Dr Richard Leblanc

On July 15th, after passing the US House of Representatives, the US Senate passed, by a vote of 60 to 39, the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The Act was signed into law by President Obama on July 21st.  This legislation (over 2,300 pages) is the most significant omnibus financial services and corporate governance legislation since the Great Depression.  Mary Schapiro, the Chairwoman of the Securities and Exchange Commission (SEC), called it a “giant step.”  Paul Volcker, former Chairman of the US Federal Reserve, said the bill “must be supported by more effective and disciplined regulation and supervision.”  The President remarked, “For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy.”

Here are some of the most significant highlights of the Act:[1]

• “Say-on-pay” – Shareholders will have a right to a non-binding vote on executive pay and “golden parachutes” arising from mergers and acquisitions.

• Proxy access – The Act affirms the authority of the SEC to create rules over proxy access (these are forthcoming).

• Board leadership – Companies must disclose and explain whether the board chair is independent and separate from the CEO, as well as the structure of their board leadership.

• Women and minorities – The Act creates an Office of Minority and Women Inclusion at each of the federal banking and securities regulatory agencies, to coordinate assistance, address diversity matters and seek diversity in the workforce of regulators.

• Clawbacks – Companies must recover executive incentive pay derived from incorrect financial statements.

• Compensation committees and compensation disclosure – Compensation committees must have fully independent members and advisors.  Committees must disclose the relationship between past compensation and company performance, and the ratio between the median annual compensation of all employees of a company, excluding the CEO, and the annual compensation of the CEO.

• Oversight of compensation in the financial services industry – The Act requires full disclosure of incentive compensation.  Regulators can prohibit any incentives deemed excessive or that could lead to significant financial losses.

• Hedging – There is to be full disclosure of directors’ or employees’ use of instruments to hedge against decreases in the value of the company’s shares.

• Broker voting – Beneficial owners must consent for a broker to vote shares on their behalf.

• Consumer protection – The Act provides for the creation of an independent Consumer Protection Financial Bureau with clearly defined oversight powers to develop rules and enforce them, to educate the public and, more generally, act in the interests of consumers.

• Investor protection – The Act also provides for the creation of the Office of Investor Advocate and an Investment Advisory Committee for investor protection.  There is to be increased funding and resources provided to, and management reform of, the SEC, the creation of a SEC program whereby whistleblowers are incented financially to come forward (with the promise of 30 percent of funds recovered), and SEC authority to impose a fiduciary duty on brokers who give investment advice.

• Derivatives trading – There is to be central clearance and exchange trading for derivatives that can be cleared, a code of conduct applied to swap dealers and participants, and enhanced market transparency and regulatory oversight for over-the-counter derivatives.

• Systemic risks – The Act provides for the creation of the Financial Stability Oversight Council with expert membership and technical expertise.  There are strict rules for leverage, capital standards, liquidity and risk management.  Non-bank financial companies will come under regulation.  Finally, there will be the power to require large, complex companies to divest some of their holdings, subject to risk assessment.

• Too big to fail – “Funeral plans” are to be submitted by large, complex financial companies to the Orderly Liquidation Authority and other regulators, and to the Treasury Secretary, who ultimately will determine whether the “failure of the financial company would threaten US financial stability.”  Orderly liquidation mechanisms (with judicial review) will provide for shareholders and creditors to bear losses and management and culpable directors to be removed.

• Reform of the Federal Reserve – The Act provides for enhanced audit, transparency, governance and supervisory accountability of the Federal Reserve, the election of Federal Reserve Bank Presidents by elected and appointed directors who represent the public (not by members elected to represent member banks), and limits on emergency lending and debt guarantees to an individual entity.

• Mortgage reform – Lenders are to ensure the ability of borrowers to repay.  Penalties are to be imposed for irresponsible lending.  Consumer disclosure is to be strengthened and consumers are to be protected from high cost mortgages.

• Hedge funds – There is to be registration with, and trading portfolio disclosure to, the SEC and greater state supervision of hedge funds.

• Credit rating agencies – The Act creates an Office of Credit Ratings at the SEC and requires the examination of “Nationally Recognized Statistical Ratings Organizations.”  These organizations are to have independent boards, disclose methodologies and track records, consider independent credible information, pass qualifying exams for personnel, institute continuing education, and address and disclose conflicts of interest.  The SEC is to create a new mechanism to prevent issuers of asset backed-securities from picking the agency that provides the highest rating.  Regulatory requirements for externally-sourced ratings are to be reduced and investors are to be encouraged to conduct their own analyses.  Investors are to have private rights of action against rating agencies.

• Volcker rule – Proprietary trading by banks and investment in and sponsorship of hedge funds and private equity funds are to be prohibited, with small exceptions.

• Credit card fees and scores – The Federal Reserve is to issue rules to ensure fees are reasonable and proportional.  Consumers are to have free access to their credit score as part of an adverse decision or action taken that is detrimental to the consumer.

• Securitization – Companies selling mortgage-backed securities are to retain at least five percent of the credit risk and disclosure of the underlying asset quality is to occur.

• Extraction Industry – The Act requires public disclosure of payments made to US and foreign governments relating to commercial development of oil, natural gas and minerals.

The above legislative changes are significant and far-reaching, affecting investors, consumers, credit rating agencies and financial services companies.  Several new and powerful regulatory offices are created, with recommendation and rule-making abilities yet to come.  The Act marks an end to regulatory deference to the financial services sector and signals a firm regulatory hand in this vital sector in the US.  There is no doubt that corporate governance practices in US financial services firms will need to adapt quickly to the new landscape.  Boards of non-financial firms should take note too as changes in this sector could signal further legislative and regulatory changes more broadly.

[1] Majority voting, interestingly, was not included in the legislation. Anne Simpson, head of corporate governance at Calpers, calls the lack of majority voting, coupled with proxy rules applied only to uncontested elections, a “big hole” in the Act. The Financial Times reports, “without majority voting [in the Act] to allow shareholders to remove incumbent directors, proxy access is next to worthless.”  See “Investing: Rules of Engagement” The Financial Times (July 11, 2010).