Although still subject to Senate approval, the House of Representatives’ June 30, 2010 vote to approve the Bill* moves broker-dealers that much closer to sweeping changes to their business and operations. Only a limited number of provisions will be effective immediately upon the President’s signing of the Bill into law. Accordingly, the overall impact of financial regulatory reform cannot be fully determined until regulators undertake required rulemaking and also determine whether — and to what extent — to exercise delegated rulemaking authority.
This alert highlights the potential federal securities law implications for broker-dealers with respect to their (1) sales practices; (2) trading and investments; and (3) investment banking and advisory services. Also summarized are potential new SEC requirements related to broker-dealers’ associated persons and a variety of new operational issues that broker-dealers are likely to face in connection with these activities, including substantial new disclosure and reporting obligations. We will continue to provide analysis and updates once the legislation is finalized, and the SEC begins its rulemaking process.
* Abbreviations used in this alert are defined in the glossary following the table.
TOPIC | Status |
I. Sales Practices | |
A. Standard of Care (Sec. 913) | |
The SEC is granted discretionary rulemaking authority under the 1934 Act and the IAA to establish comparable standards of conduct for broker-dealers and investment advisers. Specifically, the SEC is authorized, but is not required, to promulgate rules providing that the standard of conduct for broker-dealers and investment advisers, when providing personalized investment advice about securities to retail customers, and such other customers as the SEC provides by rule, is to act in the best interest of the customer without regard to the financial or other interest of the broker-dealer or investment adviser providing the advice.
Within 6 months of enactment, the SEC must complete a study comparing the legal and regulatory requirements for services offered by broker-dealers and investment advisers, and addressing any gaps in regulation and investor understanding. The study must also assess the potential impact to retail investors from changes in regulatory requirements. A standard of conduct for broker-dealers based on the IAA’s fiduciary duty standard raises a number of issues:
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No new requirements, unless the SEC exercises its rulemaking authority. |
B. Product-Specific Sales Requirements | |
1. Retail Investment Products and Services (Sec. 919) | |
The SEC is granted discretionary authority under 1934 Act section 15(n) to promulgate rules designating documents and information that broker-dealers must provide to retail investors prior to the purchase of an investment product of service.
Any information or documents required to be provided must be in summary format; contain clear and concise information about investment objectives, strategies, costs, and risks; and provide information about any compensation or other financial incentive received by a broker-dealer or other intermediary in connection with the purchase of a retail investment product. If the SEC adopts rules, guidance will be needed on a number of issues:
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No new requirements, unless the SEC exercises its rulemaking authority. |
2. Mutual Fund Shares (Sec. 918 and Sec. 919) | |
The CG is required to conduct a study and report to the Banking Committees within 18 months on mutual fund advertising to identify:
The potential impact for broker-dealers relating to mutual fund advertising will need to be determined after the CG publishes its findings. |
No new requirements, unless the SEC exercises its rulemaking authority. |
3. Sales of Proprietary Products or A Limited Range of Products (Sec. 913(g)) | |
The Bill provides that a broker-dealer’s sale of only proprietary or other limited range of products (as determined by the SEC) will not, in and of itself, be considered a violation of the standard of care.
See discussion of potential implications in Section I.A. |
No new requirements, unless the SEC exercises its rulemaking authority. |
4. ABS Risk Retention (Sec. 941) | |
Risk retention. The SEC, the Banking agencies and, in the case of residential mortgages, the Housing agencies, must jointly promulgate rules that require securitizers of ABS to maintain 5% of the credit risk in assets transferred, sold, or conveyed through the issuance of ABS; except that less than 5% of the risk will need be retained if high standards for underwriting are satisfied by the securitizers and originators of the relevant assets.
"Securitizer" means an issuer of an ABS; or a person who organizes and initiates an ABS transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer. "Originator" means any person who, through the extension of credit or otherwise, creates a financial asset that collateralizes an ABS; and sells an asset directly or indirectly to a securitizer. The potential impact of the new ABS-related requirements cannot be determined until the relevant rules are proposed. At a minimum, however, broker-dealers will want to review their due diligence and valuation processes. |
Rulemaking required within 270 days of enactment.
The rules will take effect 1 year, for securitizations of residential mortgages, and 2 years for all other securitizations, after publication in the Federal Register. |
5. Securities-Based Swaps (Sec. 764) | |
Security-based swap dealers and major security-based swap participants will be required to comply with SEC-prescribed business conduct standards. Among other things, broker-dealers who are deemed to be swap dealers or major security-based swap participants will have a duty to communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith and other standards and requirements prescribed by the SEC.
Security-based swap dealers will also have to comply with any duty prescribed by the SEC with respect to its dealings with Special Entities as counterparties, including any duty to have a reasonable basis to believe that the counterparty has an independent representative with sufficient knowledge to evaluate the transaction and risks. The SEC is authorized, but not required, to exempt from designation as a "security-based swap dealer" any person that engages in a de minimis quantity of security-based swap dealing in connection with transactions with or on behalf of its customers. (Sec. 761) |
The SEC must issue rules with 1 year of enactment. |
C. Investor Eligibility | |
1. Accredited Investors (Sec. 413) | |
The net worth standard for an "accredited investor" under the 1933 Act is set at more than $1 million of net worth, excluding the value of an individual’s primary residence, for a natural person, or joint net worth with spouse, at the time of purchase. During the first four years following enactment, the net worth standard is set at $1 million, excluding the person’s primary residence.
Every 4 years, the SEC must review the definition of "accredited investor" to determine if adjustments should be made to other eligibility criteria for natural persons. |
Effective upon enactment. |
2. Eligibility for Accredited Investor Status and to Invest in Private Funds (Sec. 415) | |
The CG is required to conduct a study on the appropriate criteria for determining financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds. The report is due to the Banking Committees within three years of enactment. | No immediate requirements. |
3. Qualified Client Standard (Sec. 418) | |
All dollar amount tests employed with respect to any factor used in any SEC rule or regulation promulgated with respect to IAA section 205(e), including the net asset threshold test, must be adjusted 1 year after enactment, and every 5 years thereafter for the effects of inflation. | The SEC must adjust the thresholds 1 year after enactment and every 5 years thereafter. |
4. Security-Based Swap Counterparties (Sec. 764) | |
Broker-dealers that are security-based swap dealers or major security-based swap participants will be required to verify that any counterparty meets the eligibility standards for an eligible contract participant. | Rules must be prescribed within 1 year of enactment. |
II. Trading & Investments | |
A. Principal Trading | |
The Bill does not include any limitation on principal trading by a broker-dealer that provides advice to retail investors. If the SEC does exercise its discretionary authority and imposes the same duty of conduct on broker-dealers as on investment advisers, exemptive or other relief will be needed to allow principal trading with clients without written trade-by-trade disclosure and consent. One possibility would be to extend the type of relief currently provided by IAA Rule 203(3)-3T for dually-registered broker-dealers’ nondiscretionary accounts. | No new requirements, unless the SEC exercises its rulemaking authority. |
B. Restrictions On Proprietary Trading and Investments In Certain Private Funds (Sec. 619) | |
1. Proprietary Trading | |
The Volcker Rule will apply to broker-dealers that are affiliates of a banking entity, including a bank holding company or any insured bank or thrift, or a company that controls an insured bank or thrift, or is deemed to be systemically important nonbank financial companies.
Market making, hedging to mitigate risks, and transactions on behalf of customers are all permitted. Transactions would be prohibited if they were found to be high risk, pose a threat to U.S. financial stability or the entity’s safety and soundness, or involve or result in a material conflict of interest between the entity and its customers, clients and counterparties. |
15 months after enactment, the SEC, CFTC and Banking agencies must adopt coordinated rulemaking.
The rules will be effective the earlier of 12 months after the issuance of final rules, or 2 years after enactment. The Federal Reserve may extend this period for 1 year, 3 times, for an aggregate of 5 years from enactment. |
2. Investments In or Sponsorships of Hedge Funds or Private Equity Funds | |
Applies to the same types of entities that are subject to the proprietary trading restriction.
Subject to certain exceptions, a banking entity or systemically important nonbank financial company is prohibited from acquiring or retaining any ownership interest in or sponsoring a hedge fund or private equity fund. Organizing and offering a hedge fund or private equity fund, including serving as a general partner, managing member, or trustee of the fund, and selecting the management or directors of the fund, among other things, is permitted when done in connection with bona fide trust, fiduciary or investment advisory services; only a de minimis investment is made; the investment does not present material conflicts of interest or pose a threat to U.S. financial stability or the entity’s safety and soundness; the entity does not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the hedge fund or private equity fund or any fund in which such fund invests; there is no shared name; and written disclosure is made to prospective and actual investors that they, and not the banking entity or nonbank financial institution, bear sole responsibility for any losses. |
Generally, the above timeframes apply, except that the Federal Reserve may, upon application, extend the transition period for 5 years to fulfill a contractual obligation that was in effect on May 1, 2010. |
C. Security-Based Swap (Sec. 763) | |
All security-based swaps must be traded on a securities exchange or through a swap execution facility unless no such entity is available for the particular swap. Limited exemptions are available from this requirement, including for trades with non-financial entities.
The SEC is authorized, but not required, to adopt business conduct standards applicable to registered security-based swap dealers and major security-based swap participants concerning: (1) fraud, manipulation, and other abusive practices involving swaps, (2) diligent supervision of the business of the registered entity, and (3) adherence to all applicable position limits; and such other matters as the SEC determines to be appropriate. (Sec. 764). |
Rules must be prescribed within 1 year of enactment. |
D. Short Selling | |
1. Real-Time Short Position Reporting (Sec. 417) | |
ORSFI is required to conduct a study on the feasibility, benefits, and costs of requiring real-time reporting of short sale positions either publicly or to the SEC and FINRA and of conducting a voluntary pilot program by public companies in which the companies agree to have all trades in their shares reported real-time to the Consolidated Tape marked "short”, ”market maker short”, ”buy”, ”buy-to-cover”, or ”long.” The report on the results of the study is due to the Banking Committees within 1 year of enactment. | No new requirements at this time. |
2. Short Selling, Including Fails (Sec. 417) | |
ORSFI is required to conduct a study on the state of short selling on national securities exchanges and in over-the-counter markets, including the incidence of the failure to deliver shares sold short. The report, together with any recommendations for market improvements, is due to the Banking Committee within 2 years of enactment. | No new requirements at this time. |
3. Short Sales Reforms (Sec. 929X) | |
1934 Act section 15(d) require that (a) broker-dealers notify customers that they may elect not to allow their fully-paid for securities to be used in connection with short sales; and (b) if a broker-dealer uses a customer’s securities in connection with short sales, the broker or dealer must notify the customer that the broker or dealer may receive compensation in connection with lending the customer’s securities.
The SEC has discretionary authority to prescribe the form, content, time, and manner of delivery of the notice. |
Effective upon enactment. |
4. Additional Enforcement Authority (Sec. 929X) | |
The SEC is required to issue any additional rules that are necessary to ensure that the appropriate enforcement options and remedies are available to prevent manipulative short selling. | No new requirements at this time. |
5. Short Sale Disclosure (Sec. 929X) | |
1934 Act section 13(f) is amended to require the SEC to prescribe rules providing for the public disclosure of the name of the issuer and the title, class, CUSIP number, aggregate amount of the number of short sales of each security, and any additional information determined by the SEC following the end of the reporting period. At a minimum, monthly public disclosure is required. | No new requirements until the SEC prescribes rules. |
III. Investment Banking and Advisory Services | |
A. Potential Codification of Global Research Settlement Controls (Sec. 919A) | |
The CG is required to conduct a study of the conflicts of interest that exist between investment banking and equity and fixed income security analyst functions within the same firm, and to report and make recommendation to Congress within 18 months on its findings. | No new requirements at this time. |
B. Municipal Advisors (Sec. 975) | |
Section 15B(c) of the 1934 Act is amended to provide that a municipal advisor and its associated persons have a fiduciary duty to any municipal entity for whom the municipal advisor acts as a municipal advisor.
The MSRB is required to draft rules requiring municipal advisors to meet specified qualification standards and other requirements. |
Effective October 1, 2010. |
C. Regulation D Offerings (Sec. 926) | |
Within one year of enactment, the SEC is required to issue rules disqualifying persons that are subject to a federal or state bar or formal order for violating a financial-related law, rule or regulation; or who are convicted of financial-related felonies and misdemeanors, from participating in offerings made pursuant to Rule 506 of Regulation D.
Broker-dealers and their associated persons who are subject to the above statutory disqualification and participate in Regulation D offerings will need to request relief from the SEC’s Division of Corporation Finance to continue to participate in offerings conducted pursuant to Rule 506. |
Rulemaking required within 1 year of enactment. |
D. ABS (Sec. 621) | |
For 1 year after the date of the first closing of the sale of an ABS, the underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary thereof, is prohibited from engaging in any transaction that would involve any material conflict of interest with respect to any investor in a transaction arising out of such activity.
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Rulemaking required within 270 days of enactment. |
E. Security-Based Swaps (Sec. 764) | |
Major security-based swap participants and security-based swap dealers that act as advisors to special entities, including federal agencies, state and municipal agencies and subdivisions, pension plans, and endowments will have a duty to act in the best interest of such entity. This will require the security-based swap dealer to make reasonable efforts to obtain information that is necessary to make a reasonable determination that any security-based swap it recommends is in the best interest of the Special Entity. | Rules must be prescribed within 1 year of enactment. |
IV. Associated Persons | |
A. Associated Persons Using "Financial Planner" and Similar Designations (Sec. 919C) | |
The CG is required to conduct a study of state and federal regulations to protect investors from misleading titles and designations and any legal or regulatory gaps in the regulation of financial planners and other individuals who provide financial planning services to consumers. Within 180 days of enactment, the CG must report its findings and recommendations for the appropriate regulation of financial planners and other individuals who provide similar services. | No new requirements at this time. |
B. Improved Investor Access to Information on Broker-Dealers and Their Associated Persons (Sec. 919B) | |
Within 6 months of enactment, the SEC is required to complete a study to improve investor access to registration information (including disciplinary actions, regulatory, judicial, and arbitration proceedings) about current and previously registered broker-dealers and their associated persons on the existing Central Registration Depository and Investment Adviser Registration Depository systems.
Within 18 months of the completion of the study, the SEC is required to implement any recommendations from the study. |
Rulemaking required within 24 months of enactment. |
C. Formerly Associated Persons (Sec. 929F) | |
The SEC’s investigative and enforcement authority extends to former as well as current associated persons of broker-dealers, government securities dealers, and members of the MSRB.
If broker-dealers’ awareness of SEC investigations of former associated persons is heightened as a result of this provision, they may have increased obligations to update Forms U-5. |
Effective upon enactment. |
V. Operational Requirements | |
A. Disclosure | |
1. Conflicts of Interest (Sec. 913) | |
The SEC is directed to facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with broker-dealers, including any material conflicts of interest. | No new requirements absent SEC action. |
2. Point of Sale Disclosure (Sec. 919) | |
The SEC may, but is not required to, issue rules designating documents or information that a broker-dealer must provide to retail investors before the purchase of an investment product or service. | No new requirements, unless the SEC exercises its rulemaking authority. |
3. Public Disclosure of Short Sales (Sec. 929X(a)) | |
See Section II.D.5. | SEC required to issue rules. |
4. Disclosure of Institutional Investment Manager Say-On-Pay and Golden Parachute Votes (Sec. 951) | |
Broker-dealers that are "institutional investment managers" subject to 1934 Act section 13(f) must disclose no less than annually how they voted on any say-on-pay and golden parachute matters.
The disclosure requirement may present client relations concerns for broker-dealers with multiple business lines (e.g., asset management and investment banking). |
Effective 6 months after enactment. |
5. ABS Repurchase Requests (Sec. 943) | |
Securitizers will be required to disclose fulfilled and unfulfilled repurchase requests across all trusts to help identify asset originators with "clear underwriting deficiencies." | Rules are required to be issued within 180 days of enactment. |
6. Security-Based Swaps (Sec. 764) | |
Security-based swap dealers and major security-based swap participants who act as advisors and counterparties to Special Entities will be required to make appropriate disclosures. | Rules must be prescribed within 1 year of enactment. |
B. Agreements and Consents | |
1. Use of Mandatory Pre-Dispute Arbitration Provisions (Sec. 921) | |
Under new 1934 Act section 15(o), the SEC may, but is not required to, impose conditions or limitations on the use of agreements that require customers or clients of broker-dealers and municipal securities dealers to arbitrate any future disputes.
If the SEC exercises its rulemaking authority, broker-dealers will need to inventory their various agreements currently in use, including legacy agreements no longer used, but still in effect with certain customers. One issue that will need to be addressed if a prohibition is adopted is whether agreements with existing customers will need to be amended. |
No new requirements, unless the SEC exercises its rulemaking authority. |
2. Consent to Broker-Dealer’s Sale of Certain Products (Sec. 913(g)) | |
The Bill authorizes the SEC to adopt rules requiring broker-dealers that sell only proprietary products or a limited range of products to provide notice to each retail customer and to obtain such customer’s consent or acknowledgement. | No new requirements, unless the SEC exercises its rulemaking authority. |
C. Reporting Requirements | |
1. Beneficial Ownership and Short-Swing Profit Reporting (Sec. 766(b) and Sec. 929R) | |
1934 Act sections 13(d) and 13(g) are amended to include the purchase or sale of a "security-based swap" as defined by the SEC. In addition, the SEC has discretionary rulemaking authority to issue rules shortening the time period within which the following must be filed with the SEC: (a) a Schedule 13D in connection with acquiring beneficial ownership of more than 5% of a registered class of equity securities; and (b) a Form 3 in connection with becoming a director, officer, or greater than 10% shareholder of a public company.
The definition of "security-based swap" is, of course, part of a larger issue. The shortened timeframe for reporting is not unexpected, but if proposed by the SEC, it will need to be evaluated for ability to achieve compliance, particularly given the addition of security-based swaps to the reporting requirements. |
No new requirements, unless the SEC exercises its rulemaking authority. |
2. Reports by Institutional Investment Managers (Sec. 766(c)) | |
1934 Act section 13(f) is amended to require reporting of security-based swaps as defined by the SEC.
As mentioned above, the definition of "security-based swap" is part of a larger issue, but once defined, institutional investment managers will need to capture and reflect purchases and sales of security-based swaps. If the SEC does not include security-based swaps on its list of 13F securities, completing Schedule 13F will become much more difficult. |
No new requirements, unless the SEC exercises its rulemaking authority. |
3. Trade Reporting (Sec. 763) | |
The SEC is authorized to make security-based swap transaction and pricing data available to the public in such form and at such times as the SEC determines appropriate to enhance price discovery. | No new requirements, unless the SEC exercises its rulemaking authority. |
4. Large Trader Reporting (Sec. 763) | |
The SEC may, but is not required to, require any person that effects transaction for such person’s own account or the account of others in any security-based swap or uncleared security-based swap and any security or loan or group or narrow-based security index of securities or loans to report such information as the SEC may prescribe regarding any position or positions in any security-based swap or uncleared security-based swap and any security or loan, or group or narrow-based security index of securities or loans and any other instrument relating to such security or loan or group or narrow-based security index of securities or loans. | No new requirements, unless the SEC exercises its rulemaking authority. |
5. Position Limits (Sec. 763) | |
The SEC is required to promulgate rules, and may direct any SRO to adopt rules, establishing limits (and related hedging exemptions) on the size of position in any security-based swap that may be held by any person. Such rules may require the aggregation of positions. | Not specified. |
D. Voting Customer Securities (Sec. 957) | |
1934 Act section 6(b) is amended to provide that a broker that is not the beneficial owner of a company’s shares (e.g., shares held in street name on behalf of customers) is prohibited from voting on the election of directors, executive compensation matters (including say-on-pay) or other significant matters as the SEC determines by rule unless the beneficial owner has provided the broker with voting instructions.
Once effective, broker-dealers will need to update policies and procedures to ensure that customers’ shares are not voted on covered issues without appropriate voting instructions. |
Amendments to securities exchange rules required.
SEC rulemaking required to define "significant matters." |
E. Books and Records Requirements (e.g., Sec. 764) | |
As is generally the case with new regulatory requirements, additional record-making and -keeping requirements will follow from the legislation and implementing regulations, including the requirements for security-based swap dealers and major security-based swap participants referenced above.
As the SEC publishes the implementing rules, we will separately track the new books and records requirements. |
Timing will be linked to the effective date of the relevant regulatory requirement. |
Glossary
1933 Act | Securities Act of 1933 |
1934 Act | Securities Exchange Act of 1934 |
ABS | Asset-backed securities |
Banking agencies | The Board of Governors of the Federal Reserve, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency |
Banking Committees | Jointly, the Senate Committee on Banking, Housing and Urban Affairs, and the House Committee on Financial Services |
Bill | The Dodd-Frank Wall Street Reform and Customer Protection Act of 2010 (H.R. 4173) |
CFTC | Commodity Futures Trading Commission |
CG | Comptroller General of the United States |
Council | Financial Services Oversight Council |
FINRA | Financial Industry Regulatory Authority |
Housing agencies | Jointly, the Department of Housing and Urban Development and the Federal Housing Finance Agency |
IAA | Investment Advisers Act of 1940 |
MSRB | Municipal Securities Rulemaking Board |
OCIE | SEC’s Office of Compliance Inspections and Examinations |
ORSFI | SEC’s Office of Risk, Strategy and Financial Innovations |
SEC | Securities and Exchange Commission |
Special Entities | Federal agencies, states, state agencies, cities, counties, municipalities, and other political subdivisions of a state, employee benefit plans and governmental plans under the Employee Retirement Income Security Act of 1974, and any endowment within the meaning of section 501(c)(3) of the Internal Revenue Code of 1974. |
SRO | Self-regulatory organization |
T&M | SEC’s Division of Trading and Markets |