It’s easy to criticize the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the controversial legislation aimed at strengthening the nation’s financial system. At 848 pages, the law is frightfully obese, yet crucial details are missing. Like most two-year-olds (July 21 marks the second anniversary of its passage) the law is still wobbly on its feet, with progress measured in baby steps. Proponents laud it, while critics see a law only its creators could love. Even many who appreciate its mission question whether it will ever be achieved.
“No law can prevent incompetent management or fraudulent management,” warns Jeffrey Burchill, CFO of insurance company FM Global. “You can penalize people for gross error or gross misconduct, but it’s very difficult to prevent that conduct.”
Dodd-Frank nonetheless aims to try. The most sweeping regulatory overhaul of the financial services industry since the Great Depression, the law created several oversight bodies and a deluge of rules for the industry. Yet because the legislation was drafted so hurriedly, and because the matters it tackles are so complex, Congress left much of the heavy lifting to regulators, saddling them with nearly 400 rulemaking requirements and calling upon them to complete dozens of studies.
It didn’t happen. By June 1 of this year, understaffed and overwhelmed regulators — at the Securities and Exchange Commission, the Federal Reserve, the Commodity Futures Trading Commission (CFTC), the Federal Deposit Insurance Corp. (FDIC), the Office of the Comptroller of the Currency, and elsewhere — had finalized only 110 of the 398 regulations they were tasked with crafting, according to law firm Davis Polk & Wardwell. They had missed 148 deadlines, including 21 for which they had not even issued any proposed rules. They faced another 140 future rulemaking deadlines, including 123 where they had no proposed rules on the table, and a clutch of additional rulemaking requirements for which they had been given no deadline. Former SEC commissioner Annette Nazareth, now an attorney with Davis Polk, says it will probably be “at least well into 2013” before rulemaking is completed. In some cases, implementation could stretch beyond that.
“Dodd-Frank was easy to pass in the aggregate, but implementing it has been difficult,” says former SEC attorney John Sten, now a partner at McDermott Will & Emery. Sten blames not only the size of the task and regulators’ budgetary constraints, but also regulators’ efforts to make sure that any rules they do hand down are both workable and reflective of Congress’s intent. Toward that end, regulators have spent thousands of hours meeting with business leaders and trade groups to get their input on rulemaking. While some have blamed business lobbying for holding up implementation of the law, Nazareth, who has represented swap dealers, broker-dealers, banks, and the Securities Industry and Financial Markets Association in talks with regulators, sees it differently.
“I understand there’s lobbying going on, but there’s also a huge amount of educational activity going on,” she says. “This is a major exercise, and regulators have to meet with people to understand what the issues are. Regulators welcome that; they really want to get it right.”
Now, as the third year of implementing Dodd-Frank begins, significant pieces of the legislation — some of them arguably the most controversial and hardest to implement — loom on the agenda. They include the so-called Volcker Rule, which would bar banks from trading with their own money; regulating the over-the-counter derivatives market; designating “systemically important” nonbank financial institutions for greater oversight; and calculating bank capital requirements.
All this is not to downplay the signature accomplishments of Dodd-Frank to date. New regulatory authorities have been created, including the Financial Stability Oversight Council, the Federal Insurance Office, and the Consumer Financial Protection Bureau. Publicly traded companies must now give shareholders a nonbinding “say on pay” indicating whether they support their companies’ executive-compensation packages. Whistle-blowers now have incentives to bypass internal compliance channels and report potentially illegal or fraudulent activity directly to the SEC.
Hedge-fund advisers are now required to register with the SEC. Beginning in June 2012, the largest funds must file reports on the value of their assets under management, their counterparty risk, their debts, and other key metrics. Also beginning in June, the nation’s largest financial institutions must have “living wills” in place outlining how they will wind down in the event they fail. In April of this year, the SEC and the CFTC issued final rules defining the terms “swap dealer” and “major swap participant,” a critical first step in regulating the over-the-counter derivatives market.
A few of these early initiatives have already had an impact on corporate behavior. In response to say-on-pay, notes attorney James Hauser of Brown Rudnick, some companies have been redesigning their compensation plans, revising change-of-control agreements, eliminating tax gross-ups on change-of-control payments, linking equity awards more tightly to total shareholder returns or other performance metrics, and providing more disclosure in their proxy statements. Many observers surmised that General Electric was seeking to head off negative say-on-pay votes in April of this year when it announced that, in the wake of “constructive conversations” with shareholders, it would retroactively apply performance measures to stock options it had awarded to CEO Jeffrey Immelt in 2010.
Elsewhere, many banks have already taken steps to cut their business ties to hedge funds, as will be required under the Volcker Rule. And growing numbers of banks and businesses are already clearing more of their over-the-counter derivatives trades as will be required by Dodd-Frank, even as they await final rules from federal regulators on exactly which trades must be cleared.
Preventing “Too Big to Fail”
Still, many of these developments are but a sideshow to the real thrust of Dodd-Frank: to prevent the unwieldy collapse of systemically important, “too big to fail” financial institutions.
The act attacks the problem from several angles — creating stiffer capital requirements for financial institutions, requiring firms that securitize assets to retain some exposure to the resulting securities, creating greater regulation and transparency in the over-the-counter derivatives market, increasing regulation and oversight of credit-rating agencies, prohibiting speculative trading by banks, and creating the Financial Stability Oversight Council. (The FSOC brings together the heads of the Treasury Department, the Federal Reserve, the SEC, and other regulatory bodies to monitor financial markets and identify potential threats to U.S. financial stability.)
The FSOC is only getting started on its mission, though, and regulators have made only partial progress on the other fronts. Few of their tasks have proven more complicated or controversial than implementing the Volcker Rule, which prohibits proprietary trading by banks for their own accounts, precludes Fed-regulated financial institutions from owning or sponsoring hedge funds or private-equity funds, and gives regulators the authority to impose additional capital requirements on nonfinancial companies engaged in proprietary trading. Dodd-Frank provides that the Volcker Rule statutory provisions take effect on July 21 of this year, yet regulators at the Fed, the SEC, the FDIC, and the Office of the Comptroller of the Currency were still debating the necessary implementation rules heading into this summer, and it is unlikely that implementation rules will be issued by the deadline. The regulators issued interim guidance that will apply until final rules are adopted.
The delay stemmed in part from the complexity of deciding just what constitutes speculative trading and what qualifies as hedging, which the Volcker Rule expressly permits. Regulators also have been the target of vigorous lobbying by bankers opposed to the rule, often led by JP-Morgan Chase chairman and CEO Jamie Dimon — although JPMorgan’s announcement in May that it had lost $2 billion trading credit-default swaps in its own account (with the chance for that number to go much higher) renewed pressure on regulators to issue final rules with real teeth. Still at question is whether the JPMorgan Chase trading would have been covered by the Volcker Rule; the bank insists it would not, while skeptics wonder whether it was, in fact, hedging and not speculating.
Other major initiatives still on the docket include identifying which nonbank financial institutions will qualify as “systemically important financial institutions,” or SIFIs, and therefore be subject to heightened regulation under Dodd-Frank; and implementing all the rules and regulations pertaining to the over-the-counter derivatives, or swaps, market, where most trades will have to be submitted for clearing to central counterparties. The FSOC spelled out in April how it will identify SIFIs, but actually identifying them is expected to take several more months.
Implementing Dodd-Frank’s swaps regulations has proved nearly as complicated as parsing out regulatory language on the Volcker Rule, with much of the controversy centered on whom, and which types of transactions, should be covered by the new rules. In addition to instituting regulation of swap dealers and major swap participants, Dodd-Frank prohibits those entities from receiving any federal assistance, such as advances from a Federal Reserve credit facility or discount window, that is not part of a broad-based eligibility program.
Following the JPMorgan Chase loss, the CFTC began looking into whether the swaps regulations should be extended to cover the overseas units of U.S. institutions, a situation U.S. banks have said would hurt their ability to compete with foreign-based rivals. “The regulation of swaps is still a work in progress,” says Sten. “It may have a bigger impact on the affected U.S. institutions than the Volcker Rule.”
Elsewhere, the SEC headed into summer still needing to issue final guidance on how companies should go about reclaiming incentive compensation in cases where companies restate their financial results due to material noncompliance with accounting laws. The Sarbanes-Oxley Act of 2002 had a similar but more forgiving “clawback” provision that kicked in only if a restatement was a result of misconduct. The new law, says Hauser, will likely require firms to amend many of their existing compensation agreements.
Finally, banking regulators are still working on some of the rules needed to fully implement the controversial Collins Amendment to Dodd-Frank, which adjusts the way bank capital requirements are calculated. One challenge: figuring out how to reconcile differences between the capital requirements spelled out in Dodd-Frank and those outlined in Basel III, the global regulatory standard that phases in beginning in 2013.
Getting Dodd-Frank’s rules wrong could impose unnecessary costs on the nation’s financial system and exaggerate, rather than mitigate, the risks the law was intended to minimize. But bad rules can be struck down. Last July, the U.S. Court of Appeals rejected an SEC rule that would have made it easier for shareholders to nominate candidates to the boards of public companies, arguing that the commission hadn’t adequately assessed its costs. “Cost-benefit analysis is extremely challenging,” observes Nazareth, who speculates that it could become an issue with other rulemaking decisions, too.
Will It Work?
With so much rulemaking yet to be done, it is probably unfair to ask if Dodd-Frank has succeeded so far in creating a stronger and more secure financial system in the United States. “I think we’ve got a long way to go before we can judge Dodd-Frank,” says Carol Beaumier, an executive vice president with Protiviti, a consulting and internal audit firm.
Still, skeptics, and outright critics, are abundant. Congressional Republicans, who opposed the law, have submitted numerous bills that would scrap all or parts of Dodd-Frank, while Presidential candidate Mitt Romney has vowed to repeal the law if he is elected, though most political analysts consider that little more than campaign bravado. Even if they captured the White House, Republicans would need to muster 60 votes in the Senate, now controlled by Democrats, to repeal the law.
That hasn’t stopped the criticism. “I think it [Dodd-Frank] has done little to solve our problems,” says Kevin Williams, CFO of Jack Henry & Associates, a $967 million provider of information-processing solutions to community banks. In the two years since the law’s passage, Williams notes, the nation’s biggest banks have gotten bigger, not smaller, with the six largest holding assets equal to 63% of the country’s gross domestic product. That makes their potential failure an even bigger concern than it would have been in the past, he contends.
Meanwhile, small community banks are being hurt by the cost of complying with a law written in response to problems created by large banks, says Williams. That charge has been echoed by former FDIC chairman Bill Isaac, now chairman of Fifth Third Bancorp., who has said he wouldn’t be surprised if half of the nation’s community banks go out of business if they don’t get some relief from Dodd-Frank.
“I think Dodd-Frank was a political response to an economic problem, and history tells us that is not always the best solution,” says Isaac.
If Williams proves prescient, Dodd-Frank will have been a large, costly, and ultimately misguided effort to strengthen the financial markets. Yet in light of the ongoing devastation wrought by the 2008 credit crisis — to the financial and housing markets and economies around the world — it is probably unrealistic to expect that policymakers would not have tried.
Randy Myers is a contributing editor at CFO.
On the SEC’s Agenda
Upcoming rulemaking activity at the Securities and Exchange Commission for implementing the Dodd-Frank Act (estimated July–December 2012)
• Corporate Governance & Disclosure
Section 952: Report to Congress on study and review of the use of compensation consultants and the effects of such use.
Sections 953 and 955: Adopt rules regarding disclosure of pay-for-performance, pay ratios, and hedging by employees and directors.
Section 954: Adopt rules regarding recovery of executive compensation.
• Credit Ratings
Section 932: Adopt rules regarding NRSRO [nationally recognized statistical rating organizations] reports of internal controls over the ratings process, preventing sales and marketing activities from influencing the production of ratings, providing for a report to the SEC and “look-back” when an entity subject to a rating employs a person who previously worked for the NRSRO.
Section 932: Adopt rules regarding transparency of NRSRO ratings performance.
Section 936: Adopt rules establishing training, experience, and competence standards, and a testing program for NRSRO analysts.
Section 939F: Report to Congress on study on the rating process for structured finance products and associated conflicts of interest, the feasibility of an assignment system, metrics to determine the accuracy of ratings, and alternative compensation that creates incentives for accurate ratings.
Section 719(d): Joint report to Congress (with the CFTC) on study regarding stable value contracts.
Sections 763 and 766: Adopt rules on trade reporting, data elements, and real-time public reporting for security-based swaps.
Section 763: Adopt antimanipulation rules for security-based swaps.
Section 763: Adopt rules regarding the registration and regulation of security-based swap execution facilities.
Section 764: Adopt rules regarding the registration and regulation of security-based swap dealers and major security-based swap participants.
Section 765: Adopt rules regarding conflicts of interest for clearing agencies, execution facilities, and exchanges involved in security-based swaps.
• Market Oversight
Section 210: Jointly with other financial regulators prescribe recordkeeping requirements that will assist the FDIC when acting as a receiver.
Section 417: Report to Congress on study on the state of short selling on exchanges and in the over-the-counter markets.
Section 619: Adopt rules to implement prohibition on proprietary trading and certain relationships with hedge funds and private-equity funds (the Volcker Rule).
Section 917: Report to Congress on study to identify financial literacy among retail investors.
• Municipal Securities
Section 975: Adopt permanent rules for the registration of municipal advisers.
Source: SEC (updated 6/20/12). Not all planned activity is listed above. Other regulators are also responsible for rulemaking.
10 Years After: The Sarbanes-Oxley Act
July also marks the anniversary of another landmark piece of legislation: the Sarbanes-Oxley Act of 2002. Aimed at preventing a repeat of the egregious accounting scandals that had felled once high-flying companies like Enron and WorldCom, the law mandated rigorous internal control procedures for publicly traded companies, assigned personal responsibility for accurate financial statements to CEOs and CFOs, required rapid public disclosure of material changes in a company’s financial condition or operations, and imposed a host of other accounting and corporate-governance mandates. Like the Dodd-Frank Act of 2010, Sarbox was written hastily and passed quickly in response to a crisis. Yet at just 66 pages, it was practically a footnote compared with Dodd-Frank, which clocked in at 848 pages.
Ten years later, it is clear that Sarbox did not completely eliminate accounting fraud or the sketchy use of off-balance-sheet bookkeeping to mask a company’s true financial condition. When commodities trader Refco collapsed in 2005, for example, investigators discovered that its CEO and chairman had hidden approximately $430 million in bad debts from the company’s auditor and investors. And when Wall Street investment bank Lehman Brothers fell in 2008, regulators discovered that it had been using off-balance-sheet accounting to understate the leverage on its books.
Nor has Congress been completely satisfied with what it wrought. Earlier this year, the JOBS (Jumpstart Our Business Startups) Act exempted emerging growth companies, which it identifies as those with annual revenues under $1 billion, from certain provisions of both Dodd-Frank and Sarbox.
Still, it is also true that since Sarbox there has been no rash of accounting scandals like the ones that prompted Congress to create the law. This held even in the midst of the 2008 credit crisis, when any corporate executive inclined to shade the truth might have been tempted to whitewash what was happening to the corporate balance sheet. “The law has had value in bringing more integrity and transparency to financial statements,” says Carol Beaumier, an executive vice president with Protiviti, a consulting and internal audit firm.
Whether Sarbox says anything about the future for Dodd-Frank is questionable. “They are very different statutes,” says Annette Nazareth, a former SEC commissioner and now an attorney with Davis Polk & Wardwell. “I think Sarbanes-Oxley had a lot of merit, even though there were parts that didn’t work as well and took some time to resolve. Dodd-Frank was much more ambitious, and in a lot of places duplicative, with several provisions aimed at solving the same problems. Is it going to make our financial system better? We hope so, but it’s difficult to say.” — R.M.
Keeping Track of Dodd-Frank
Keeping track of regulatory progress on implementing the Dodd-Frank Act is no easy matter. As one attorney recently confessed, “No one really knows what the hell is going on with Dodd-Frank.”
But there are study aids. Law firm Davis Polk & Wardwell publishes a monthly progress report available on its website at www.davispolk.com/Dodd-Frank-Rulemaking-Progress-Report/. For anyone just being introduced to the act’s intricacies, “The Dodd-Frank Act: A Cheat Sheet,” published by law firm Morrison & Foerster, is still helpful. It can be found on the firm’s website at www.mofo.com/files/Uploads/Images/SummaryDoddFrankAct.pdf.
Meanwhile, many regulatory agencies are doing their best to keep the public informed as well. The Securities and Exchange Commission has more rulemaking requirements than any other agency, and it routinely publishes news on its latest activities. To see the page where it spotlights its progress on Dodd-Frank, go to www.sec.gov/spotlight/dodd-frank.shtml. — R.M.