Tag: Dodd-Frank Wall Street Reform and Consumer Protection Act

The SEC and Rating Agencies

The SEC examined all 10 firms registered Nationally Recognized Statistical Rating Organization (.pdf 23 pages) and found all 10 had “apparent failures”. The SEC has requested remediation plans from each of the agencies within 30 days and is continuing its investigation.

The issues found included “apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest.”

Personally, I think the rating agencies have not gotten enough of the blame for their roles in the events leading up to the 2008 financial crisis. Without the golden top rating they issued to the toxic mortgage-backed securities,  I think the popping of the housing bubble would not have been so vicious.

In 2006, the Credit Rating Agency Reform Act granted the authority to establish a registration and oversight program for credit rating agencies to the SEC and gave them oversight over those credit rating agencies that register with the Commission as Nationally Recognized Statistical Rating Organizations (“NRSROs”). However, it expressly prohibits the SEC from regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.

The Dodd-Frank Wall Street Reform and Consumer Protection Act enhanced the regulation and oversight by imposing new reporting, disclosure, and examination requirements. The new law also requires the SEC to conduct an examination of each NRSRO at least annually.  The 2011 Summary Report of t Commission’s Staff Examinations of Each Nationally Recognized Statistical Rating Organization (.pdf 23 pages) is the first to look at the ten under the new framework.

  1. A.M. Best Company, Inc.
  2. DBRS Inc.
  3. Egan-Jones Rating Company
  4. Fitch, Inc.
  5. Japan Credit Rating Agency, Ltd.
  6. Kroll Bond Rating Agency
  7. Moody’s Investors Service, Inc.
  8. Morningstar Credit Ratings, LLC
  9. Rating and Investment Information, Inc.
  10. Standard & Poor’s Ratings Services

The SEC did not determine that any finding discussed in this Report constitutes a “material regulatory deficiency”. That would have meant a referral to the Division of Enforcement and gotten more lawyers involved. The SEC does not single out by name any credit-rating agency for questionable actions in the report, but it does describe specific problems it found.

It will be interesting to see what happens next year. As most compliance people know, the failure to fix a problem pointed out by the SEC is likely to lead to trouble the next time they show up.

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Nationally Recognized Statistical Rating Organization (.pdf 23 pages)

Conflicts of Interest and Securitizations

The Big Short highlighted some of the difficulties of taking an investment position in a real estate downturn. The situation was taken a step further with Goldman Sachs’ help in putting together mortgage backed securities with the primary purpose of helping a client take an investment position that the securities will default. It turned out very well for Goldman’s client and terrible for the purchasers of the securities.

Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security from engaging in a transaction that would involve or result in certain material conflicts of interest. It then leaves it up to the Securities and Exchange Commission to issue rules for the purpose of implementing this new prohibition.

The SEC published a proposed rule at its Open Meeting on Sept. 19, 2011: Prohibition against Conflicts of Interest in Certain Securitization (.pdf).

The proposed rule could — if certain conditions are otherwise met — prohibit a firm from packaging Asset Backed Securities, selling them to an investor, and subsequently shorting the Asset Backed Securities to potentially profit at the same time as the investor would incur losses.

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Report on Mutual Fund Advertising

Section 918 of Dodd-Frank Act required a study on mutual fund advertising. The Government Accountability Office delivered that report before the 18 month deadline to the designated Congressional committees. The Report’s objectives were “to examine (1) what is known about the impact of mutual fund advertisements on investors, (2) the extent to which performance information is included in mutual fund advertisements, and (3) the regulatory requirements that exist for mutual fund advertisements and how they are administered and enforced.” Just for fun, the GAO included ETFs in the study given their popularity and some similar legal structures

The GAO reviewed Securities and Exchange Commission and Financial Industry Regulatory Authority (FINRA) rules and studies related to mutual fund advertising’s impact on investors. They also reviewed a random sample of 300 fund advertisements.

The most interesting finding (at least most interesting to me) is that they did not find a clear harm from advertisements that included performance results. Traditionally, research has shown that past performance generally does not persist and is not predictive of future performance. Therefore performance advertisements would be inherently misleading. Under Rule 482, mutual fund advertisements that includes performance data have to point out that past performance does not guarantee future results.

However, the GAO found some studies illustrate that investors who are influenced by performance advertising may still achieve returns that exceed market indexes or other funds.

The main recommendation that came out of the report was to ensure the “FINRA develops sufficient mechanisms to notify all fund companies about changes in rule interpretations for fund advertising.” Both SEC and FINRA agreed with the recommendation.

Risk Retention and Funding Private Equity Deals

From Federal Reserve's Section 946 Risk Retention Study

There is no doubt that securitization helped fuel the residential housing bubble that lead to the Great Panic of 2008. Lenders found ready buyers for their loan portfolios, could sell them, then lend the money out again to create new loan portfolios to resell. One of the issues is that the lenders became purely loan originators, selling off 100% of their interest. So their focus was on generating new loans and not making sure the loans were re-paid. Their lending standards consequently grew more and more lax.

That’s an oversimplification of the process, but shows the general problems of not “having any skin in the game.” By removing the credit risk, securitization may reduce an originator’s incentives to properly underwrite and evaluate borrowers. In addition, since the investor in the securitization is generally several steps removed from the loan origination, there is an information asymmetry.

Section 941 of Dodd-Frank requires securitizers to retain economic interest of at least five percent of credit risk of assets they securitize. As with much of Dodd-Frank, it’s up to the regulators to figure this all out and promulgate the rules. The idea is that properly structured risk retention can address some of the inherent risks of securitization.

Although risk retention may be good for bondholders, it may be bad for the amount of credit and liquidity available. It may also result in higher costs for borrowers. The banks need to retain some its capital in the form of retention. That capital will just be sitting there until the underlying debt obligations are repaid.

On April 29, 2011, the OCC, Board, FDIC, Commission, FHFA and HUD published a joint notice of proposed rulemaking for public comment to implement the credit risk retention requirements of section 15G of the Securities Exchange Act of 1934 (15 U.S.C. § 78o-11), as added by section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The rule will inevitably affect the amount credit available for deal flow and re-investment. There will likely be higher borrowing costs and barriers to execution.

The rule will also affect the residential real estate market since it creates a new category of “Qualified Residential Mortgages” that are exempt from risk retention requirements. I assume that loans that fall outside the exemption will be more expensive for the borrowers and limit the availability of credit for home purchases.

The proposed regulations extend for about 100 pages. That’s a big chunk of new law that will have profound effects on the lending industry.

For commercial mortgage backed securities, the sponsor must retain a “horizontal residual interest” of at least 5% of the par value. There is an option to hold a cash reserve account instead of equity. There is an exception to the risk retention requirements for commercial real estate loans with a laundry list of requirements:

  • Secured by a first lien on the commercial real estate.
  • Verified and documented the current financial condition of the borrower;
  • Obtained a written appraisal of the real property securing the loan that
  • Qualified the borrower for the CRE loan based on a monthly payment amount derived from a straight-line amortization of principal and interest over the term of the loan (but not exceeding 20 years);
  • Conducted an environmental risk assessment to gain environmental information about the property securing the loan and took appropriate steps to mitigate any environmental liability determined to exist based on this assessment;
  • Conducted an analysis of the borrower’s ability to service its overall debt obligations during the next two years, based on reasonable projections;
  • Determined that, based on the previous two years’ actual performance, the borrower had:
    (A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
    (B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
    (C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan;
  • Determined that, based on two years of projections, which include the new debt obligation, following the origination date of the loan, the borrower will have:
    (A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
    (B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
    (C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan.
  • The loan documents  require the borrower to provide financial statements and supporting schedules on an ongoing basis.
  • The loan documents impose prohibitions on:
    (A) The creation or existence of any other security interest with respect to any collateral for the CRE loan;
    (B) The transfer of any collateral pledged to support the CRE loan; and
    (C) Any change to the name, location or organizational structure of the borrower, or any other party that pledges collateral for the loan.
  • The loan documents require the borrower to maintain insurance that protects against loss on any collateral.
  • The loan documents require the borrower to pay taxes, charges, fees, and claims, where non-payment might give rise to a lien on any collateral for the CRE loan.
  • The loan documents require the borrower take any action required to perfect or protect the security interest and to defend such collateral against claims adverse to the originator’s or subsequent holder’s interest.
  • The loan documents require the borrower to allow inspection the collateral for the CRE loan and the books and records of the borrower or other party relating to the collateral for the CRE loan.
  • The loan documents require the borrower to maintain the physical condition of the collateral for the CRE loan;
  • The loan documents require the borrower to comply with all environmental, zoning, building code, licensing and other laws, regulations, agreements, covenants, use restrictions, and proffers applicable to the collateral.
  • The loan documents require the borrower to comply with leases, franchise agreements, condominium declarations, and other documents and agreements relating to the operation of the collateral, and to not modify any material terms and conditions of such agreements over the term of the loan without the consent of the originator or any subsequent holder of the loan, or the servicer.
  • The loan documents require the borrower not materially alter the collateral.
  • The loan prohibits the borrower from obtaining a loan secured by a junior lien on any property that serves as collateral for the loan
  • The CLTV ratio for the loan is:
    (i) Less than or equal to 65 percent; or
    (ii) Less than or equal to 60 percent, if the capitalization rate used in an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section is less than or equal to the sum of:
    (A) The 10-year swap rate, as reported in the Federal Reserve Board H.15 Report as of the date concurrent with the effective date of an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section; and
    (B) 300 basis points.
  • All loan payments required to be made under the loan agreement are based on straight-line amortization of principal and interest over a term that does not exceed 20 years; and
  • Loan payments made no less frequently than monthly over a term of at least ten years.
  • Maturity of the note occurs no earlier than ten years following the date of origination.
  • The borrower is not permitted to defer repayment of principal or payment of interest.
  • The interest rate on the loan is:
    (A) A fixed interest rate; or
    (B) An adjustable interest rate but the borrower obtained a derivative that effectively results in a fixed interest rate.
  • The originator does not establish an interest reserve at origination to fund all or part of a payment on the loan.
  • At the closing of the securitization transaction, all payments due on the loan are contractually current.

That is big set of regulations for commercial loan documents. A positive result of the rules would be to have a more standardized set of loan documents used for loans. That could help offset some of the additional costs that may result from the rules.

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Weekend Humor: Dodd-Frank Update

Jon Stewart helps celebrate the one year anniversary of Dodd-Frank (for those of you who grew up on Schoolhouse Rocks.)

Happy Birthday Dodd-Frank!

This happened one year ago:

Since then, it’s been a whirlwind of regulatory production. It was a huge bill. (My copy goes on for 848 pages.) The Regulations it requires are many times more massive that the bill itself.

We will experience the repercussions for years. So we may as well keep count.

Dodd-Frank Wall Street Reform and Consumer Protection Act (.pdf 2MB)

SEC Made It Harder to Earn Performance Fees

As a general rule, investment adviser cannot charge performance fees. Section 205(a)(1) of the Investment Advisers Act of 1940 generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client. That means no performance fees.

Unless the SEC makes an exception, which it has done so for people that don’t need the protections of that prohibition. Historically, that has meant the person has a “big pile of cash”. The big pile of cash standard had been if the client has at least $750,000 under the management of an investment adviser or the adviser reasonably believes the client has a net worth of more than $1,500,000.

Back in May the SEC has proposed raising those limits to $1 million under management or a minimum net worth of $2 million. The SEC was required to adjust the standard under Section 418 of Dodd-Frank. The adjustment was keyed to inflation. The SEC decided to exclude the value of person’s home, just as they did with the accredited investor standard, in calculating net worth.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund if it is relying on the 3(c)(1) exemption under the Investment Company Act. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

The new standard will go into effect on September 19, 2011.

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SEC Extends Deadline and Adopts Rules for Advisers and Private Funds

At an open meeting on June 22, the Securities and Exchange Commission adopted new rules under the Investment Advisers Act of 1940 aimed at investment advisers, private fund managers, venture capital funds, and family offices.

Based on the statements at the meeting, there will be three new rules would:

Delay Registration Deadline and a New Form ADV. The new registration/reporting deadline for new Advisers Act registrants and “exempt reporting advisers” will be March 30, 2012. Previously exempt private advisers, particularly those to hedge funds and private equity funds, will not be required to register until March 30, 2012. All advisers will be required to make a filing in the first quarter of 2012. Those previously registered advisers who no longer qualify for SEC registration will be required to withdraw by June 28, 2012.

The SEC staff pointed out that 2012 is a leap year, so the 90 day deadline is March 30 instead of March 31 in 2012.

Form ADV is going to change. No surprise. Under the amended adviser registration form, advisers to private funds will have to provide:

  • Basic organizational and operational information about each fund they manage, such as the type of private fund that it is (e.g., hedge fund, private equity fund, or liquidity fund), general information about the size and ownership of the fund, general fund data, and the adviser’s services to the fund.
  • Identification of five categories of “gatekeepers” that perform critical roles for advisers and the private funds they manage (i.e., auditors, prime brokers, custodians, administrators and marketers).
  • More information about conflicting or potential conflicting relationships.

Define Venture Capital Funds. Under the definition, a venture capital fund is a private fund that:

  • Invests primarily in “qualifying investments” (generally, private, operating companies that do not distribute proceeds from debt financings in exchange for the fund’s investment in the company); may invest in a “basket” of non-qualifying investments of up to 20 percent of its committed capital; and may hold certain short-term investments.
  • Is not leveraged except for a minimal amount on a short-term basis. Borrowing is limited in time as well.
  • Does not offer redemption rights to its investors.
  • Represents itself to investors as pursuing a venture capital strategy.
  • Is not registered under the Investment Company Act.

There will be a rule on grandfathering substantially as proposed in November, with the three conditions that the fund had been represented to be a “venture capital fund,” that the first closing was prior to December 31, 2010 and that no new capital commitments are made after July 21, 2011.

The new category of venture capital fund advisers and other “exempt reporting advisers” will file portions of Part 1 of Form ADV. Commissioner Schapiro noted that there was no current intention to subject exempt reporting advisers to routine examinations, while also noting that the SEC retains the authority to examine those advisers in its discretion. The Staff noted that the Form ADV will include a uniform calculation for “assets under management.”

Family Office Exemption. This exemption should be consistent with no-action relief previously provided and the proposed rule. It sounds like there will be some expansion to address a broader universe of permitted family clients and ta longer transition period (through December 31, 2013) for the termination of relationships with charitable entities that were not exclusively funded by the family.

These rules will have completed most of the rulemaking required under Title IV of Dodd-Frank, the Private Fund Investment Advisers Registration Act.

My printer is still cranking out the text of the new rules and I need to dive deeper into the details.

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Felons and Fund Managers

Most private funds rely on a Rule 506 exemption under Regulation D to sell their limited partnership interests to investors. A new SEC rule amending Rule 506 should catch the eye of private fund compliance officers. The concept it fairly straight-forward: felons should not be allowed to take advantage of the private offering exemptions.

Dodd-Frank

Section 926 of Dodd-Frank requires the SEC to adopt rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

What types of felonies?

The  proposal is not for all felonies, just those related to the securities industry. So you could be a convicted Under the proposed rule, a “disqualifying event” would include:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction would have to have occurred within 10 years of the proposed sale of securities (or five years, in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order would have to have occurred within five years of the proposed sale of securities.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from:
    • associating with a regulated entity.
    • Engaging in the business of securities, insurance or banking.
    • Engaging in savings association or credit union activities.
  • Or orders that are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years before the proposed sale of securities.
  • Certain Commission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect;
  • Suspension or expulsion from membership in a “self-regulatory organization” or from association with an SRO member, which would be disqualifying for the period of suspension or expulsion;
  • Commission stop orders and orders suspending the Regulation A exemption issued within five years before the proposed sale of securities; and
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Who is covered?

The proposed rule would cover

  • the issuer (i.e. the fund)
  • its predecessors and affiliated issuers
  • Directors, officers, general partners and managing members of the issuer.
  • 10 percent beneficial owners and promoters of the issuer (i.e. the fund manager).
  • Persons compensated for soliciting investors
  • the general partners, directors, officers and managing members of any compensated solicitor (i.e. employees of your placement agents).

The rule is bit fuzzy on how this would apply to fund manager, since it is not legally the issuer. Under the investment advisers registration you already need to disclose criminal activity. That disclosure is broader than what is proposed under the new rule. This is just disclosure, not a bar from use of the offering exemption.

Reasonable Care Exception

The proposed rule would provide an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

Paragraph (c)(1) of this section shall not apply:

(i) Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied; or

(ii) If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed under paragraph (c)(1) of this section.

Instruction to paragraph (c)(2)(ii). An issuer will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist. The nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and the other offering participants.

Here is where compliance steps in. The rule has no explicit record-keeping, reporting or disclosure requirements. But if you want make sure you can take advantage of the “reasonable care exception” you will need to keep records.  It looks like we will need a new form for employees to fill out asking for a disclosure of events under the rule. It also looks like you will need to run criminal background checks on your principals and key employees.

In the release the SEC said: “The steps required would vary with the circumstances, but we anticipate may include such steps as making appropriate inquiry of covered persons and reviewing information on publicly available databases.”

Comments

This is still a proposed rule, but time is short. Under Dodd-Frank, the disqualification rules need to be in place by July 21, 2011. There is time to Submit Comments.

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Will Private Equity be Exempted from Registration?

In earlier versions of Dodd-Frank, when it was being formulated in the House committee, there was an exemption for private equity fund managers from registration under the Investment Advisers Act. It also had an exemption for venture capital fund managers. Only the venture capital exemption managed to survive.

Of the many attempts to cut back on Dodd-Frank, at least one bill is slowly moving forward. The Small Business Capital Access and Job Preservation Act, H.R. 1082, would exempt advisers to private equity funds from SEC registration under the Investment Advisers Act.

The bill is straightforward:

Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds.

It still leaves you with issue of how to define “private equity fund or funds.” The SEC would have 6 months to define the term. Even if the SEC extends the deadline for registration and even if this bill gets passed quickly, that would leave a very narrow window for a private equity fund manager to determine if they need to register.

The first contingency seems destined. Most fund manager CCOs that I’ve talked to are not expecting the July 21 deadline to be in place. Everyone is expecting the deadline to be extended into the first quarter of 2012. They’re just wondering what is taking the SEC so long to make it official.

The bigger question is whether this bill be passed quickly and whether it will be passed at all. Certainly there is some legislative support for the exemption. It had been in earlier versions of Dodd-Frank. The risks of private equity are not the same risks as hedge funds. On the other hand, the some Congressional testimony about the bill focused on the leverage buyout sector of private equity. Many associate this high leverage business model with all of private equity.

The bill was forwarded by the Subcommittee on Capital Markets and Government Sponsored Enterprises to the full House Committee on Financial Services. It still has a long way to go and its future is uncertain. Continue moving forward with implementing your compliance program.

For those of you who need a brush-up on the legislative process, Schoolhouse Rocks still tells it best:

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