Table of Contents
Introduction
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), signed into law by President Obama on July 21, 2010, has been fairly described as a monumental overhaul of U.S. financial regulation. Although the Act requires extensive rulemaking for the implementation of its various provisions, the broad impact of the law, it is now clear, extends far beyond U.S.-based companies and financial institutions. The Act will also have significant effects on non-U.S. public companies and financial institutions, as well as a variety of other participants in the global capital markets.
In addition to instances of explicit regulation of overseas entities, some of the Act’s effects on non-U.S. companies and financial institutions will be indirect. The Act will have global implications in part due to restructuring within the financial services industry in response to the increased regulatory burden placed on financial services firms that conduct business in the United States or with U.S. persons. These new burdens, which will be borne primarily by U.S.-based financial institutions, may in turn present an opportunity to non-U.S. based financial institutions. For example, the “Volcker Rule” has already resulted in U.S. financial institutions announcing plans to divest or scale back their global proprietary trading and fund-related businesses. This trend may make it easier for non-U.S. based financial institutions to make acquisitions or expand into these areas. Non-U.S. companies seeking access to capital may find globally active financial services firms more willing to engage with them outside the purview of the Act.
The Act’s direct effects on non-U.S. companies and financial institutions, both positive and negative, will become increasingly evident as final rules are implemented over the coming months and years. This alert discusses ways that non-U.S. companies and financial institutions may experience these potential direct and indirect effects, and also describes potential opportunities for non-U.S. market participants under the new U.S. regulatory regime.
I. Potentially Heightened U.S. Regulatory Requirements for Nonbank Financial Institutions Outside the United States
Non-U.S. financial institutions and other businesses with U.S. operations, or that transact business with U.S. persons, could face heightened regulatory requirements, even though they are not banks. The heightened regulation is triggered by a finding that a particular institution is systemically important.
The newly established Financial Stability Oversight Council (the “Council”) is empowered to determine that non-U.S. financial institutions that are not banks, as well as certain other non-U.S. businesses, should be subjected to supervision by the Board of Governors of the Federal Reserve System (the “Fed”) under heightened prudential standards. The Council can make this determination if it makes two findings. First, the Council must determine that the particular business is “predominantly engaged” in financial activities. The Act empowers the Fed to adopt regulations elaborating on what this means. Under the language of the Act itself, a company is “predominately engaged” in financial activities if 85% or more of its annual gross revenues are derived from, or 85% or more of its consolidated assets are related to, activities that are financial in nature, such as investment management, investment advice, lending or dealing in credit, insurance, and securities underwriting and brokerage. Second, the Council must determine that material financial distress of the business or its nature, scope, size, scale, concentration, interconnectedness and mix of activities could pose a threat to the financial stability of the United States.
In making a determination that a non-U.S. financial institution or business must be supervised by the Fed under heightened prudential standards, the Council must consider these additional factors:
Non-U.S. companies are potentially subject to broad financial data collection requirements from the Council, for the purpose of determining whether they meet the standard for Fed supervision. Thus, even companies that ultimately avoid having to submit to Fed supervision and heightened regulatory requirements may face a compliance burden in establishing that they do not meet the revenue, assets or nature-of-business thresholds of the Act. Typically, the non-U.S. company will be dealing not only with U.S. regulators in responding to demands for financial data, but also its home country regulator, since the Act requires the Council to consult with the appropriate national regulators and rely upon documents the non-U.S. company has produced to them, to the extent possible. A non-U.S. company that is notified of the Council’s determination that it is subject to enhanced supervision by the Fed has the right to appeal at a formal hearing. That right must be exercised within 30 days.
Non-U.S. companies designated for supervision by the Fed under heightened prudential standards must register with the Fed within 180 days after the date of the final determination by the Council. In addition, such companies are subject to the following types of heightened prudential standards, the specifics of which will be determined through the Fed’s rulemaking process:
The Fed in its discretion may tailor the related regulatory requirements for these companies, evaluating the relative threat their distress might pose to the financial stability of the United States based on their scope, size, scale, concentration, interconnectedness or mix of activities. The Fed is given the discretion to establish additional standards relating to contingent capital requirements, enhanced public disclosures, short-term debt limits and other requirements it deems appropriate. Beyond establishing prudential standards, the Fed also has the authority to require divestiture of assets, an early remediation regime, prior notice of large acquisitions and additional capital requirements, among other things.
The heightened prudential standards are generally applicable to all banking organizations, including banks, bank holding companies, financial holding companies, and savings and loan companies, that have $50 billion or more in assets. This includes non-U.S. banks with U.S. operations. Moreover, the Act does not exempt non-U.S. banking organizations with U.S. operations holding less than $50 billion in assets in the United States. Thus, Fed supervision, along with heightened prudential regulatory requirements, is possible for larger non-U.S. banks with few assets in the United States.
Aside from establishing prudential standards, the Fed also has the authority to require such banking organizations to divest themselves of assets, to establish an early remediation regime, to provide prior notice of large acquisitions and to meet additional capital requirements, among other things. The Fed may require parent holding companies to establish intermediate holding companies to isolate more risky and less traditional financial services and activities from less risky and more traditional activities.
Under the Act, the Fed must impose concentration limits to control the risks that the failure of any individual company could pose to a financial institution subject to the Fed’s supervision. The regulations must prohibit each financial institution subject to the Fed's supervision from having credit exposure to any unaffiliated company that exceeds 25% of its capital stock and surplus (or such lower amount as the Fed may determine). “Credit exposure” is broadly defined, and includes all extensions of credit, repurchase agreements, guarantees, counterparty credit exposure and other transactions that the Fed may determine. Non-U.S. organizations will be required to monitor and control these concentration limits to a degree not necessarily required under their home country regime.
Financial institutions deemed to be systemically important — either because they have been so designated by the Council, or because they are banking organizations with $50 billion or more in assets — must create resolution plans, or so-called “living wills.” The purpose of these is to map out alternatives for breaking apart or liquidating the organization in the event of its financial distress or insolvency. The Federal Deposit Insurance Corporation (“FDIC”) is given orderly liquidation authority over systemically significant non-depository institutions. Although this authority applies to companies organized in the United States, a non-U.S. holding company, which has previously anticipated that any insolvency of its U.S. subsidiary would be governed by the U.S. Bankruptcy Code, will now find that the potential application by the FDIC of its orderly liquidation authority stands to take the subsidiary’s resolution outside the known, established bankruptcy process. This may create uncertainty for the parent and the U.S. subsidiary’s creditors alike.
It will take several months for the Council and the Fed to propose and finalize their rules and regulations interpreting the Act. During the pendency of these rulemakings, nonbank financial institutions and businesses outside of the United States should scrutinize their operations to analyze the cost and benefit of the potential application of these requirements, particularly in light of the differing national and international regulatory regimes that are developing. There is concern that non-U.S. financial institutions may decide to tailor their global operations to specifically avoid being designated for Fed supervision under heightened prudential standards.
II. The Global Impact of the “Volcker Rule”
The Volcker Rule generally prohibits banks and certain other financial institutions from engaging in proprietary trading, or sponsoring or investing in a hedge fund or private equity fund. As some of the largest financial institutions in the world are based in the United States, the Volcker Rule may require them to divest or scale back their global proprietary trading and fund-related activities worldwide. The forced exodus of U.S.-based players from the proprietary trading market may create a competitive advantage for non-U.S. entities that do not have systemically important operations in the United States.
A lynchpin of the Volcker Rule’s operation for domestic and non-U.S. entities alike is the definition of proprietary trading. The Act defines “proprietary trading” to mean engaging as a principal for the “trading account” of a banking entity, or of a nonbank financial institution supervised by the Fed. Trading that is covered by this definition includes any transaction, by the applicable entity as principal and for its trading account, to purchase or sell any security; any derivative; any contract of sale of a commodity for future delivery; and any option on any such security, derivative or contract. The definition also encompasses any other instrument that federal agencies decide to add to this list through future rulemaking.
The Volcker Rule requires the U.S. banking agencies, the SEC and the CFTC to promulgate rules that generally prohibit banking entities from engaging in proprietary trading. “Banking entity” is defined to include any insured depository institution, any company that controls an insured depository institution, and any affiliate or subsidiary. It would include a non-U.S. bank that has a U.S. branch or agency. It would also include the holding company of a non-U.S. bank with a U.S. branch or agency.
There are a series of permitted activities exempt from this general prohibition. One of these exemptions is available to eligible non-U.S. banking entities. An “eligible non-U.S. banking entity” must be organized outside the United States. In addition, the greater part of its business must be conducted outside the United States, or all of its business in the United States must be incidental to its international business. Eligible non-U.S. banking entities are permitted to engage in proprietary trading if the trading occurs solely outside the United States and the entity is not controlled or owned by a banking entity that is organized under the laws of the United States or of one or more states.
The Volcker Rule generally prohibits a banking entity from acquiring or retaining any equity, partnership or other ownership interest in a hedge fund or private equity fund. In addition, it prohibits banking entities from sponsoring hedge funds or private equity funds. However, a banking entity may organize and offer a private equity or hedge fund to which it provides bona fide trust, fiduciary or investment advisory services, provided that the fund is organized and offered only in connection with the provision of these services and only to persons who are customers of these services of the banking entity and so long as the banking entity does not acquire or retain an equity interest, partnership interest or other ownership interest in the fund apart from certain de minimis investment.
Notably, the Act provides an exception for sponsorship of or ownership in a hedge fund or private equity fund acquired or retained by an eligible non-U.S. banking entity. An eligible non-U.S. banking entity may acquire or retain an ownership interest in, or sponsor, a hedge fund or private equity fund solely outside the United States, provided that no ownership interest in the fund is offered for sale or sold to a resident of the U.S., and provided the entity is not controlled by a banking entity that is organized under the laws of the United States or of one or more states.
The Volcker Rule authorizes the Fed to impose additional capital requirements on overseas nonbank financial institutions that engage in proprietary trading in the United States, or that retain equity, partnership or other ownership interests in or sponsor a hedge fund or a private equity fund that is offered for sale or organized in the United States.
The Volcker Rule effectively scales back the merchant banking powers previously extended to financial holding companies under U.S. law. These powers, which had been granted to U.S. financial holding companies under the Gramm-Leach-Bliley Act of 1999, until now permitted U.S. companies to compete with non-U.S. financial institutions that had long possessed such powers. Similarly, U.S. bank holding companies and banks are no longer permitted to invest in up to 5% of the outstanding voting shares of any company. In these ways, the Act has restored to non-U.S. banking institutions their former competitive advantage under national regulatory regimes that require less separation between banking and commerce.
For non-U.S. banks and nonbank financial institutions, as for domestic U.S. entities, the Volcker Rule will take effect on the earlier of (i) 12 months after the issuance of final implementing rules by the banking agencies, the SEC and the CFTC; or (ii) July 21, 2012. A non-U.S. banking entity or nonbank financial institution subject to its provisions must bring its activities and investments into compliance with the Volcker Rule not later than two years after the date on which the requirements become effective or two years after the date on which the entity or institution becomes a nonbank financial company supervised by the Fed. However, the Fed may in its discretion grant an extension for up to three additional years (one year at a time) and, upon application, extend the date as to illiquid funds to permit fulfillment of contractual obligations.
The Volcker Rule should create business opportunities for non-U.S. financial institutions and businesses both within and without the U.S. market. As rulemaking proceeds, careful consideration of how the Volcker Rule might apply to your own business and to others in your industry can be of strategic benefit. In addition, non-U.S. companies should be thoroughly familiar with the Rule’s implications when seeking to acquire U.S. companies. Ownership of a business subject to the Volcker Rule could constrain the activities of other U.S. affiliates of the acquiring non-U.S. company.
III. Impacts on Non-U.S. Banking Institutions
The Act creates many new and expanded regulatory requirements for non-U.S. banking institutions with operations in the United States. With the cost of doing business in the United States increasing, banking institutions able to operate outside the United States may have a competitive advantage, but marketing financial products and services to U.S. citizens will subject them to the Act’s new restrictions.
Increased Capital Standards
The Act establishes minimum leverage and risk-based capital requirements on a consolidated basis for insured depository institutions and holding companies. Non-U.S. banking institutions with intermediary holding companies in the United States will find that their intermediary holding companies are now subject to capital requirements, when previously the intermediary holding company was exempt if the Fed determined that the parent company was well-capitalized and well-managed under its home country standards. These capital standards will be not less than the current standards applicable to depository institutions themselves. The minimum leverage and risk-based capital requirements established cannot be: (i) less than the “generally applicable” leverage and risk-based capital requirements, which must serve as a floor for any capital requirements; or (ii) quantitatively lower than the generally applicable leverage or risk-based capital requirements in effect for insured depository institutions as of the Act’s date of enactment.
The capital requirements are intended to cause institutions to maintain capital on a counter-cyclical basis, meaning that the institutions are being directed to build up capital as reserves even during strong economic times. A further effect of the requirements is to eliminate banking institutions’ ability to rely on hybrid capital instruments, such as trust-preferred instruments, as a form of Tier 1 capital. This is in line with the legislative aim to base core capital primarily on common equity, as opposed to debt and hybrid instruments.
Non-U.S. and domestic depository institution holding companies with less than $15 billion in assets are exempted from the capital requirements, as are bank holding companies subject to the Fed’s Small Bank Holding Company Policy Standard.
Interaction With Basel III Requirements
The tightened U.S. capital requirements come as the Basel III capital and liquidity proposals are being finalized. Basel III also seeks to encourage more counter-cyclical behavior by institutions and to increase institutions’ reliance on common equity capital, as opposed to hybrid instruments. The September 2010 Basel III proposal calls for more stringent minimum capital standards which focus on common equity capital (common shares and retained earnings) as the predominant form of Tier 1 capital; introduction of a leverage ratio; a framework for counter-cyclical capital buffers; measures to limit counterparty credit risk; and short- and medium-term quantitative liquidity ratios. The various standards under Basel III have different target implementation deadlines, ranging from implementation of the minimum Tier 1 capital levels in 2013 to full implementation of the proposal by January 2019.
Although the Dodd-Frank and Basel III efforts have similar goals, there will be differences between the rules as proposed by the Fed and the standards proposed by Basel III. The Act contemplates a much tighter timeframe for the enhanced capital and other prudential requirements than does the Basel III proposal. This will result in heightened capital and prudential standards for banking institutions subject to U.S. regulation, as compared to those that financial institutions subject to other national regulation will be required to meet. More stringent capital standards and a higher cost of compliance for U.S. banking institutions will constrict the ability of the institutions to lend and engage in other activities, which may result in greater opportunities for competitors doing business outside the United States.
“Source of Strength” Doctrine Formalized; Enhanced Fed Role
The Act formalized the “source of strength” doctrine for bank holding companies, financial holding companies, savings and loan holding companies, and any controlling party of a depository institution. Some non-U.S. institutions may not have anticipated providing additional capital to their U.S. depository institutions in the event of financial stress. However, with the formalization of the “source of strength” doctrine, capital and other forms of support will be required.
The Act enhances the role and the authority of the Fed as the primary supervisor of bank and financial holding companies. It removes the prior paradigm in U.S. law that separately regulated financial affiliates primarily regulated by their functional regulator. Although these entities will still be regulated by their functional regulator, the Fed is required to exercise supervision as the “umbrella supervisor” over the parent company and its entities as a whole.
Larger non-U.S. entities will feel the impact of the Fed’s role in many ways. All financial institutions subject to heightened Fed regulation and any financial holding company (including those with than less $50 billion in assets) must obtain the Fed’s prior approval before acquiring a nonbank company with more than $10 billion in assets. In addition, financial institutions subject to heightened Fed regulation and all bank holding companies, regardless of size, will be subject to a concentration limit — they are prohibited from merging or acquiring a company if, on consummation of the transaction, the total consolidated liabilities of the financial institution would exceed 10% of the aggregate consolidated liabilities of all financial companies. Financial institutions subject to heightened Fed regulation posing grave threats to U.S. financial stability may be required by the Fed, with a two-thirds approval from the Council, to maintain a 15-to-1 debt-to-equity ratio, and may also be subject to break-up provisions, whereby the institution may be required to restrict its product offerings, divest assets or take other steps to reduce systemic risk.
In the event that a non-U.S. entity would like to escape Fed supervision by selling off its U.S. depository institution, the Act contains a “Hotel California” provision which enables the Fed to continue to supervise a former bank holding company, if important for U.S. financial stability, even after it no longer holds a U.S. depository institution. Charter flipping is also restricted —if a depository institution is subject to an enforcement action from its existing primary regulator, it may be prohibited from converting its charter.
Larger Assessments on Non-U.S. Institutions for Deposit Insurance
The Act includes deposit insurance reforms. Notably, the Act changes the deposit insurance assessment base and repeals a provision that prevented the FDIC from discriminating among institutions based on size in determining risk category. Deposit insurance assessments will now be based on average total consolidated assets minus average tangible equity, instead of total domestic deposits. The minimum reserve ratio is increased, with the increase in assessment to be borne by banks having assets of $10 billion or more.
Larger non-U.S. institutions with U.S. depository institutions will pay more in insurance assessments because of their asset size. The insurance coverage level was also permanently increased to $250,000 for individuals for all accounts held at one institution, which may help attract a more stable deposit base to U.S. financial institutions.
Reg Q Repeal
The Act eliminates the longstanding restrictions under Regulation Q from paying interest on demand deposit accounts. This means, however, that institutions will likely compete for deposit funds by offering higher interest rates.
Non-U.S. Banks With State Charters in the United States Gain Access to Interstate Branching
With respect to interstate branching changes, state banks are now able to branch into additional states on the same basis as are national banks, that is, they are subject to the same branching restrictions imposed for its own state banks by the state in which a branch is proposed to be established. For non-U.S. institutions holding state bank charters, this change may enable them to better compete with national banks and federal savings banks in establishing branches across state lines.
No Federal Insurance Regulation
With respect to insurance regulation, the Act does not establish a federal insurance regulatory regime to replace the existing state regulatory system. However, the Act establishes a new Federal Insurance Office, whose director has a seat on the Council, and the Act requires various studies of the insurance regulatory system in the United States. These developments open the door to larger changes to the insurance regulatory system in the years to come, and may introduce for non-U.S. organizations holding U.S. insurance entities an increased element of uncertainty regarding how the U.S. insurance regulatory system will be organized over time.
Bureau of Consumer Financial Protection
Greater regulatory uncertainty is also present in the consumer financial services area. The Act establishes a new Bureau of Consumer Financial Protection (the “Bureau”), which is created as an independent executive agency and given broad authority to regulate consumer financial services products and services provided by banks and a wide range of nonbank entities. The Act consolidates into the Bureau the consumer financial protection responsibilities currently held by the five banking agencies, HUD and the FTC.
“Consumer financial products and services” are broadly defined and include any products or services used by consumers primarily for personal, family or household purposes, including loan products, real estate settlement services, property appraisals, consumer reporting activities and debt collection activities. For non-U.S. institutions that were accustomed to having their U.S. depository institution’s safety and soundness regulator also be its consumer protection regulator, the Bureau will be a new well-funded regulator empowered with full examination and enforcement authority. It is anticipated that the Bureau will be an active regulator, and that as a result, both non-U.S. bank and nonbank financial services companies offering consumer financial services products and services to U.S. persons will be required to comply with the Bureau’s regulations. More detailed and more extensive consumer compliance regulation will increase the cost of doing business in the United States.
Diminished Federal Preemption
The scope of federal preemption of conflicting state laws is diminished under the Act. State consumer laws that do not directly or indirectly discriminate against national banks, federal savings banks and federal branches of non-U.S. banks are preempted only if: (i) application of the state laws would have a discriminatory effect on the national bank, federal savings bank or federal branch when compared to its effect on state banks; (ii) the law meaningfully interferes with the ability of the national bank, federal savings bank or federal branch to engage in the business of banking (as specified in the Barnett Bank v. Nelson case); or (iii) the state law is preempted by a federal law other than Dodd-Frank.
For a non-U.S. institution that had selected a U.S. national or federal savings bank charter for its U.S. depository institution, the diminished federal preemption standard means that its U.S. depository institution will be more restricted in its ability to offer uniform products and services across the United States and face higher compliance costs associated with complying with varying state consumer laws.
Restrictions on Abusive Mortgage Lending
In the mortgage lending reform area, the Act imposes additional standards aimed at correcting predatory and abusive mortgage lending practices. The provisions apply to both U.S. and non-U.S. lenders who make loans in the United States. Importantly, the mortgage lender is required to conduct, in effect, a suitability test to determine that the borrower can afford the monthly mortgage payments and may only propose loan modifications that provide a net tangible benefit to the borrower. In addition, yield spread premiums are eliminated; prepayment penalties are limited; closing costs must be paid in full at the closing (or all costs must be rolled into the loan); and the borrower is entitled to receive a copy of the credit score used by the lender. The upshot of these mortgage lending reform provisions is again a higher cost of compliance for offering such products in the United States.
Debit Card Interchange Fees
In the payments area, the Act gives regulatory authority to the Fed over debit card payment fees, with the aim of reducing the interchange fees imposed on merchants. The Fed will determine what constitutes “reasonable and proportional” fees for debit card transactions. If the non-U.S. institution had anticipated a certain revenue stream from its U.S. debit card transactions, the Fed’s rules, once proposed and finalized, will interfere with profitability derived from debit card payment fees.
Non-U.S. banks should closely examine the relative costs and benefits of the changed regulatory landscape from a competitive perspective. Although overall regulatory compliance burdens on doing business in the United States will increase, several of the changes affecting non-U.S. banking institutions will improve their ability to compete in the U.S. market. Non-U.S. banking institutions should also consider ways to harmonize their compliance with conflicting Basel III and other national standards, and may wish to explore opportunities for competitive advantage that may arise as a result of relative benefits conferred under their home country’s regime.
IV. Registration of Non-U.S. Advisers to Hedge Funds and Private Equity Funds
Non-U.S. advisers to hedge funds and private equity funds that have previously relied on the “private adviser” exemption from SEC registration will likely now be required to register because that exemption has been eliminated by the Act.
The Act will require many investment advisers and fund managers with their principal office and place of business outside the United States to register with the SEC under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). This is particularly true for non-U.S. advisers that have previously relied on the “private adviser” exemption from SEC registration‚ which has been eliminated by the Act. Non-U.S. advisers should consider whether they are required to register under the Advisers Act well before the compliance date, July 21, 2011.
Although the SEC may issue further guidance with respect to special requirements or exemptions for non-U.S. advisers within the next year, it is prudent for non-U.S. advisers that do not fit within one of the exemptions set forth in the Act to assume they will be required to register with the SEC under the Advisers Act and comply with the regulations applicable to registered investment advisers under the Advisers Act.
A non-U.S. adviser currently relying on the “private adviser” exemption and ineligible for another exemption from Advisers Act registration will be required to register with the SEC unless it qualifies for the “foreign private adviser” exemption by meeting all of the following tests:
As a practical matter‚ there are a number of reasons that many non-U.S. advisers who currently rely on the “private adviser” exemption will not qualify for the “foreign private adviser” exemption. For example, if the adviser manages funds with $25 million or more invested by U.S. investors, or if it has 15 or more U.S. clients or U.S. investors in the private funds it manages, it will be ineligible for the “private adviser” exemption. Those advisers should consider whether they are eligible for another exemption from Advisers Act registration. One exemption possibly available to them applies to advisers solely to private funds with assets under management in the United States of less than $150 million. Another exemption applies to advisers solely to “venture capital funds,” a term that will be defined by the SEC.
A non-U.S. adviser that registers with the SEC must observe, with respect to its U.S. clients, the full spectrum of SEC regulations that apply to registered investment advisers. These regulations include, for example, adopting and implementing compliance policies and procedures, making and maintaining certain books and records, making and maintaining publicly available filings with the SEC, accepting periodic SEC examinations, and adopting and enforcing detailed codes of ethics and personal trading rules for their personnel. The SEC, however, has in the past permitted a “regulation lite” approach that registered non-U.S. advisers may observe with respect to their non-U.S. clients (including, without limitation, non-U.S. funds in which U.S. persons invest). It is reasonable to expect that the “regulation lite” regime will continue in some form for non-U.S. advisers, but it is not clear at this point whether that regime will apply, or the extent to which it will apply, to non-U.S. funds with U.S. investors. The Act will also impose new disclosure and recordkeeping requirements on many non-U.S. advisers, including non-U.S. advisers exempt from SEC adviser registration because, for example, they rely on certain new exemptions from Advisers Act registration established by the Act.
Finally, in addition to the registration and reporting requirements described above, the Act provides for immediate and periodic modifications to the definition of “accredited investor.” This change in the law is important to non-U.S. private funds that sell interests to U.S. investors through private placements under Rule 506 of SEC Regulation D. Under Regulation D, investors must generally be “accredited investors.” Individuals will no longer be permitted to include the value of their primary residence in determining whether they have sufficient net worth, or joint net worth with their spouse, to qualify as “accredited investors.” The Act also directs the SEC to maintain the net worth threshold at $1 million exclusive of the value of the investor's primary residence for four years after enactment of the Act, and to review the definition of “accredited investor” as it applies to natural persons and make any necessary adjustments or modifications at least once every four years. Non-U.S. advisers to private funds offered in the United States to accredited investors should adjust the “accredited investor” definition in their offering and subscription materials in order to require individual investors to exclude their primary residences when determining if they meet the $1 million net worth “accredited investor” test.
The new registration requirements for private fund advisers will result in many non-U.S. fund and financial institutions having to conduct comprehensive reviews of their structure and documentation for any nexus to U.S. investors. In certain cases, non-U.S. advisers may seek to change their business strategies in order to reduce their exposure to U.S. regulation.
Non-U.S. advisers that decide to register with the SEC will likely have to confront at least dual registration costs and compliance burdens in both the United States and their home country. Other issues that should be considered include the effects of dual or multiple national regulation on the treatment of confidential information pertaining to non-U.S. clients. Non-U.S. advisers should carefully monitor the issuance of new regulations to determine whether these concerns may be ameliorated.
The Act effects a complete overhaul of the regulation of the U.S. derivatives market. Under the new regulatory scheme, swaps entities will be subject to registration, capital, margin and business conduct requirements and swap trading will be subject to clearing, trading and reporting requirements.
Under the Act, the U.S. Commodity Futures Trading Commission (the “CFTC”) is given broad authority to regulate swaps, swap dealers and major swap participants, while the U.S. Securities and Exchange Commission (the “SEC”) is given broad authority to regulate security-based swaps, security-based swap dealers and major security-based swap participants. The rules relating to swaps will not apply to activities outside of 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 the CFTC’s anti-evasion rules. The rules relating to security-based swaps will not apply to activities outside of the United States unless they contravene the SEC’s anti-evasion rules. Currently, it is difficult to state with any certainty how the regulators will interpret these provisions in practice.
A non-U.S. entity may be designated as a swap dealer or major swap participant because of the level of its U.S. swap activities. If such designation is made, the non-U.S. entity will be independently subject to the Act’s registration, reporting, clearing, trading, business conduct, and capital and margin requirements. However, such determination will be fact-based and can only be made after the CFTC and SEC have promulgated rules and interpretive guidance. Furthermore, even if a non-U.S. entity is not required to register as a swap dealer or major swap participant, by mere virtue of being a counterparty to a U.S. entity, it may be subject to the Act’s reporting, clearing, trading and margin requirements.
In addition, any swaps entity (meaning a swap dealer or major swap participant) that receives U.S. federal assistance will be subject to the Act’s “push-out provision.” For these purposes, “federal assistance” means the use of advances from any Federal Reserve credit facility or discount window for the purpose of transacting with any swaps entity. The “push-out provision” requires a swaps entity to conduct its swap businesses out of a nonbank affiliate in order to continue receiving federal assistance. The provision is qualified, however, by exceptions provided to insured depository institutions that conduct bona fide hedging and traditional bank activities, such as interest rate or foreign exchange swaps. It is unclear whether the U.S. branches of non-U.S. banks, which are not insured depository institutions, will be eligible for the same exceptions. The literal meaning of the text implies they will not. However, Senator Lincoln, in a colloquy with Chairman Dodd, made clear that the Act intends to treat U.S. branches of non-U.S. banks and U.S. insured depository institutions equally with regards to the permitted exceptions.
Finally, it is within the CFTC or SEC’s powers to bar a non-U.S. entity from participating in U.S. swap markets entirely if it determines that the regulation of swaps in the non-U.S. jurisdiction undermines the stability of the U.S. financial system. Furthermore, in order to close the so-called “London Loophole,” the Act prohibits non-U.S. boards of trade from providing direct access to U.S. participants for transactions settled against contracts listed for trading in the United States, unless the Commission determines otherwise.
The Act’s full effect on non-U.S. entities is subject to CFTC and SEC rulemaking and interpretation, which will require several months at a minimum. The practical effects will also be determined by the nature and extent of non-U.S. derivatives regulation and the level of coordination and cooperation among regulators globally. Non-U.S. entities should follow the ongoing rulemakings closely to determine how the Act’s requirements may trigger new compliance requirements in the jurisdictions in which they conduct derivatives business. Non-U.S. entities engaging in swap activities should consider carefully the Act’s direct and indirect effects in determining how to structure their derivatives businesses.
VI. Legal Changes Affecting U.S. SEC Enforcement Against Non-U.S. Entities and Persons
The Act provides the SEC with an expanded set of enforcement tools including expanded extraterritorial jurisdiction and the authority to provide monetary rewards to whistleblowers, which may drastically increase the risk to non-U.S. entities and persons, especially in light of the large fines and criminal sanctions available under the U.S. regulatory regime.
Non-U.S. Companies Subject to Fraud Suits in U.S. Courts
For non-U.S. companies, the expansion of U.S. securities law enforcement jurisdiction, which partially reverses a recent U.S. court decision, will have significant impact on foreign private issuers and non-U.S. financial institutions.
The extraterritorial reach of the SEC under the antifraud provisions of the U.S. federal securities statutes has been expanded to cover conduct occurring outside the United States that has a foreseeable effect within the United States and conduct within the United States that constitutes significant steps in furtherance of the violation. The extraterritorial jurisdiction applies “even if the securities transaction occurs outside the United States and involves only foreign investors.”
The Act also directs the SEC to study whether this expanded extraterritoriality should be extended to include private civil suits as well as government law enforcement actions.
“Whistleblowers” Could Increase Non-U.S. Companies’ Exposure to FCPA Liability; Companies Can Also Be Liable for Retaliation
The Act provides potent new monetary incentives for whistleblowers who provide original information to the SEC relating to a violation of the securities laws resulting in monetary penalties exceeding $1 million. Whistleblowers will be entitled to receive between 10% to 30% of the amount of the penalties collected. The Act also provides employees a private right of action against employers who retaliate against them for their whistleblowing activities.
Given that monetary sanctions in recent enforcement actions have routinely resulted in settlements exceeding $100 million, multimillion-dollar rewards will now be available to whistleblowers in these cases. One particular area of concern for non-U.S. companies should be the Foreign Corrupt Practices Act (FCPA), which makes it unlawful for a company or people acting on its behalf to offer or give anything of value to non-U.S. officials to obtain business. Increasingly, the U.S. government has sought to enforce the FCPA against non-U.S. companies and individuals.
The extraterritorial reach of the FCPA is broad: it extends to any non-U.S. company with a U.S. subsidiary; any non-U.S. company that employs a U.S. national in any of its offices or subsidiaries around the world; any foreign private issuer; and any non-U.S. company with ADRs traded on a U.S. exchange that require periodic reporting to the SEC. It also extends to any bribery committed entirely by non-U.S. persons, if the violation occurs in significant part within the United States. Moreover, international cooperation among securities regulators and law enforcement agencies is expanding through the IOSCO Multilateral Memorandum of Understanding, now signed by 51 national securities regulators. In addition, the United States and 37 other countries are parties to the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. The new whistleblower provision is expected to play a significant role in identifying and prosecuting violations of the FCPA, among other kinds of securities law violations.
Foreign private issuers may be more closely scrutinized by the SEC because of these bounties. They will also be required to pay damages to whistleblowers, and reimburse them for their legal fees, if the whistleblowing employee successfully sues the company for taking retaliatory action. This is a particularly thorny issue because the company may not, in fact, know that an employee is a whistleblower, since there is no requirement the whistleblower inform the company a complaint has been made to the SEC. Indeed, the Act provides that whistleblowers do not even need to identify themselves to the SEC — they can report to the SEC through counsel.
If a non-U.S. company were to take disciplinary action against an employee without knowing that the employee had claimed whistleblower status, the company could nonetheless face allegations in an employee lawsuit that it knew about its employee’s whistleblowing. Until the lawsuit is resolved, which could be many years, a company that fires, demotes or suspends the employee could face additional liability because the employee will have claimed whistleblower status, and the Act expressly protects whistleblowers from retaliatory firing, demotion or suspension. Any employee who feels that he or she has been the subject of retaliation by the non-U.S. company anywhere in the world can bring a private right of action in U.S. federal court against the company. The damages and remedies that will be available to an employee who prevails are substantial, including double back pay with interest, and reinstatement of seniority. The employee would also be entitled to full compensation for his or her legal fees and costs.
The SEC is undertaking rulemakings with respect to these provisions. Foreign private issuers may wish to comment on the new rulemakings, which can be done on the SEC’s website at http://www.sec.gov/spotlight/regreformcomments.shtml.
VII. New SEC Requirements for Non-U.S. Public Companies
The Act contains many provisions that will affect not only non-U.S. companies in the financial services industry, but also many non-U.S. public companies in other industries. The most significant of these changes involve corporate governance and executive compensation.
The SEC’s forthcoming rules implementing the Act, as well as some that have already been issued, will make express provision for “foreign private issuers.” The SEC defines a “foreign private issuer” as a non-U.S. public company that is both incorporated in a foreign jurisdiction and majority-owned by non-U.S. residents. In addition, at least one of the following conditions must exist: (i) a majority of the company’s directors and officers are not U.S. citizens or residents; (ii) the company’s business is administered from outside the United States; or (iii) a majority of the company’s assets are located outside the United States.
In the case of executive compensation, a foreign private issuer will face less stringent rules than U.S. companies. This is because even after the Act, for most aspects of executive compensation a foreign private issuer will remain subject to the legal and regulatory requirements of its home jurisdiction, rather than those of the United States. To accommodate these differences, a foreign private issuer with securities listed on a U.S. securities exchange will be required by the SEC to disclose in its annual reports the significant ways in which its corporate governance practices differ from those of U.S. companies listed on the same U.S. exchange. In addition, while the NYSE, NASDAQ and other U.S. exchanges exempt a listed foreign private issuer from many of their corporate governance requirements, they also require a foreign private issuer to disclose the ways its governance practices differ from the exchange’s listing standards. This disclosure can be made either in the company’s annual report, or on its website.
There are, however, several areas of executive compensation, corporate governance and disclosure in which foreign private issuers may be directly affected by new U.S. financial regulation. These include:
Executive Compensation Independence Requirements
Forthcoming SEC rules interpreting the Act’s requirement of an independent compensation committee of the board of directors, with higher thresholds of independence which will be imposed through SEC requirements for rules of U.S. securities exchanges, are expected to exempt foreign private issuers that make annual disclosure of the reasons they do not have an independent compensation committee in place. The Act also requires new disclosures concerning the independence of compensation consultants and other advisors; these requirements may apply to foreign private issuers or not, depending upon future SEC rulemaking.
Requirement to “Claw Back” Executive Compensation After Accounting Restatements
The Act directs the SEC to issue rules requiring national securities exchanges to require all public companies, without exception for foreign private issuers, to develop, implement and disclose a “clawback” policy for executive compensation. Such a policy allows the issuer, in the event of an accounting restatement due to material noncompliance with financial reporting requirements, to recover from any current or former executive any excess incentive-based compensation that was paid based on the erroneous data during the three-year period preceding the restatement. The amount that would be “clawed back” is the excess of what was actually paid over the amount that would have been paid under the restated results.
Of particular note to foreign private issuers is that the provision applies to former executives as well as current ones, and that no finding of fraud or even negligence by the executive is required. Because of its inherent retroactivity, strict liability and applicability to individuals whose service to the company is years in the past, the practical difficulties from this provision could be significant. For this reason, the forthcoming SEC rules could adopt an exemption for foreign private issuers listed on U.S. exchanges.
Required Disclosure of CEO/Chairman Structure
The Act directs the SEC to issue rules not later than January 17, 2011, requiring an issuer’s annual proxy statement to disclose the reasons the issuer chose to combine or separate the positions of chairperson of the board and CEO. The existing SEC proxy rules already require disclosures about an issuer’s leadership structure and the role of its board, and specifically, whether and why the company has chosen to combine or separate the principal executive officer and board chair, but these rules do not apply to foreign private issuers.
The SEC could, by rule, extend this requirement to foreign private issuers. If the existing SEC disclosure requirements were applied to foreign private issuers, companies that have combined the roles of CEO and chairman would also have to disclose whether and why the company has a lead independent director, the specific role the lead independent director plays in the leadership of the company, and the board’s role in risk oversight.
We believe it is more likely, however, that the SEC will choose not to apply these requirements to foreign private issuers, consistent with the fact that foreign private issuers are not required generally to comply with the proxy rules.
New Responsibilities for Consultants, Legal Counsel and Advisers to Compensation Committees
The compensation committee must have authority to engage, and the funds to pay, consultants, counsel and advisors. Consultants, counsel and advisors are not required to be independent, but the compensation committee must consider factors affecting independence before making a selection. The compensation committee must have direct responsibility for the appointment, compensation and oversight of the work of the compensation consultant, counsel or adviser. This requirement will apply to foreign private issuers unless the SEC uses its exemptive authority to exclude them from this requirement.
New Sarbanes-Oxley §404 (b) Exemption Relieves Smaller Non-U.S. Issuers From Auditor Attestation Requirement
Foreign private issuers will benefit from the Act’s amendment of the Sarbanes-Oxley Act to exempt non-accelerated filers and smaller reporting companies from the application of Section 404(b), which requires a public company’s external auditors to provide an attestation report on the issuer’s internal control over financial reporting. In addition, the SEC will conduct a study of ways to reduce the burden of compliance with the auditor attestation requirement for companies with market capitalization of between $75 million and $250 million. An express purpose of the study, as outlined in the Act, is to determine whether a reduction in this burden would encourage companies to list on U.S. exchanges.
Credit Ratings Used in Offerings for Securities of Non-U.S. Issuers Will Now Subject Ratings Agencies to New Civil Liability as Experts
The Act increases credit rating agencies’ liability exposure under the securities laws by imposing new liability standards. The pleading standard in private securities fraud class actions against credit rating agencies for money damages related to a rated security has been lowered so that a plaintiff need only plead with particularity facts giving rise to a strong inference that the credit rating agency “knowingly or recklessly failed to conduct a reasonable investigation or obtain reasonable verification of the factual elements it relied upon to evaluate credit risk.” This provision takes effect immediately and applies to registration statements of foreign private issuers.
“Conflict Minerals” Disclosures
The SEC is directed to require certain new disclosures regarding conflict minerals or derivatives determined by the Secretary of State to be financing conflict in the Democratic Republic of the Congo. The new disclosure requirements are not limited to companies actually using materials originating in the conflict zone. Instead, the SEC must apply the new requirement to every reporting company, including foreign private issuers, for which the specified minerals are necessary to the functionality or production of a product manufactured by such person.
Mine Safety Disclosures
The Act requires any SEC reporting company, including a foreign private issuer, that is an operator, or has a subsidiary that is an operator, of a coal or other mine to detail, in each annual and quarterly report it files with the SEC, information regarding the safety record of each mine, related administrative proceedings and pending legal actions involving each mine before the Federal Mine Safety and Health Review Commission. In addition, such issuers must file periodic reports on Form 8-K regarding any shutdowns and patterns of violations at the mine. A violation of these provisions will be treated for all purposes as a violation of the Securities Exchange Act of 1934 subject to SEC enforcement. This section is effective 30 days after enactment of the Act.
Disclosure of Payments to Foreign Governments for Resource Extraction
The Act directs the SEC to promulgate rules requiring SEC reporting companies, including foreign private issuers, that engage in the commercial development of oil, natural gas or minerals, to include in their annual reports filed with the SEC disclosure about all payments, including taxes, royalties, fees and other amounts, made by the issuer or an entity controlled by the issuer to the U.S. or to any non-U.S. government for the purpose of commercial development of oil, natural gas or minerals. The new disclosure must be provided using interactive data tags for six specific categories. The SEC is directed to compile this information and make it publicly available on the Internet to the extent practicable.
Expected Exemptions for Foreign Private Issuers From Additional Provisions of the Act
The Act requires periodic “say-on-pay” advisory shareholder votes and gives the SEC authority to enact rules in other areas, including so-called “proxy access” for shareholder director nominations. These and similar requirements for U.S. public companies are not expected to apply to foreign private issuers because there is no explicit requirement of applicability in the Act, and because foreign private issuers have not traditionally been subject to either the proxy rules or to rules concerning executive compensation.
Foreign private issuers should review their corporate governance policies and practices in light of these provisions. They should also closely follow the SEC’s rulemakings, as well as those of the exchanges on which their shares are listed, for information fleshing out these new requirements.
VIII. New Financing Requirements on U.S. Treasury Will Create Opportunities for Non-Traditional Lenders in U.S. Market
For non-U.S. financial institutions and businesses of all kinds, the U.S. government’s extraordinary fiscal policy response to the financial crisis will have even greater short- and long-term impacts on global capital markets than the legislative and regulatory responses. In combination with the higher regulatory compliance burdens imposed by the Act on U.S. financial institutions, the anticipated massive borrowings by the U.S. Treasury may result in additional unmet demand for capital by businesses both within and without the United States. This will create opportunities for the financial services industry outside the United States, including nonbank financial institutions and non-traditional lenders, as well as for some U.S. financial market participants.
In the fiscal year ended September 30, 2009, the U.S. government spent $3.5 trillion, with revenues of only $2.1 trillion. This represented an 18% increase in spending compared to 2008, at the same time that revenues fell by over 16%. For fiscal year 2010, the net deficit was very similar, with a preliminary deficit estimate from the Congressional Budget Office (CBO) of $1.3 trillion. Even more significantly, over the last five years, the U.S. government’s on and off-balance sheet liabilities have expanded by over $6 trillion per year, chiefly from growing demands on the Medicare health care entitlement for senior citizens. In 2010, the United States further expanded public health care mandates to include the rest of the population in many new benefits, with the added expense partly financed by new taxes. This new entitlement will, according to the CBO, add $1 trillion in spending during the first six years of the program.
In combination, these unprecedented fiscal pressures are placing enormous new financing requirements on the U.S. Treasury. By the end of next year, the U.S. publicly held debt will have more than doubled since 2007, from $5 trillion three years ago to well over $10 trillion. The U.S. national debt, as a share of GDP, will grow from 40% in 2008 to 60% this year and 70% in 2011, according to the CBO. The growing amounts of U.S. Treasury securities that will have to be sold in global capital markets to finance this debt are estimated to rise to $25 trillion per year within 10 years, up from $11 trillion per year now.
These rapidly growing Treasury issuances will have to be financed just as other national governments, which until now have been the major purchasers of U.S. Treasury securities, are facing their own domestic pressures that may cause them no longer to be able to — or willing to — continue to do so. According to official figures, China has significantly scaled back its investment in U.S. Treasuries, buying less than 5% of new Treasury debt last year, compared with over 20% in 2008, and 47% in its peak year of 2006. Meanwhile, some other national governments are unable to buy U.S. debt at past levels because they face their own massive deficits.
With foreign sovereigns no longer guaranteed to take up the slack, the Fed may be required to purchase Treasuries. To the extent it does not do so, financing the new borrowing may largely be left to commercial banks, because they are among the few institutions with capacity on their balance sheets to become more significant buyers of Treasuries. Unfortunately for borrowers, but perhaps fortunately for non-traditional lenders approaching the U.S. market from overseas, the availability of so much new U.S. government debt may permit banks to hold relatively more Treasury securities in order to maintain less risky and more liquid balance sheets. Together with the more stringent leverage, capital and liquidity requirements that will be applicable to many large banking institutions under the Act, this may further constrain the ability of U.S. financial institutions to extend credit and invest, both in the United States and overseas. Conversely, the burden on U.S.-based financial institutions may be a benefit to non-U.S. financial institutions.
Non-U.S. financial institutions and businesses should consider the potential market opening in the United States created by the current risk aversion of both commercial banks and investment banks in the new regulatory environment. The combination of heightened regulation of U.S. financial institutions, their ability to meet the heightened capital and liquidity requirements with holdings of U.S. Treasury securities, and the availability of vastly more Treasury securities in the public market than ever before, may well create new opportunities in the United States for nonbank lending, and for investment from domestic and overseas funds, as well as other non-U.S. sources of capital. Non-U.S. firms should immediately assess their business models with this in mind.
The broad reforms of the Dodd-Frank Wall Street Reform and Consumer Protection Act will have profound effects on non-U.S. banks, financial institutions, investment advisers, hedge funds and public companies in a variety of industries, depending on their level of interaction with U.S. markets. For a full analysis of the Act, please see our comprehensive summary, available at: /Media.aspx?MediaID=10963. Non-U.S. companies may be affected through:
The extent to which these changes will apply to non-U.S. entities depends in significant part on rules yet to be written. It will be many months, and in some cases years, before individual rulemakings are initiated and even longer until they are completed. A further cause for delay is the fact that the U.S. Congress adjourned for the November 2010 elections without appropriating the funds necessary for implementation of the Act — with the result that the SEC, which was expecting an 18% percent increase in its budget to hire 800 new staff, and the CFTC, which had been expecting an increase of over 50% in its budget to hire more than 200 new staff, will be unable to hire new staff for the time being. Existing resources will be heavily taxed as these agencies undertake an unprecedented number of rulemakings mandated by the Act, including in particular new regulation of the derivatives market. Moreover, the delay in funding could stretch into 2011.
Non-U.S. entities will also be affected indirectly due to the Act’s restrictions on their U.S. competitors and counterparties, and these effects will be amplified by virtue of the consequences of U.S. fiscal responses to the financial crisis. These indirect effects may well be positive for those able to take advantage of the Act’s restrictions on U.S. competitors (for example, in businesses such as commercial lending, proprietary trading and funds management), and negative for globally active firms that have heretofore benefited from their significant U.S. investments and the flexibility of U.S. counterparties.
Non-U.S. entities should carefully follow the development of rulemakings under the Act, as well as concurrent further developments in non-U.S. regulatory reform. The substantial changes in the regulatory environment that the Act has introduced are sure to reverberate throughout the global capital markets for years to come.
Please direct questions to any of the listed lawyers or to any other Bingham lawyer with whom you ordinarily work on related matters:
Christopher Cox, Partner, Bingham McCutchen LLP
chris.cox@bingham.com, 714.830.0606
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247
Kenneth A. Kopelman, Partner, Broker-Dealer Group
ken.kopelman@bingham.com, 212.705.7278
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615
Neal E. Sullivan, Practice Group Leader, Broker-Dealer; Co-chair, Financial Services Area
neal.sullivan@bingham.com, 202.373.6159
This article was originally published by Bingham McCutchen LLP.