On June 17, President Obama and Treasury Secretary Geithner released the Obama administration's almost 90-page blueprint for financial services reform. The proposal includes many important aspects: the creation of a new Financial Oversight Council to identify emerging systemic risk issues and improve inter-agency coordination, a new National Bank Supervisor to replace the OCC and OTS, and a new Consumer Financial Protection Agency, among others. But let's look at how the proposal affects the Securities and Exchange Commission (SEC) and the industries the SEC traditionally oversees.  

The SEC Keeps Its Basic Mission
As an institution, the SEC survives in the administration's plan largely intact. The plan would allow the Federal Reserve Board to designate certain companies posing the greatest level of systemic risk to the financial system as "Tier 1 Financial Holding Companies."  The Fed would have the primary role in supervising and regulating those Tier 1 FHCs, including setting stricter capital, liquidity and risk management standards for those firms. In theory any firm, not just a bank but even a large hedge fund, could be deemed a Tier 1 FHC, and be subject to these rules. After the decisions last year by the largest broker-dealers to merge with banks or to opt into bank-holding company status, this proposal effectively ratifies what is already the status quo for those firms. The Fed's ability to make emergency loans to Tier 1 firms (albeit only with the consent of Treasury) would be institutionalized, whether or not those firms are banks. The Treasury would be authorized to resolve the affairs of failing Tier 1 firms-an authority it could delegate to the SEC in the case of a firm with primary assets consisting of broker-dealer operations.

The Obama administration proposal does not propose to expand the SEC in the ways some commentators have suggested-the Commodity Futures Trading Commission (CFTC) would remain independent, and the new Office of National Insurance would be placed in the Treasury Department.  But, aside from the Fed's supervisory role for the largest firms, the SEC does not lose authority.  The new Consumer Financial Protection Agency (CFPA) would oversee many retail financial products (including mortgages and credit cards) but not securities.  As discussed below, OTC derivatives, including credit default swaps, will be subject to comprehensive SEC and CFTC regulation, which the two agencies are instructed to "harmonize."

Private Investment Funds

The SEC would receive a significant expansion of its authority over private investment funds and their advisors. The proposal would require all advisors to private funds over an undefined but "modest" threshold to register with the SEC. Moreover, funds themselves would be subject to books and records and disclosure regulation and SEC examination. Private funds would have regulatory reporting requirements concerning assets under management, borrowing, and off-balance-sheet exposures, but these reports would be non-public.  These requirements would extend not only to hedge funds, but also to private equity and venture capital funds. The administration's view is that these private funds, even if they do not individually present systemic risks to the financial system, collectively may present significant risks that at a minimum need to be monitored.

Money Market Mutual Funds
The proposal authorizes the SEC in the first instance to propose new regulations concerning money market mutual funds. The proposal suggests that the SEC require money market funds maintain increased liquidity buffers, reduce maximum weighted average maturity, tighten concentration limits, improve credit risk analysis and allow fund boards to suspend redemptions in extraordinary circumstances. The proposal also directs the President's Working Group on Financial Markets, by Sept. 15, 2009, to prepare a report concerning broader possible changes to money market fund regulation, such as abolishing the stable ($1 per share) net asset value, and/or requiring money market funds to obtain access to emergency liquidity facilities.1

Point-Of-Sale Disclosure
The SEC receives several specific mandates in the administration proposal. First is to review point-of-sale disclosure for financial products, which the proposal distinguishes from the type of post-sale, confirmation disclosure that now exists for mutual funds and most other securities sold pursuant to prospectuses or registration statements. The SEC proposed mutual fund point-of-sale disclosure earlier this decade, but did not move forward with the concept in the face of industry complaints about the overwhelming costs of paper-based point-of-sale disclosure.  Perhaps Web-based disclosure would allow the SEC to achieve this point-of-sale goal.

Investment Advisor/Broker-Dealer Harmonization
The SEC also would receive authority to harmonize the legal standards for broker-dealers and investment advisors, with broker-dealers becoming subject to a fiduciary duty standard when making investment recommendations to customers. The SEC would be permitted (but not required) to ban certain forms of compensation that create conflicts of interest that could cause them to recommend securities that are not in the best interests of their clients.  Notably, the proposal does not mention creating a self-regulatory organization (SRO) for investment advisors, as several previous proposals have suggested.  Nor does the proposal require that all investment advice be provided by registered investment advisors, as some consumer groups have suggested.

State Enforcement And Preemption
The proposal provides, as a general matter, that states and the federal government will have concurrent enforcement authority, and that states may establish higher standards than the relevant federal agency. While this proposal appears designed to repeal the broad preemption positions taken by the OCC and OTS in the banking area, it is unclear whether this would affect the National Securities Markets Improvement Act preemption that forbids state regulation of investment companies, large investment advisors, or "covered securities." The issue of preemption bears careful attention.

Mandatory Arbitration
The SEC would receive authority to ban mandatory arbitration clauses in contracts between broker-dealers or investment advisors and retail clients. Before it could issue such a ban, the SEC would be required to study the use of mandatory arbitration clauses and consider whether changes to the arbitration system are appropriate. The CFPA would receive parallel authority concerning arbitration clauses in agreements for nonsecurities products such as mortgages and credit cards. The prospect of fiduciary liability and an end to arbitration could have a significant effect on the broker-dealer industry.

Issuers And Securitization
The SEC would receive explicit authority to adopt a "say on pay" rule for public-company proxy statements. This provision is one part of a broader set of initiatives designed to limit financial industry compensation and better align that compensation with the risks taken by financial services firms. The proposal also provides for significant changes in the asset securitization markets, such as requiring that originators of securitizations maintain a "material" (but not yet specified) level of "skin in the game"-a major change in a market that has experienced significant defaults. The SEC is directed to expand disclosure requirements for issuers of asset-backed securities and include those securities in the TRACE trade reporting system.

Credit Rating Agencies
The SEC would get some new authority over credit-rating agencies.  Credit-rating agencies would have to differentiate structured credit products from ordinary debt, and disclose more about the risks they are attempting to assess and the methodologies they use.  But the SEC still would not oversee the credit models themselves. The SEC and other regulators are encouraged to limit (but are not required to eliminate) their use of credit ratings in regulations and supervisory activities, which presumably will result in a greater scrutiny of firms' own credit evaluation processes.  

SEC Enforcement
The SEC would receive some new enforcement authority. Currently the SEC may pay "bounties" to whistleblowers only in insider trading cases.  The proposal would allow the SEC to pay bounties to whistleblowers concerning any securities law violations. The SEC would receive "collateral bar" authority, which would allow, for example, someone who violated broker-dealer rules to be barred not only from the broker-dealer industry, but also from being associated with an investment advisor or investment company. Finally, the proposal would harmonize the various tests for "primary liability" under the federal securities, presumably using the liberal First Circuit standard from the SEC v. Tambone decision.

The proposal would make permanent the SEC's new Investor Advisory Committee.  This committee would meet quarterly with a larger Financial Consumer Coordinating Council to identify more general gaps in U.S. consumer protection regulation.

SEC-CFTC Harmonization
Although the Obama administration proposal does not suggest merging the CFTC and SEC, it does direct the CFTC and SEC to work to harmonize their statutory and regulatory schemes. The proposal pushes the CFTC to be more precise and specific than its current "principles-based" approach to regulation. The SEC is directed to speed its review of dually regulated new products and make more SRO filings effective on filing.  The SEC and CFTC are instructed to propose any necessary statutory changes to Congress by Sept. 30, 2009.  

The administration proposal also requires that standardized derivatives be cleared through regulated central counterparties (CCPs) which will be able to impose margin and other risk control requirements.  Although the proposal does not bar customized derivatives, it provides for a presumption that any derivative which a CCP is willing to clear is required to be standardized and centrally cleared.  The proposal also requires that all derivatives, including customized derivatives, be reported to a centralized trade repository, and that the CFTC, SEC and other regulators have access to an institution's trades and positions in derivatives.  The CFTC and SEC are to establish limits on what types of investors may participate in derivatives transactions (for example, small municipalities may not be permitted), as well as establish disclosure and standard of care requirements.

In sum, the plan would make some of the most far-reaching changes in U.S. financial services regulation since the Roosevelt administration.  However, the fundamental role of the SEC in that regulatory scheme would remain largely the same as it has been for the past 75 years. The House Financial Services Committee has stated that it intends to hold hearings on the proposal before its August recess, but the Senate's plans for action on the proposal are not yet clear. There appears to be broad consensus that the current financial regulatory system did not respond adequately to the events of the last two years. Some issues, such as the ability of the Fed to oversee Tier 1 FHCs and the ability of Treasury to resolve the affairs of a failing Tier 1 FHC, appear to require urgent legislative action.  However, the administration's proposal affects a broad range of individuals and entities, and there is already a Republican alternative circulating on Capitol Hill. Moreover, even at almost 90 pages, the proposal does not define many critical issues.  Although the Obama administration takes the view that its package is a unified vision, not a menu of alternatives from which Congress should choose, it is difficult to predict when or with what changes the proposal ultimately will be enacted.

W. Hardy Callcott, a partner in the Bingham McCutchen law firm in San Francisco, concentrates his practice on regulatory counseling concerning securities market and regulatory issues for broker-dealers, investment advisors, mutual funds and others in the financial services industry.

1 The President's Working Group would ultimately be replaced by a new Financial Services Oversight Council, consisting of the heads of the Treasury, Federal Reserve Board, National Bank Supervisor, Consumer Financial Product Agency, SEC, CFTC, FDIC and Federal Housing Finance Authority.