Financial Reform Legislation Heats Up: Bill to the Senate Floor as Early as This Week; Many Open Issues for Broker-Dealers and Investment Advisers

April 20, 2010

Senator Dodd introduced in mid-March a much revised financial regulatory reform bill that is now likely to be presented for consideration by the full Senate as early as this week. The bill, the “Restoring American Financial Stability Act of 2010” (the “Dodd Bill”) differs in many significant ways from the bill that the House of Representatives passed in December 2009 (the “House Bill”).1 Given Senator Dodd’s intent to leave a legacy of financial regulatory reform before he retires from the Senate at the end of this term, we believe it is likely that he will be willing to make compromises in order to ensure passage of a bill in the Senate. After Senate passage, a Conference Committee between the House and Senate could reintroduce those potentially controversial aspects of financial regulatory reform that may need to be dropped in order to permit Senate passage of a bill.

For broker-dealers and investment advisers, there are a number of provisions in the Dodd Bill that differ from the House Bill. The Dodd Bill includes the “Volcker Rule” which would prohibit proprietary trading by banks and their affiliates (including broker-dealers). The Dodd Bill also differs from the House Bill in the way it addresses the question of whether securities brokers should be made fiduciaries when providing personalized advice to retail customers, the future of mandatory predispute arbitration clauses, and changes in the income and net worth thresholds for accredited investors. The House Bill and the Dodd Bill are less different in the way both would expand the SEC’s scope of authority and enforcement capability without revolutionizing the Commission’s role in the federal regulatory regime. Specifically, both bills delegate responsibility for addressing systemic risk posed by financial institutions (including broker-dealers) to a new, interagency Financial Stability Oversight Council (“FSOC”), while strengthening the existing authority of primary regulators.2 

This update focuses on the Dodd Bill’s impact in five key areas: (1) implementation of the Volcker Rule prohibiting proprietary trading by banks and their affiliates; (2) duties of securities brokers and investment advisers to retail customers; (3) registration and regulation of advisers to private funds; (4) income and net worth thresholds for accredited investors; and (5) SEC enforcement.

The Dodd Bill Would Codify the Volcker Rule and Prohibit Many Types of Proprietary Trading by Banks and Their Affiliates

The Dodd Bill would codify the proposed Volcker Rule, which would significantly limit proprietary trading accounts at all banks and their affiliates, and prohibit all banks and their affiliates from owning, operating, or sponsoring hedge funds or private equity funds (Section 619).

The Volcker Rule would apply to insured depository institutions, companies that control insured depository institutions or are treated as bank holding companies for purposes of the Bank Holding Company Act, and any subsidiary of such institution or company. Banks and their affiliates would be prohibited from investing in or sponsoring hedge funds and private equity funds;3 however, investments in small business investment companies would be exempt from this prohibition. The Volcker Rule would create a limited number of exceptions for trading in obligations of (1) the United States government and its agencies; (2) Ginnie Mae, Fannie Mae, and Freddie Mac; and (3) state and municipal obligations. Proprietary trading by a foreign company that occurs solely outside of the United States, unless the company is controlled by a U.S. firm, also would be explicitly excepted from the prohibition. The Dodd Bill would not generally limit a bank or its affiliates’ ability to engage in trading “on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of customer relationships, including risk-mitigating hedging activities.”4 

Although the Dodd Bill would direct the FSOC to complete studies on the Volcker Rule’s activity and concentration limits within six months of its enactment, and recommend any modifications to its activity limits, the Council’s authority to modify the rule is very limited and does not extend to making any fundamental changes. The appropriate federal banking agencies would be required to promulgate final rules to implement the activity and concentration limits of the Volcker Rule within nine months of the study’s completion. Firms within the scope of the Volcker Rule’s authority would have two years after the issuance of these regulations to come into compliance with the activity limits, but could receive up to three one-year extensions from the appropriate federal banking agency.

Program of Investor Protection Would Not Immediately Subject Securities Brokers to Fiduciary Duties, But Includes Investor Advisory Committee to Advocate for Retail Investors

Brokers and dealers are currently excluded from the definition of “investment adviser” under the Investment Advisers Act of 1940 if their advisory activities are solely incidental to brokerage activities and they receive no special sales compensation. Broker-dealers therefore are not regulated as investment advisers, unless their activities constitute investment advisory activities. In a significant departure from the House Bill,5 which would impose fiduciary duties upon securities brokers when providing personalized investment advice to their retail customers, the Dodd Bill calls for the SEC to conduct a one-year study for Congress on the effect of proposed changes to current standards of care imposed upon brokers, dealers, investment advisers, and their associated persons who provide individual securities advice to retail customers (Section 913). If the study yields results indicating that there are gaps or overlaps in the regulatory framework, then the SEC is required to begin rulemaking procedures to address those issues within two years.

The Dodd Bill would establish the Investor Advisory Committee as a consultant body to make findings and non-binding recommendations to the SEC on regulatory and legislative initiatives to protect investor interest and promote investor confidence. The Committee will be comprised of members representing the interests of individual investors and state securities commissions. The Dodd Bill also would establish the Office of Investor Advocate, appointed by the SEC Chair, to assist retail investors in resolving significant problems with the SEC or self-regulatory organizations, and represent the interests of retail investors from within the SEC (Section 914).

Advisers to Private Funds, Including Hedge Funds, Would Be Subject to SEC Registration, Reporting, and Recordkeeping Requirements

The Dodd Bill would broaden the class of investment advisers required to register with the SEC, and heighten recordkeeping and recording requirements to provide authorities with data to assess the level of risk to the stability of the U.S. financial system (Section 403). The Dodd Bill amends the Investment Advisers Act of 1940 to remove the exception for advisers with “fewer than 15 clients,” and provides no exception for funds created outside the U.S. or where U.S. citizens have less than a 10 percent ownership interest in the fund.

While this proposal would broaden the class of advisers subject to federal registration requirements, Section 410 is likely to reduce this class by raising the threshold for required SEC registration from $25 million under management to $100 million. This approach contrasts with that of the House Bill, which proposed to raise the threshold to $150 million.6 Neither Bill provides clarity as to the impact on advisers that manage more than $25 million, but less than $100 million, and therefore currently are required to register with the SEC. Neither Bill provides for grandfathering, so it is possible that these provisions, if law, would require these advisers to de-register with the SEC and to register with the appropriate state authorities. It seems likely that the SEC and states would have to provide guidance in the event that these changes become codified.

The Dodd Bill would exempt from the SEC registration requirement advisers to venture capital funds, private equity funds, and advisers to small business investment companies (Sections 403, 407-408). These advisers would be required to maintain for SEC inspection records and reports on such matters as fund size, governance, investment strategy, risk, and any other issues the SEC determines are necessary and appropriate (Section 408). The terms “venture capital fund” or “private equity fund” are not defined. Instead, the proposed legislation requires the SEC to define those terms within six months of the bill’s passage. The House Bill does not include any exemption from registration for private equity funds, although it does exempt venture capital funds. The Dodd Bill would exempt family offices (Section 409) and certain advisers to foreign private funds (Section 402(a))7 from registration, recordkeeping, and reporting requirements. The Dodd Bill provides a one-year transition period before these registration requirements take effect; however, any adviser that would be subject to the new registration requirement may take steps to comply during the transition.

The Dodd Bill also imposes new disclosure requirements upon advisers designed to provide the FSOC and its Office of Financial Research with the data necessary to monitor systemic risk issues (Section 404). The SEC would receive broad authority to define its recordkeeping and reporting requirements, but specifies that a fund’s records and reports must describe (1) the amount of assets under management and use of leverage; (2) counterparty credit risk exposure; (3) trading and investment positions; (4) valuation policies and practices of the fund; (5) types of assets held; (6) side arrangements or side letters, providing favorable terms for certain investors; (7) trading practices; and (8) all other information “necessary and appropriate” to protect investors, the public, and assess systemic risk. Although the SEC is directed to share with the FSOC all data necessary to the assessment of systemic risk, the Dodd Bill also includes confidentiality provisions to safeguard proprietary information.

The SEC Would Gain the Authority to Reaffirm, Prohibit, or Limit Mandatory Pre-Dispute Arbitration Clauses

The Dodd Bill does not require the SEC to enact rules to prohibit, limit, or condition mandatory predispute arbitration clauses in contracts between customers, brokers, dealers, and municipal securities dealers arising under the securities laws or the rules of a self-regulatory organization; however, the Dodd Bill does give the Commission the authority to enact such rules at its discretion. Unlike other provisions of the Dodd Bill, Section 921 does not require the SEC to act on mandatory predispute arbitration clauses within a specified timeframe.

In the non-securities context, the House Bill would provide the Consumer Financial Protection Bureau with the authority to limit or ban mandatory predispute arbitration clauses in consumer financial contracts.8 By contrast, the Dodd Bill would merely authorize the consumer protection agency to conduct a study on the issue before the agency may limit the use of mandatory predispute arbitration clauses (Section 1028). Although both Bills would provide the SEC with authority to address mandatory predispute arbitration clauses in securities contracts, the House Bill would grant the SEC authority to “prohibit, impose conditions or limitations” on these agreements;9 whereas the Dodd Bill would allow the SEC also to “reaffirm” these agreements (Section 921).

Current Income and Net Worth Thresholds for Accredited Investors Would Be More Than Doubled From Their Current Levels

The Dodd Bill would require the SEC to adjust retroactively for inflation the income and net worth thresholds for “accredited investors.” The Bill would elevate from the current income threshold of $200,000 for individuals ($300,000 for couples) and current net worth threshold of $1 million to proposed income thresholds of approximately $450,000 for individuals (and $675,000 for couples), and net worth thresholds of approximately $2.25 million (Section 412).10 The House Bill contains no similar provision. The Dodd Bill calls for those thresholds to be adjusted for inflation since the time when those figures were determined in 1982, and then to be readjusted at least once every five years. The Dodd Bill also calls for the GAO to conduct a study on the appropriate criteria for determining the financial thresholds needed to qualify for accredited investor status and eligibility to invest in private funds (Section 413). The Dodd Bill calls for this report to be submitted to the appropriate House and Senate committees within one year of the law’s enactment.

These increases would have a potentially significant effect on private placement agents, venture capital funds, and angel investors, who likely would have access to a smaller pool of individual investors.

The SEC Would Have Fewer Enforcement Tools, But Proposed Self-Funding May Allow SEC to Pursue Aggressive Enforcement Agenda

The House contains two key SEC enforcement measures that the Dodd Bill omits. First, the House Bill would authorize the SEC to seek civil monetary penalties in administrative proceedings, instead of federal district court.11 Second, the House Bill would grant the SEC access to grand jury materials — currently only available to prosecutors.12 The House Bill also contains provisions relating to aiding and abetting and control person liability, and extraterritorial jurisdiction, that are missing in the Dodd Bill. Both the House Bill and the Dodd Bill would also expand the incentives for whistleblowers to report evidence of securities law violations.13 The two bills would authorize the SEC to reward whistleblowers for reporting violations of any securities law (rather than just for insider trading violations, as is currently the case), and to increase from 10 percent to 30 percent the maximum reward that whistleblowers can recover when the SEC imposes sanctions on violators. 

The Dodd Bill would empower the SEC to become a self-funding entity, with the authority to set its own budget outside of the Congressional appropriations process (Section 991), although we understand that some Senate Republicans object to this proposal. The House Bill authorizes a larger budget for the SEC and would allow the SEC to impose fees on investment advisers to fund an expanded examination program;14 however, the SEC’s budget would still be subject to the appropriations process. The Dodd Bill also would disband the SEC’s Office of Compliance, Inspections and Examinations (OCIE) and would instead provide the Division of Trading and Markets and the Division of Investment Management with a staff of examiners to perform compliance inspections (Section 965). The Dodd Bill would require a series of reports from the SEC and GAO to Congress regarding SEC management, personnel, and financial issues.

The GAO and SEC Would Be Required to Conduct a Broad Range of Studies to Inform Future Rulemaking on the Topics in the Bill

The Dodd Bill would authorize several studies in addition to the significant ones mentioned above. The Bill directs the Government Accountability Office to conduct studies on (1) the feasibility of forming a self-regulatory organization to oversee advisers to private funds, private equity funds, and venture capital (Section 414); (2) legally required uses of nationally recognized statistical rating organizations (Section 939); (3) alternative compensation models for credit rating agencies (Section 939B); (4) increased disclosure to investors by issuers of municipal securities (Section 976); (5) municipal securities markets (Section 977); (6) proprietary trading by banks (Section 989); (7) potential conflicts of interest between investment banking and equity and fixed income securities analyst functions within the same firm (919); and (8) access of investors to registration information (including disciplinary actions, regulatory, judicial, and arbitration proceedings, and other information) about investment advisers, broker-dealers, and their associates (Section 919A). The Bill also directs the SEC to conduct studies on (1) financial literacy among investors (Section 916), (2) mutual fund advertising (Section 917), (3) funding for the Government Accounting Standards Board (Section 978); (4) strengthening credit rating agency independence (Section 939A); and (5) the effect of short selling on national securities exchanges (Section 415).


Although there appeared to be some bipartisan appetite for financial services reform in Congress, on Friday, April 16, the White House received a letter from all 41 Republican Senators objecting to much of the Dodd Bill and asking that negotiations of key provisions be revived in bipartisan meetings prior to a bill being brought to the Senate floor. Financial reform is, however, a top priority for the White House right now, and the White House is pushing for a Senate floor vote before Memorial Day. Therefore, it is likely that significant informal negotiations on many key provisions are occurring both on Capitol Hill and between legislators and the White House. Of the issues discussed here, the proposed codification of the Volcker Rule is most likely to be the subject of negotiations at this point in the process. Other issues that appear to be most in controversy between the Senate Democrats and Republicans (derivatives reform, consumer protection, resolution authority for financial institutions, and “too big to fail”) are largely outside of the securities area, although each has securities components an could ultimately impact the activities of broker-dealers and investment advisers. Overall, however, although it remains unclear if and when financial reform legislation will be enacted, it is very likely that there will be much activity in this area in the weeks to come. We believe the Dodd Bill and the House Bill represent the “bid-ask” spread for any final bill, and where the two bills differ, a final bill will consist of a compromise between the current positions.

For assistance, please contact the following lawyers:

Amy Natterson Kroll, Partner, Broker-Dealer Group, 202.373.6118

David C. Boch, Partner, Broker-Dealer Group, 617.951.8485

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Timothy P. Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

1 H.R. 4173, passed by the House of Representatives on December 11, 2009.
2 Bingham published an alert on “The Role of the SEC Under the House of Representatives Financial Services Reform Bill” on December 18, 2009; On March 17, 2010, Bingham issued a client alert discussing specifically the Dodd Bill’s proposed reforms to the regulation of asset-backed securities.
3 The Dodd Bill also would subject bank holding companies and their subsidiaries and hedge funds or private equity funds advised by that company to the strictures on transactions between affiliates that are codified in Sections 23A and 23B of the Federal Reserve Act (Section 619(e)(1)).
4 The Dodd Bill also contains a provision designed to prevent the creation of “too big to fail” financial firms by prohibiting any “financial company” from merging with or acquiring the assets or control of another company if the combined entity’s total liabilities would exceed 10 percent of the total liabilities of all financial companies. The aggregate consolidated liability of all financial companies would be determined from the end of the prior calendar year. Section 619 also requires the Federal Reserve to impose additional capital requirements, specifying additional quantitative limits for non-bank financial institutions the FSOC has designated “too big to fail” that engage in proprietary trading or sponsoring and investing in hedge funds and private equity funds. The same exemptions that apply to proprietary trading in banks — specifically, trading in federal government obligations, GSE obligations, or state and municipal obligations — would apply to these nonbank financial firms as well. The Bill omits any prescription as to how the Fed should set these capital requirements or quantitative limits.
5 H.R. 4173 § 7103.
6 H.R. 4173 § 5007.
7 A foreign private adviser is defined as any investment adviser who (1) has no place of business in the U.S.; (2) has fewer than 15 U.S. clients; (3) has less than $25 million in aggregate assets under management attributable to U.S. clients and U.S. investors in private funds advised by the adviser; and (4) does not hold itself out generally as an investment adviser to the public in the U.S.
8 H.R. 4173 § 4208.
9 H.R. 4173 § 7201.
10 Inflation Calculator, Bureau of Labor Statistics (available at
11 H.R. 4173 § 7211.
12 H.R. 4173 § 7214. Both bills also would expand the scope of collateral bars to prevent securities law violators from associating with any SEC-regulated firms. (H.R. Section § 7206; Dodd Bill § 925). Current law bars offenders from associating only with those firms regulated by the specific provision violated.
13 H.R. 4173 § 7607; Dodd Bill § 922.
14 H.R. 4173 § 7301.

This article was originally published by Bingham McCutchen LLP.