Dodd-Frank: Title IX - Investor Protections and Improvements to the Regulation of Securities

Introduction

 

Increasing Investor Protection

Sections 911, 915 and 919D amend the Securities Exchange Act of 1934 by creating an Investor Advisory Committee (“IAC”), an Office of the Investor Advocate (“OIA”) and an ombudsman appointed by the Investor Advocate. Sections 913, 914 and 917 also require the Securities & Exchange Commission (“SEC”) to conduct studies on the financial literacy levels of retail investors and the current rules and regulations concerning brokers, dealers and investment advisors. Additionally, sections 918 and 919A require the Government Accountability Office to conduct studies on conflicts of interest within investment firms and on the information presented to investors in mutual fund advertisements.

 

Accountability, Executive Compensation and Corporate Governance 

 

Sections 953 and 951 address the issues of executive compensation and corporate governance by imposing additional disclosure requirements on publicly traded companies and requiring that shareholders be given the power to vote on executive compensation.  Section 954 requires public companies to adopt “clawback” policies that recover executive compensation made on the basis of erroneous and noncompliant financial statements. Further, section 956 prohibits regulators and financial institutions from allowing any incentive-based compensation arrangements that might cause the financial institution to suffer a material financial loss. Section 952 also forces securities exchanges to require that the compensation committees of publicly traded companies be independent of the company.

 

Improvements to the Regulation of Credit Rating Agencies

 

Sections 932, 935 and 939 impose more stringent internal control requirements on credit rating agencies and create new rules dictating credit rating procedures and processes. Furthermore, section 932 requires credit rating agencies to file additional disclosures that analyze the accuracy of prior credit ratings.

 

Improvements to the Asset-Backed Securitization Process

 

Section 941 specifies risk retention standards to which securitizers of asset-backed securities must adhere. Section 942 requires issuers of asset-backed securities to make additional disclosures of loan-level data and review the securities’ underlying assets. Further, section 943 requires credit rating agencies to disclose the representations, warranties and enforcement mechanisms for any asset-backed securities being rated.

 

Increasing Regulatory Enforcement and Remedies

 

Section 922 requires the SEC to compensate certain whistleblowers with a percentage of collected monetary sanctions. Additionally, section 929I substantially limits the SEC’s mandatory public disclosure requirements.

Increasing Investor Protection

 

Title IX amends the Securities Exchange Act of 1934 by creating an Investor Advisory Committee (“IAC”), an Office of the Investor Advocate (“OIA”) and an ombudsman appointed by the Investor Advocate. Title IX also requires the Securities & Exchange Commission to conduct studies on the financial literacy levels of retail investors and the current rules and regulations concerning brokers, dealers and investment advisors. The Government Accountability Office is also required to conduct studies on the potential conflicts of interest between the investment bankers and analysts within the same firm and on mutual fund advertisements with a particular focus on the use of past performance data in marketing materials.

 

Provisions:

 

Title IX amends the Securities Exchange Act of 1934 by creating an Investor Advisory Committee (“IAC”), an Office of the Investor Advocate (“OIA”) and an ombudsman appointed by the Investor Advocate.

 

The IAC is a committee within the Securities & Exchange Commission (“SEC”) comprised of ten to twenty members that the SEC appoints to serve four-year terms. See 15 U.S.C. § 78pp(b). The members are knowledgeable about current securities issues and must collectively represent the interests of both individual and institutional investors. See id. The IAC advises the SEC on current issues from an investor’s perspective and provides the SEC with regulatory recommendations to promote investor confidence in the integrity of securities markets. See 15 U.S.C. § 78pp(a). After reviewing each recommendation, the SEC must promptly issue a public statement evaluating the recommendation and disclosing any related action the SEC plans to take. See 15 U.S.C. § 78pp(g).

 

The OIA is an office within the SEC that is headed by the Investor Advocate. See 15 U.S.C. § 78d(g). The Investor Advocate is an individual with extensive experience advocating for investor interests and is appointed by the SEC Chairman. See 15 U.S.C. § 78d(g)(2)(A)(ii). Primarily, the Investor Advocate aims to resolve investor problems with the SEC or a self-regulatory organization (“SRO”), identify and propose changes in SEC regulations and SRO rules that would benefit investors, identify investor problems with financial services and products, and analyze the potential impact on investors of proposed SEC regulations or SRO rules. The Investor Advocate also appoints an Ombudsman to act as a liaison between the SEC and investors that have a problem with the SEC or an SRO. See 15 U.S.C. § 78d(g)(4).

 

Title IX requires the SEC to conduct studies on the current rules and regulations concerning brokers, dealers and investment advisors. The SEC is required to conduct a study on the existing standards of care applicable to brokers, dealers and investment advisers that provide investment recommendations to retail investors. See Dodd Frank Wall Street Reform and Consumer Protection Act § 913(b)(1). If the study determines that the existing standards of care are inadequate or confusing for retail investors, Title IX authorizes the SEC to apply the standard of care currently imposed on investment advisers to brokers and dealers as well. See 15 U.S.C. § 78o(k). Title IX also requires the SEC to conduct a study to determine whether to improve examination and enforcement resources for investment advisers. See Dodd-Frank Act at § 914(a)(1). The SEC must use the study as a basis for revising or promulgating applicable SEC rules and regulations. See id. at § 914(b).

 

Title IX also requires the Government Accountability Office (“GAO”) to conduct studies and issue reports to Congress on its findings. The GAO must conduct a study on mutual fund advertisements with a particular focus on the use of past performance data in marketing materials. See Dodd-Frank Act § 918(a)(2). Upon completion of the study, the GAO must provide Congress with recommendations on how to improve investor protections to ensure that investors make informed decisions when purchasing mutual fund shares. See id. at § 918(a)(4). The GAO is also required to study potential conflicts of interest between the investment bankers and analysts within the same firm and to recommend ways to protect investors from harm resulting from such conflicts to Congress. See id. at § 919A(a).

 

The SEC is also required to conduct a study to determine the financial literacy levels of retail investors and to devise a strategy on the basis of that study to educate investors and bring about a positive change in investor behavior by increasing financial literacy. See Dodd-Frank Act § 917(a).

 

Purpose & Implementation:

 

The IAC and OIA investor advocacy groups are designed to incorporate a retail investor focus into SEC decision-making and eliminate the public perception that SEC regulations are unduly influenced by large companies and institutional investors. See Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates, The Dodd-Frank Act: Commentary and Insights 85 (2010).

 

Additionally, Title IX encourages financial literacy among retail investors and promotes informed investment decision-making. Upon completion of its study on mutual fund advertisements, the GAO determined that, to further protect investors, the SEC should require the Financial Industry Regulatory Authority, which is a private self-regulatory organization under the jurisdiction of the SEC that is responsible for regulating its members and exchange markets, to notify all mutual fund companies of new rule interpretations as they arise during the course of FINRA's regulatory reviews of advertisements. See U.S. Gov’t Accountability Office, GAO-11-697, Mutual Fund Advertising: Improving How Regulators Communicate New Rule Interpretations to Industry Would Further Protect Investors (2011).

 

Improvements to the Regulation of Credit Rating Agencies

Title IX imposes much more stringent internal control requirements on credit rating agencies and creates new rules dictating credit rating procedures and processes. Credit rating agencies will also be required to file additional disclosures analyzing the accuracy of prior credit ratings.

 

Provisions:

 

Credit Rating Processes

 

Title IX requires new credit rating procedures. Credit rating agencies must disclose a description of the data used, as well as their rating methodology, on a standardized form. See 15 U.S.C. § 78o-7(s). Credit rating agencies will also be required to file additional disclosures analyzing the accuracy of their prior credit ratings. See id. Title IX also requires credit rating agencies to consider credible information provided from sources other than the securities issuer. See 15 U.S.C. § 78o-7(v).

 

Corporate Governance

 

Title IX requires credit rating agencies to file compliance reports with the SEC, implement policies to prevent marketing materials from influencing credit ratings, and establish internal controls to identify conflicts of interest and ensure adherence to credit rating procedures. See 15 U.S.C. § 78o-7. Title IX also recommends that the SEC should attempt to prevent additional conflicts of interest by promulgating rules forbidding credit rating agencies from providing additional services. See 15 U.S.C. § 78o-7(h)(2)(B).

 

Purpose & Implementation:

 

Congress believes that credit rating agencies’ performances are matters of public interest because of the immense reliance placed on credit ratings by both individual and institutional investors. See Dodd-Frank Act § 931. Credit rating agencies are essential to capital formation and investor confidence in the integrity of securities markets.  See id. at § 931(1). In the past, credit rating inaccuracies have contributed significantly to the mismanagement of investment risk and adversely impacted economic health. See id. at § 931(5).  Thus, Congress believes that credit rating agencies should be subject to the same standards that apply to auditors, securities analysts, and investment bankers. See id. at § 931(3).

Improvements to the Asset-Backed Securitization Process

 

Title IX makes several improvements to the asset-backed securitization process. Title IX specifies the risk retention standard for securitizers of asset-backed securities. Issuers of asset-backed securities must also make additional disclosures of loan-level data and review the securities’ underlying assets. Further, credit rating agencies must disclose the representations, warranties and enforcement mechanisms for any asset-backed securities being rated.

 

Provisions:

 

Risk Retention

 

A securitizer must keep at least 5% of the credit risk for an asset-backed security unless the security is collateralized entirely by qualified residential mortgages. See 15 U.S.C. 78o-11(c). The SEC and the federal banking agencies are required to promulgate rules detailing the standards of risk retention for asset-backed securities, including allowable forms and minimum periods of duration. See 15 U.S.C. 78o-11(b). The act also prohibits securitizers from hedging the credit risk they are required to retain, but allows the federal banking agencies and the SEC to promulgate exceptions. See 15 U.S.C. 78o-11(c),(e)(1). Any promulgated exemptions must promote the public interest by ensuring high underwriting standards, promoting sound risk management practices, and improving credit access. See 15 U.S.C. 78o-11(e)(2).

 

Enhanced Disclosures

 

Title IX requires asset-backed securities issuers to disclose loan-level data that investors need in order to exercise due diligence. See 15 U.S.C. § 77g(c). The loan data must include the identities and related compensation of both the asset brokers and originators, and the risk retained by the securitizer and originator. See id. Additionally, the Title directs the SEC to issue rules requiring issuers of asset-backed securities to review the underlying assets themselves, and to disclose the nature of the review. See Dodd-Frank Act at § 943. Credit rating agencies must also disclose the representations, warranties and enforcement mechanisms for the asset-backed security being rated. See id.   

 

Purpose & Implementation:

 

Congress has addressed the issues concerning asset-backed securities’ that contributed most significantly to the 2008 financial crisis. Congress hopes to mitigate the problems that arise when securitizers retain an insufficient amount of risk, and when investors and issuers are unable to assess the specific assets underlying asset-backed securities. Securitizers of asset-back securities must now expend money and time gathering and disclosing extensive loan-level information.

 

Additional Sources:

 

Bryan Cave International Consulting LLC, Improvements to the Asset-Backed Securitization Process Under the Dodd-Frank Wall Street Reform Bill (2010).

 

Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates, The Dodd-Frank Act: Commentary and Insights 67-70 (2010).

Accountability, Executive Compensation and Corporate Governance

 

Title IX addresses the issues of executive compensation and corporate governance by imposing additional disclosure requirements on publicly traded companies, and requiring that shareholders be given the opportunity to vote on the amount and form of executive compensation.  Additionally, Title IX requires public companies to adopt “clawback” policies that recover executive compensation made on the basis of erroneous financial statements. Further, Federal regulators and financial institutions are prohibited from allowing any incentive-based compensation arrangements that might cause the financial institution to suffer a material financial loss. Title IX also forces national securities exchanges to require that the compensation committees of publicly traded companies be independent of the company.

 

Provision:

 

Disclosure Requirements

 

Title IX directs the Securities and Exchange Commission (‘SEC”) to issue rules requiring public companies to make additional disclosures of executive compensation. See 15 U.S.C. § 78n(i). Specifically, public companies must disclose the relationship between the total compensation paid and the company’s financial performance in any consent solicitation materials presented to shareholders at annual meetings or in connection with proxy voting. See id. The calculations of financial performance must account for changes in stock value and any dividends or distributions issued. See id. Title IX also suggests that the SEC should require this information to be presented in graph format. See id.

 

Title IX also directs the SEC to require public companies to make additional disclosures of the relationship between the Chief Executive Officer’s (“CEO”) compensation and the compensation of the company’s other employees. See 17 C.F.R. § 229.402. Under the SEC’s new rule, public companies will be forced to disclose the (1) CEO’s compensation, (2) the median compensation of the company’s other employees, and (3) the ratio of the median compensation of the company’s other employees to the CEO’s compensation. See id.

 

Title IX also requires public companies to add disclosures to any consent solicitation materials presented to shareholders at annual meetings or proxies when any employees or board members are allowed to purchase financial instruments designed to hedge against any decrease in the company’s stock value. See 15 U.S.C. § 78n(j).

 

Clawbacks

 

Public companies must adopt “clawback” policies that recover executive compensation made on the basis of erroneous and noncompliant financial statements. See 15 U.S.C. § 78j-4(b)(2). If the company is directed to restate its reported figures, the executive must repay excess compensation received. See id. Title IX directs the SEC to require securities exchanges to delist the stock of any companies that fail to adopt “clawback” policies. See 15 U.S.C. § 78j-4(a).

 

Prohibited Compensation Practices

 

Title IX also requires Federal regulators and certain financial institutions to prohibit any incentive-based compensation arrangements that might provide executives, shareholders, board members or employees with excessive compensation or benefits or that could cause the financial institution to suffer a material financial loss. See 12 U.S.C. § 5641(a).

 

Increased Independence

 

Title IX forces national securities exchanges to require that the compensation committees of publicly traded companies be independent of the company. See 15 U.S.C. § 78j-3(a)(2). In assessing independence, exchanges should consider the committee members’ source of compensation and whether the members are affiliated with the company or any of its subsidiaries. See 15 U.S.C. § 78j-3(a)(3). Compensation committee advisers, such as lawyers or consultants, must also be independent. See 15 U.S.C. § 78j-3(b)(2).

 

Shareholder Approval of Executive Compensation

 

Shareholders must be given the power to vote on the amount and form of executive compensation. See 15 U.S.C. § 78n(a).  At the first shareholder meeting following the Title’s enactment, the shareholders must also be given the power to vote on the frequency of future votes to approve executive compensation, with the requirement that the votes are held at least once every three years. See id. At least once every six years there must be another vote to re-determine how often the vote on approval of compensation should be held. See id. Shareholders may also vote to ban any Golden Parachute compensation. See Dodd-Frank Act at § 951(b)(1). The shareholder votes are all non-binding. See id. at § 951(c).

 

Purpose & Implementation:

 

Congress is attempting to encourage companies to carefully scrutinize the amount of compensation paid to executives, especially in situations where increased compensation is matched with a deteriorating firm value. Congress also hopes to bring attention to the increasing disparity between executive compensation and the salaries paid to the rest of a company’s employees.

 

Additional Sources:

 

Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates, The Dodd-Frank Act: Commentary and Insights 89 (2010).

 

Increasing Regulatory Enforcement and Remedies

 

Title IX substantially limits the SEC’s required disclosures and requires the SEC to compensate certain whistleblowers with a percentage of collected monetary sanctions.

 

Provisions:

 

Whistleblower Awards

 

The SEC is required to promulgate rules that award payment to whistleblowers whose voluntary disclosures provided the SEC with information leading to a successful enforcement. See 15 U.S.C. § 78u-6(b)(1). The whistleblower is entitled to receive between ten and thirty percent of collected monetary sanctions over $1 million. See id.

 

SEC’s Disclosure Requirements

 

Unless subject to a judicial or congressional inquiry, the SEC is exempt from disclosing information obtained in furtherance of Title IX, including surveillance, risk assessments, or other regulatory and oversight activities. See Dodd-Frank Act § 929I(d). 

 

Purpose & Implementation:

 

Congress wanted to incentivize individuals to expose violations early and reward those who provide significant evidence that helps the SEC bring successful cases. The SEC is a government agency with limited resources and thus is dependent on people with first-hand knowledge of securities violations. The SEC promulgated a final rule officially creating the SEC’s whistleblower program on May 25, 2011.

 

Because of the new limitation on disclosure requirements, the SEC can refuse to supply any documents to the public it deems as being part of its regulatory and oversight activities. The Committee on Oversight and Government Reform has issued a critique of Title IX, claiming it allows the SEC the “operate in secrecy,” without any accountability to the United States public.


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