment Advisors.
The Act grants the SEC the authority to create a fiduciary duty on the part of broker dealers and investment advisors when the provide investment advice to retail customers.
FamilySecurityMatters.org Contributor Otto Sorensen has practiced corporate finance and securities law in Southern California since 1977. Active in civic affairs, he was a founder and President of the San Diego Technology Finance Forum and a two-term President of the San Diego chapter of the Association for Corporate Growth. He has also served on the Board, and as President of, the La Jolla Symphony Association. A native Californian, Mr. Sorensen graduated from Claremont McKenna College in 1973 and the University of Minnesota Law School in 1976.