Federal Financial Reform: Insurance-Related Provisions

Above:  President Obama signs H.R. 4173, which is considered to be the most sweeping financial reform bill since the Great Depression.

 

 

Signed by President Obama on July 21, 2010, H.R. 4173, known as the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” is considered to be historic legislation that will make the most sweeping changes to financial services regulation since the Great Depression.

Generally, the bill seeks to prevent taxpayer-funded bailouts that followed the nation’s financial crisis of 2008-2009.  Among other changes to the United States financial system, H.R. 4173 will revamp regulation of mortgages, credit cards, broad financial system risks and the $600 trillion derivatives market.

For the insurance industry, the focus of the 2,000-page bill is Title V, which creates a Federal Insurance Office (“FIO”) within the U.S. Treasury.  Under Title V, the Secretary of the Treasury is given rulemaking authority to implement and delegate the new duties of the FIO.   H.R. 4173 also establishes that surplus and reinsurance insurers will be subject to the regulation of their “domicile” instead of having to comply with multiple state requirements.

Following is a narrative outline of Title V components, followed by a brief summary of several miscellaneous insurance-related provisions within the bill, and then a general summary of H.R. 4173:

 

About the FIO

With a Director appointed by the Secretary of the Treasury (“Secretary”), the FIO will monitor all aspects of the insurance industry, including identifying issues or gaps in the regulation of insurers that could contribute to a systemic crisis in the insurance industry or the U.S. financial system.

Including those duties as assigned by the Secretary, other functions of the FIO include:

• Monitoring the extent to which traditionally underserved communities and consumers, minorities and low- and moderate-income persons have affordable access to all lines of insurance products (oversight excludes health insurance);
• Making recommendations to the Financial Stability Oversight Council (“FSOC,” as outlined in H.R. 4173) that it designate an insurer, including the affiliates of such insurer, as an entity subject to regulation as a nonbank financial company supervised by the Federal Reserve’s Board of Governors (pursuant to Title I of H.R. 4173);
• Assisting the Secretary in administering the Terrorism Insurance Program established in the Department of the U.S. Treasury (“Treasury”) under the Terrorism Risk Insurance Act of 2002;
• Coordinating federal efforts and developing federal policy on prudential aspects of international insurance matters, including representing the United States, as appropriate, in the International Association of Insurance Supervisors (or a successor entity) and assisting the Secretary in negotiating certain covered agreements (as defined in H.R. 4173);
• Determining whether State insurance measures are preempted by certain covered agreements; and
• Consulting with states (including state insurance regulators), the Secretary and the FSOC on insurance-related matters of national importance and prudential insurance matters of international importance.

 

Scope of FIO Authority

Except under certain circumstances, the FIO’s authority would extend to all lines of insurance except health insurance; long-term care insurance (except long-term care insurance that is included with life or annuity insurance components); and crop insurance.

To perform its required functions, the FIO may receive and collect data and information on, and from the insurance industry.  It also may enter into information-sharing agreements, analyze and disseminate data and information and issue reports regarding all lines of insurance (except health insurance). 

In the collection of information from insurers and affiliates, except as provided, the FIO may require an insurer, or any affiliate of an insurer, to submit certain data or information.  As provided by H.R. 4173 in reference to data collection, the term “insurer” is defined as any entity that writes insurance or reinsures risks and issues contracts or policies in one or more states.  However, the bill makes an exception for small insurers and affiliates that meet a minimum size threshold that the FIO may establish, whether by order or rule.

H.R. 4173 specifically outlines applicable confidentiality provisions and the FIO Director’s subpoena powers relating to insurer data submission.

Ensuring states’ continued ability to self-regulate their insurance markets was among the major points of debate in relation to H.R. 4173.  As passed by the U.S. House of Representatives and Senate on July 15, the bill outlines how a state insurance measure could be preempted if the FIO Director determines that the regulation results in less favorable treatment of an insurer domiciled in a foreign jurisdiction that is subject to a covered agreement than a United States insurer domiciled, licensed, or otherwise admitted in that state; and is inconsistent with a covered agreement.

While guidelines on how such determinations are made, how potential inconsistencies in the decision-making process are to be avoided and how the review process is conducted are provided by H.R. 4173, the bill nevertheless emphasizes that the FIO Director must consult with consult with state insurance regulators–either individually or collectively–in carrying out the FIO’s functions (to the extent the Director determines appropriate). 

To further solidify states’ autonomy, bill emphasizes that “Nothing . . . shall preempt any State insurance measure that governs any insurer’s rates, premiums, underwriting, or sales practices; any State coverage requirements for insurance; the application of the antitrust laws of any State to the business of insurance; or any State insurance measure governing the capital or solvency of an insurer, except to the extent that such State insurance measure results in less favorable treatment of a non-United States insurer than a United States insurer . . . ” and that ” . . . nothing in (the corresponding section) shall be construed to establish or provide (the FIO) or the Department of the Treasury with general supervisory or regulatory authority over the business of insurance.”

However, beginning September 30, 2011, the FIO must report on, or before September 30 of each calendar year to the President, as well as to the U.S. House of Representatives’ Committees on Financial Services and Ways and Means and the U.S. Senate Committees on Banking, Housing, and Urban Affairs and Finance on any actions it has taken on the preemption of inconsistent state insurance measures.   The bill also paves the way for the FIO and legislative committees to request the FIO to report on “any information deemed relevant” in relation to the insurance industry.

Other insurance-related reports required by the bill include:

• By September 30, 2012, a report describing the breadth and scope of the global reinsurance market and the critical role this market plays in supporting the U.S. insurance industry;
• By January 1, 2013, and updated not later than January 1, 2015, a report describing the impact of Part II of the Nonadmitted and Reinsurance Reform Act of 2010 on the ability of state regulators to access reinsurance information for regulated companies in their jurisdictions;
• Not later than 18 months after the date of H.R. 4173’s enactment, the FIO must conduct a study and report to Congress on how to modernize and improve the United States’ system of insurance regulation. The study and report, which will include legislative, regulatory and administrative recommendations, must be based on, and guided by the following considerations:
  • Systemic risk regulation with respect to insurance;
  • Capital standards and the relationship between capital allocation and liabilities, including standards relating to liquidity and duration risk;
  • Consumer protection for insurance products and practices, including gaps in state regulation;
  • The degree of national uniformity of state insurance regulation;
  • The regulation of insurance companies and affiliates on a consolidated basis;
  • International coordination of insurance regulation;
  • The costs and benefits of potential federal regulation of insurance across various lines of insurance (except health insurance);
  • The feasibility of regulating only certain lines of insurance at the federal level, while leaving other lines of insurance to be regulated at the state level;
  • The ability of any potential federal regulation or federal regulators to eliminate or minimize regulatory arbitrage;
  • The impact that developments in the regulation of insurance in foreign jurisdictions might have on the potential federal regulation of insurance
  • The ability of any potential federal regulation or federal regulator to provide robust consumer protection for policyholders;
  • The potential consequences of subjecting insurance companies to a federal resolution authority, including the effects of any federal resolution authority;
  • In regard to the operation of state insurance guaranty fund systems, the potential consequences of the loss of guaranty fund coverage if an insurance company is subject to a federal resolution authority;
  • In regard to policyholder protection, the potential consequences of the loss of the priority status of policyholder claims over other unsecured general creditor claims;
  • In the case of life insurance companies, the potential consequences of the loss of the special status of separate account assets and separate account liabilities; and
  • The international competitiveness of insurance companies.

To create the report, H.R. 4173 authorizes the FIO Director to consult with state insurance regulators, consumer organizations, representatives of the insurance industry and policyholders and other organizations and experts, as appropriate.

 

Definition of “Covered Agreements”

Section 314 of H.R. 4173 authorizes the Secretary and the United States Trade Representative to jointly negotiate and enter into “covered agreements” on behalf of the United States.

H.R. 4173 partially defines a “covered agreement” as ” . . . a written bilateral or multilateral agreement regarding prudential measures with respect to the business of insurance or reinsurance that is entered into between the United States and one or more foreign governments, authorities, or regulatory entities; and relates to the recognition of prudential measures with respect to the business of insurance or reinsurance that achieves a level of protection for insurance or reinsurance consumers that is substantially equivalent to the level of protection achieved under State insurance or reinsurance regulation.”

 

Subtitle B:  The “Nonadmitted and Reinsurance Reform Act of 2010”

Cited as the “Nonadmitted and Reinsurance Reform Act of 2010,” Subtitle B of H.R. 4173 relates to state-based insurance reform.  Except as otherwise provided, it becomes effective 12 months after the enactment of H.R. 4173.

 

PART I:  NONADMITTED INSURANCE

Under the provisions of Subtitle B, Part 1, which relates to nonadmitted insurance, no state other than the home state of an insured may require any premium tax payment for nonadmitted insurance.  However, states may enter into a compact or otherwise establish procedures to allocate the premium taxes paid to an insured’s home state among themselves.  H.R. 4173 provides the parameters for the regulation of such a compact.

Except as otherwise provided, the placement of nonadmitted insurance shall be subject to the statutory and regulatory requirements solely of the insured’s home state.

In regard to broker licensing, no state other than an insured’s home state may require a surplus lines broker to be licensed in order to sell, solicit or negotiate nonadmitted insurance with respect to such insured.  However, H.R. 4173 specifies that, with the exception of workers’ compensation, any law, regulation, provision or action of any state that applies or purports to apply to nonadmitted insurance sold to, solicited by, or negotiated with an insured whose home state is another state shall be preempted with respect to such application.

 

National Producer Database

After the expiration of the two-year period beginning on the date of the enactment of Subtitle B, a state may not collect any fees relating to licensing of an individual or entity as a surplus lines broker in the state, unless the state has laws or regulations in effect at the time that provide for participation by the state in the National Association of Insurance Commissioners’ (“NAIC”) insurance producer database, or any other equivalent uniform national database for the licensure of surplus lines brokers and the renewal of such licenses.

 

Surplus Lines Eligibility

In regard to surplus lines eligibility, a state may not impose eligibility requirements on, or otherwise establish eligibility criteria for, nonadmitted insurers domiciled in a U.S. jurisdiction, except in conformance with such requirements and criteria in sections 5A(2) and 5C(2)(a) of the NAIC’s Non-Admitted Insurance Model Act, unless the state has adopted nationwide uniform requirements, forms and procedures developed in accordance with Subtitle B’s provisions for alternative nationwide uniform eligibility requirements.

States also may not prohibit a surplus lines broker from placing nonadmitted insurance with, or procuring nonadmitted insurance from, a nonadmitted insurer domiciled outside the United States that is listed on the Quarterly Listing of Alien Insurers maintained by the International Insurers Department of the NAIC.

Surplus lines brokers seeking to procure or place nonadmitted insurance in a particular state for an exempt commercial purchaser would not be required to satisfy any state requirement to make a due diligence search to determine whether the full amount or type of insurance sought by such exempt commercial purchaser can be obtained from admitted insurers if the following conditions apply:

• The broker procuring or placing the surplus lines insurance has disclosed to the exempt commercial purchaser that such insurance may or may not be available from the admitted market that may provide greater protection with more regulatory oversight; and
• The exempt commercial purchaser has subsequently requested in writing the broker to procure or place such insurance from a nonadmitted insurer.

To monitor these provisions, H.R. 4173 provides that the Comptroller General (General Accounting Office) of the United States must conduct a study of the nonadmitted insurance market to determine the effect of the aforementioned enactment on the size and market share of the nonadmitted insurance market for providing coverage typically provided by the admitted insurance market.  The bill calls for the study to determine and analyze the following:

• The change in the size and market share of the nonadmitted insurance market and in the number of insurance companies and insurance holding companies providing such business in the 18-month period that begins upon the effective date of Subtitle B;
• The extent to which insurance coverage typically provided by the admitted insurance market has shifted to the nonadmitted insurance market;
• The consequences of any change in the size and market share of the nonadmitted insurance market, including differences in the price and availability of coverage available in both the admitted and nonadmitted insurance markets;
• The extent to which insurance companies and insurance holding companies that provide both admitted and nonadmitted insurance have experienced shifts in the volume of business between admitted and nonadmitted insurance; and
• The extent to which there has been a change in the number of individuals who have nonadmitted insurance policies, the type of coverage provided under such policies and whether such coverage is available in the admitted insurance market.

In conducting this study, H.R. 4173 authorizes the Comptroller General to consult only with the NAIC.  The study is due 30 months after Subtitle B’s effective date.

Definitions set forth by H.R. 4173 in regard to nonadmitted insurers and surplus lines eligibility include:

CONTROL:  An entity has “control” over another entity if:

• The entity directly or indirectly or acting through one or more other persons owns, controls or has the power to vote on 25 percent or more of any class of voting securities of the other entity; or
• The entity controls in any manner the election of a majority of the directors or trustees of the other entity.

EXEMPT COMMERCIAL PURCHASER:  The term “exempt commercial purchaser” means any person purchasing commercial insurance that, at the time of placement, meets the following requirements:

• The person employs or retains a qualified risk manager to negotiate insurance coverage;
• The person has paid aggregate nationwide commercial property and casualty insurance premiums in excess of $100,000 in the immediately preceding 12 months;
• The person meets at least one of the following criteria:

(I) The person possesses a net worth in excess of $20 million, as such amount is adjusted pursuant to clause (ii);

(II) The person generates annual revenues in excess of $50 million, as such amount is adjusted pursuant to clause (ii);

(III) The person employs more than 500 full-time or full-time equivalent employees per individual insured or is a member of an affiliated group employing more than 1,000 employees in the aggregate;

(IV) The person is a not-for-profit organization or public entity generating annual budgeted expenditures of at least $30 million, as such amount is adjusted pursuant to clause (ii);

(V) The person is a municipality with a population in excess of 50,000 persons;

(ii) Effective on the fifth January 1 occurring after the date of the enactment of Subtitle B, and each fifth January 1 occurring thereafter, the amounts in subclauses (I), (II), and (IV) of clause (i) shall be adjusted to reflect the percentage change for such five-year period in the Consumer Price Index for All Urban Consumers as published by the Bureau of Labor Statistics of the Department of Labor.

HOME STATE:  Except as provided, the term “home state” means, with respect to an insured:

• The state in which an insured maintains its principal place of business or, in the case of an individual, the individual’s principal residence; or
• If 100 percent of the insured risk is located out of the state referred to in clause (i), the state to which the greatest percentage of the insured’s taxable premium for that insurance contract is allocated.

AFFILIATED GROUPS:  If more than one insured from an affiliated group are named insureds on a single nonadmitted insurance contract, the term “home State” means the home state (as determined pursuant to this portion of the bill), of the member of the affiliated group that has the largest percentage of premium attributed to it under such insurance contract.

INDEPENDENTLY PROCURED INSURANCE:  The term “independently procured insurance” means insurance procured directly by an insured from a nonadmitted insurer.

NONADMITTED INSURANCE:  The term “nonadmitted insurance” means any property and casualty insurance permitted to be placed directly or through a surplus lines broker with a nonadmitted insurer eligible to accept such insurance.

NONADMITTED INSURER:  The term “nonadmitted insurer” means, with respect to a state, an insurer not licensed to engage in the business of insurance in such state; but does not include a risk retention group, inasmuch as that term is defined in section 2(a)(4) of the Liability Risk Retention Act of 1986 (15 U.S.C. 3901(a)(4)).

QUALIFIED RISK MANAGER:  The term “qualified risk manager” means, with respect to a policyholder of commercial insurance, a person who meets all of the following requirements:

(A) The person is an employee of, or third-party consultant retained by the commercial policyholder;

(B) The person provides skilled services in loss prevention, loss reduction or risk and insurance coverage analysis, and purchase of insurance;

(C) The person:

(i)(I) has a bachelor’s degree or higher from an accredited college or university in risk management, business administration, finance, economics or any other field determined by a state insurance commissioner or other state regulatory official or entity to demonstrate minimum competence in risk management; and

(II)(aa) has three years of experience in risk financing, claims administration, loss prevention, risk and insurance analysis or purchasing commercial lines of insurance; or

(bb) has–

(AA) a designation as a Chartered Property and Casualty Underwriter (in this subparagraph referred to as ‘CPCU’) issued by the American Institute for CPCU/Insurance Institute of America;

(BB) a designation as an Associate in Risk Management (ARM) issued by the American Institute for CPCU/Insurance Institute of America;

(CC) a designation as Certified Risk Manager (CRM) issued by the National Alliance for Insurance Education & Research;

(DD) a designation as a RIMS Fellow issued by the Global Risk Management Institute; or

(EE) any other designation, certification, or license determined by a State insurance commissioner or other state insurance regulatory official or entity to demonstrate minimum competency in risk management;

(ii)(I) has at least seven years of experience in risk financing, claims administration, loss prevention, risk and insurance coverage analysis or purchasing commercial lines of insurance; and

(II) has any one of the designations specified in sub-items (AA) through (EE) of clause (i)(II)(bb);

(iii) has at least 10 years of experience in risk financing, claims administration, loss prevention, risk and insurance coverage analysis or purchasing commercial lines of insurance; or

(iv) has a graduate degree from an accredited college or university in risk management, business administration, finance, economics or any other field determined by a state insurance commissioner or other state regulatory official or entity to demonstrate minimum competence in risk management.

STATE:  The term “State” includes any state of the United States, the District of Columbia, the Commonwealth of Puerto Rico, Guam, the Northern Mariana Islands, the Virgin Islands and American Samoa.

 

PART II:  REINSURANCE

The first section of Subtitle B, Part II relates to the regulation of credit for reinsurance and reinsurance agreements.

If the state of domicile of a ceding insurer is an NAIC-accredited state, or has financial solvency requirements substantially similar to the requirements necessary for NAIC accreditation, and recognizes credit for reinsurance for the insurer’s ceded risk, then no other state may deny such credit for reinsurance.  In addition to this provision, all laws, regulations, provisions or other actions of a state that is not the domiciliary state of the ceding insurer, except those with respect to taxes and assessments on insurance companies or insurance income, are preempted to the extent that they:

• Restrict or eliminate the rights of the ceding insurer or the assuming insurer to resolve disputes pursuant to contractual arbitration to the extent such contractual provision is not inconsistent with the provisions of Title 9, United States Code;
• Require that a certain state’s law shall govern the reinsurance contract, disputes arising from the reinsurance contract, or requirements of the reinsurance contract;
• Attempt to enforce a reinsurance contract on terms different than those set forth in the reinsurance contract, to the extent that the terms are not inconsistent with this part; or
• Otherwise apply the laws of the state to reinsurance agreements of ceding insurers not domiciled in that state.

Reinsurer Solvency

If the state of domicile of a reinsurer is an NAIC-accredited state or has financial solvency requirements substantially similar to the requirements necessary for NAIC accreditation, then such state shall be solely responsible for regulating the financial solvency of the reinsurer.

If the state of domicile of a reinsurer is an NAIC-accredited state or has financial solvency requirements substantially similar to the requirements necessary for NAIC accreditation, no other state may require the reinsurer to provide any additional financial information other than the information the reinsurer is required to file with its domiciliary state.

States that are not the state of domicile of a reinsurer are permitted to receive a copy of any financial statement filed with its domiciliary state.

Applicable definitions corresponding to Subtitle B, Part II include:

REINSURER:  The term “reinsurer” means an insurer to the extent that the insurer:

• Is principally engaged in the business of reinsurance;
• Does not conduct significant amounts of direct insurance as a percentage of its net premiums; and
• Is not engaged in an ongoing basis in the business of soliciting direct insurance.

DETERMINATION:  A determination of whether an insurer is a reinsurer shall be made under the laws of the state of domicile in accordance with this paragraph.

Other insurance-related provisions proliferate throughout H.R. 4173.  These include the following:

In regard to the authorization of the authority for orderly liquidation of companies, H.R. 4173 defines an insurance company as any entity that is engaged in the business of insurance; subject to regulation by a state insurance regulator; and covered by a state law that is designed to specifically deal with the rehabilitation, liquidation, or insolvency of an insurance company.

In making a determination of systemic risk involving an insurance company, or in cases which the largest U.S. subsidiary (as measured by total assets as of the end of the previous calendar quarter) of a financial company is an insurance company, the FIO Director, in conjunction with other federal financial authorities, is empowered with the capacity of making certain recommendations.

H.R. 4173 also ordains the treatment of insurance companies and insurance company subsidiaries in reference to rehabilitation and liquidation. If an insurance company is a covered financial company or a subsidiary or affiliate of a covered financial company, the liquidation or rehabilitation of such insurance company and any subsidiary or affiliate of such company that is not otherwise excepted shall be conducted as provided under applicable state law.  An exception is made for any subsidiary or affiliate of an insurance company that is not itself an insurance company.

 

H.R. 4173 HIGHLIGHTS

 

Deposit Insurance Reforms

A permanent increase in deposit insurance to $250,000 will be effected for banks, thrifts and credit unions, retroactive to January 1, 2008.

 

Consumer Financial Protection Bureau

H.R. 4173 creates the Consumer Financial Protection Bureau (“CFPB”), which will be led by an independent director appointed by the President and confirmed by the Senate.  The agency will have a dedicated budget funded by the Federal Reserve system.

Under the provisions of H.R. 4173, the CFPB is authorized to write rules autonomously for consumer protections governing all financial institutions – banks and non-banks – offering consumer financial services or products.

It also is authorized to examine and enforce regulations for banks and credit unions with assets of over $10 billion and all mortgage-related businesses (lenders, servicers, mortgage brokers and even “foreclosure scam operators”), payday lenders and student lenders, as well as other non-bank financial companies that are large, such as debt collectors and consumer reporting agencies.  Banks and credit unions with assets of $10 billion or less will be examined for consumer complaints by the appropriate regulator.

Consumer protection-related responsibilities currently handled by the Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corporation, Federal Reserve, National Credit Union Administration, the Department of Housing and Urban Development and Federal Trade Commission would be consolidated into the CFPB under the provisions of H.R. 4173.   The CFPB also will oversee the enforcement of federal laws intended to ensure fair, equitable and nondiscriminatory access to credit for individuals and communities.

 

Office of Financial Literacy

H.R. 4173 creates the Office of Financial Literacy (“OFL”) within the CFPB that will oversee a national consumer complaint hotline that features a toll-free number to report problems with financial products and services. 

The OFL will be part of the regulatory examination process for banks, with the goal of preventing undue regulatory burden and consults with regulators before a proposal is issued. 

Of note, the bill provides protections for small business from unintentional CFPB regulation, but excludes businesses that meet certain standards.

 

Financial Stability Oversight Council

H.R. 4173 establishes Financial Stability Oversight Council (“FSOC”), which is composed of 10 federal financial regulators, an independent member and five non-voting members, which includes the FIO Director and possibly an insurance industry appointee.

The FSOC is charged with identifying and responding to emerging risks throughout the financial system.   It is also authorized to make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.  Significant requirements could resultantly be placed on companies that pose risks to the financial system.

With a two-thirds vote and vote of the chair, the FSOC is authorized to require a non-bank financial company to be regulated by the Federal Reserve if the FSOC believes there would be negative effects on the financial system if the company failed, or if its activities would pose a risk to the financial stability of the United States.   As a last resort, H.R. 4173 provides that the same vote could enable a Federal Reserve decision to require a large, complex company to divest some of its holdings if it is deemed to pose a grave threat to the nation’s financial stability.

H.R. 4173 also establishes a floor for capital that cannot be lower than the standards in effect today and authorizes the FSOC to impose a 15-1 leverage requirement at a company if necessary to mitigate a grave threat to the financial system.

 

Limitation of Large, Complex Financial Companies; Prevention of Future “Too Big to Fail” Bailouts

H.R. 4173 clearly states that U.S. taxpayers will not fund the rescue or liquidation of a failing financial company.

H.R. 4173 requires regulators to implement regulations for banks, their affiliates and holding companies in order to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, thus limiting relationships with hedge funds and private equity funds.  Proprietary trading and hedge fund and private equity investments by non-bank financial institutions supervised by the Federal Reserve also would be restricted.  

 

Payment, Clearing and Settlement Regulation

H.R. 4173 provides a specific framework for promoting uniform risk-management standards for systemically important financial market utilities and systemically important payment, clearing and settlement activities conducted by financial institutions.

Dubbed  the “funeral plans,” a portion of the bill requires large, complex financial companies to periodically submit plans for their rapid and orderly shutdown should they begin to fail.  If companies fail to submit acceptable plans, higher capital requirements and restrictions on growth and activity will be imposed, along with divestment.   The “funeral plans” are expected to help regulators understand the structure of the companies they oversee and serve as a roadmap for orderly liquidation.  

To liquidate a company under the provisions of H.R. 4173, the FDIC can now borrow only the amount of funds that it expects to be repaid from the assets of the company being liquidated.  Funds not repaid from the sale of the company’s assets will be repaid first through the “claw back” of any payments to creditors that exceeded liquidation value and then through assessments on large financial companies, with the riskiest paying more based on considerations included in a risk matrix.

H.R. 4173 significantly alters the Federal Reserve’s 13(3) emergency lending authority to prohibit “bailing out” an individual company.   The Secretary must approve any lending program.  Such programs must be broad-based and not aid a failing financial company.  Collateral must be sufficient to protect taxpayers from losses.

To prevent bank runs, the FDIC will be able to guarantee debt of solvent insured banks, but only after meeting certain substantial requirements.

 

Federal Reserve Reform

H.R. 4173 limits the Federal Reserve’s 13(3) emergency lending authority by prohibiting emergency lending to an individual entity.   The Secretary must approve any lending program, which must be broad-based.  Loans to insolvent firms are prohibited.  

The General Accounting Office (“GAO”) will be authorized to conduct a one-time audit of all Federal Reserve 13(3) emergency lending that took place during the financial crisis.  Details on all lending will be published on the Federal Reserve Web site by December 1, 2010.  In the future, the GAO will have on-going authority to audit 13(3), emergency lending, discount window lending  and open market transactions.  On an ongoing basis, the Federal Reserve will be required to disclose counterparties and information about amounts, terms and conditions of this type of lending.

H.R. 4173 creates the Vice Chairman for Supervision, a position that will entail membership on the Federal Reserve Board of Governors and the development of Board policy recommendations on supervision and regulation.

The bill authorizes the GAO to conduct a study of the current system for appointing Federal Reserve Bank directors in order to examine whether the current system effectively represents the public, and whether there are actual or potential conflicts of interest.  It will also examine the establishment and operation of emergency lending facilities during the recent financial crisis and the involvement of Federal Reserve banks.  The GAO will identify measures that would improve reserve bank governance.

Presidents of the Federal Reserve Banks will be elected by class B directors, who are elected by district member banks to represent the public, together with class C directors, who are appointed by the Board of Governors to represent the public.  Class A directors, who are elected by member banks to represent member banks, will no longer vote for presidents of the Federal Reserve Banks.

 

Derivatives

H.R. 4173 provides the Securities and Exchange Commission (“SEC”) and the U.S. Commodity Futures Trading Commission with authority to regulate over-the-counter derivatives.  It also requires central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared.

Market transparency would be expect to improve through the requirement of data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding to risks.

Safeguards to ensure that dealers and major swap participants have adequate financial resources to meet responsibilities are added through H.R. 4173, which also provides regulators with the authority to impose capital and margin requirements on swap dealers and major swap participants, but not end users.

The bill sets forth a code of conduct for all registered swap dealers and major swap participants when advising a swap entity.  When acting as counterparties to a pension fund, endowment fund or state or local government, dealers must have a reasonable basis to believe that the fund or governmental entity has an independent representative advising them.

 

Office of Minority and Women Inclusion

At federal banking and securities regulatory agencies, the bill establishes an Office of Minority and Women Inclusion that will, among other functions, address diversity-related employment and contracting matters.  The offices will coordinate technical assistance to minority-owned and women-owned businesses and seek diversity in the regulator workforce.

 

Mortgage Reform

H.R. 4173 establishes a simple federal standard for all home loans by mandating that institutions must ensure borrowers can repay the loans they are sold.   It also prohibits prepayment penalties and financial incentives for subprime loans that encourage lenders to steer borrowers into more costly loans, including the bonuses known as “yield spread premiums” that lenders pay to brokers to inflate loan costs.  The bill expands the protections available under federal rules on high-cost loans by lowering the interest rate, points and fee triggers that define high cost loans.

Lenders and mortgage brokers who don’t comply with new standards can be penalized for as much as three-years of interest payments and damages, plus attorneys’ fees (if any).  

Lenders must disclose the maximum a consumer could pay on a variable rate mortgage, with a warning that payments will vary based on interest rate changes.

H.R. 4173 further establishes an Office of Housing Counseling within the Department of Housing and Urban Development to boost homeownership and provide rental housing counseling.

Hedge Fund Regulation

H.R. 4173 ends the “shadow” financial system by requiring hedge funds and private equity advisors to register with the SEC as investment advisers and to provide information about their trades and portfolios necessary to assess systemic risk.  This data will be shared with the Systemic Risk Regulator, while the SEC will report to Congress annually on how it uses this data to protect investors and market integrity.

The bill raises the assets threshold for federal regulation of investment advisers from $30 million to $100 million, an action expected to significantly increase the number of advisors under state supervision.   Because states have proven to be strong regulators in this area and it is expected that subjecting more entities to state supervision will allow the SEC to focus its resources on regulating newly registered hedge funds.

 

Credit Rating Agencies

The bill creates an SEC Office of Credit Ratings with the authority to fine agencies.  The SEC is required to examine Nationally Recognized Statistical Ratings Organizations (“NRSROs”) at least once a year and publicize key findings.

NRSROs will be required to disclose their methodologies, use of third parties for due diligence efforts and their ratings track record.

Compliance officers will be prohibited from working on ratings, methodologies or sales.  Further, new requirements are established for NRSROs to conduct an annual review when an NRSRO employee goes to work for an obligor or underwriter of a security or money market instrument subject to a rating by that NRSRO.  A mandatory report must be issued to the SEC when certain employees of the NRSRO go to work for an entity that the NRSRO has rated in the previous twelve months.

Under the provisions of H.R. 4173, investors can bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts, or to obtain analysis from an independent source.  NRSROs will now be subject to “expert liability” with the nullification of Rule 436(g) which provides an exemption for credit ratings provided by NRSROs from being considered as part of a registration statement.

Other miscellaneous provisions:

• The SEC is now authorized to deregister an agency for providing bad ratings over time.
• H.R. 4173 requires ratings analysts to pass qualifying exams and have continuing education.
• The bill eliminates many statutory and regulatory requirements to use NRSRO ratings. It also reduces over-reliance on ratings and encourages investors to conduct their own analysis.
• Half the members of NRSRO boards are now required to be independent by having no financial stake in credit ratings.
• After conducting a study and subsequent reporting to Congress, a new mechanism will be created by the SEC to prevent issuers of asset backed-securities from picking the agency they think will give the highest rating.

 

Executive Compensation and Corporate Governance

Corporate shareholders will have a “say on pay,” with the right to a non-binding vote on executive pay and golden parachutes.  Further, the SEC is authorized to grant shareholders proxy access to nominate directors.  These requirements are expected to help shift management’s focus from short-term profits to long-term growth and stability.

Standards for listing on a stock exchange will require that compensation committees include only independent directors and that they have authority to hire compensation consultants in order to strengthen their independence from the executives they are rewarding or punishing.

Public companies will be able to set policies that provide for rescinding executive compensation if it was based on inaccurate financial statements that don’t comply with accounting standards.

H.R. 4173 directs the SEC to clarify disclosures relating to compensation, including requiring companies to provide charts that compare their executive compensation with stock performance over a five-year period.

Federal financial regulators will be required to issue and enforce joint compensation rules specifically applicable to financial institutions with a Federal regulator.

 

Improvements to Bank and Thrift Regulations

H.R. 4173 implements a strengthened version of the Volcker Rule by not allowing a study of the issue to undermine the prohibition on proprietary trading and investing a banking entity’s own money in hedge funds, with a de minimis exception for funds where the investors require some “skin in the game” by the investment advisor–up to three percent of Tier 1 capital in the aggregate.

The bill abolishes the Office of Thrift Supervision and transfers its authorities mainly to the Office of the Comptroller of the Currency.  However, the Thrift Charter is preserved.

Credit exposure from derivative transactions will be added to banks’ lending limits.

H.R. 4173 requires the Federal Reserve to examine non-bank subsidiaries that are engaged in activities that the subsidiary bank can do (e.g. mortgage lending) on the same schedule and in the same manner as bank exams.  Backup authority will be provided to the primary federal bank regulator if that does not occur.

It also allows use of intermediate holding companies by commercial firms that control grandfathered unitary thrift holding companies to better regulate their financial activities, rather than commercial activities.

The prohibition on banks paying interest on demand deposits is repealed.

A regulatory arbitrage opportunity is removed by prohibiting a bank from converting its charter (unless both the old regulator and new regulator do not object) in order to avoid an enforcement action.

 

Interchange Fees

H.R. 4173 requires the Federal Reserve to issue rules to ensure that fees charged to merchants by credit card companies debit card transactions are reasonable and proportional to the cost of processing those transactions.

 

Credit Score Protection

Consumers will be allowed free access to their credit score if it negatively affects them in a financial transaction or a hiring decision.  They also will be given access to credit score disclosures as part of an adverse action and risk-based pricing notice.

SEC and Improving Investor Protections

H.R. 4173:

• Authorizes the SEC to impose a fiduciary duty on brokers who give investment advice;
• Creates an SEC program to encourage people to report securities violations by creating rewards of up to 30 percent of funds recovered for information provided;
• Mandates a comprehensive outside consultant study of the SEC, an annual assessment of the SEC’s internal supervisory controls and GAO review of SEC management;
• Creates the Investment Advisory Committee, which is a committee of investors to advise the SEC on its regulatory priorities and practices; the Office of Investor Advocate in the SEC, which will identify areas where investors have significant problems dealing with the SEC and provide them assistance; and an ombudsman to handle investor complaints; and
• Provides more resources to the chronically underfunded SEC to carry out its new duties.

 

Securitization

H.R. 4173 requires companies that sell products such as mortgage-backed securities to retain at least five percent of the credit risk, unless the underlying loans meet standards that reduce riskiness.   Issuers also will be required to disclose more information about the underlying assets and to analyze their quality.

 

Municipal Securities

Municipal advisors will be required to be registered and subjected to rules written by the Municipal Securities Rulemaking Board (“MSRB”) and enforced by the SEC.

The MSRB will be required to have a majority of independent members at all times in order to ensure that the public interest is better protected in the regulation of municipal securities.

A fiduciary duty will be imposed on financial advisors to ensure that they adhere to the highest standard of care when advising municipal issuers.

 

Tackling the Effects of the Mortgage Crisis

H.R. 4173 provides $1 billion to states and localities to combat the negative impact of the foreclosure crisis on neighborhoods (such as falling property values and increased crime) by rehabilitating, redeveloping and reusing abandoned and foreclosed properties.

Building on a successful Pennsylvania program, the bill provides $1 billion for bridge loans to qualified unemployed homeowners with reasonable prospects for re-employment to help cover mortgage payments until they are reemployed.

It also authorizes a HUD-administered program for making grants to provide foreclosure legal assistance to low- and moderate-income homeowners and tenants related to home ownership preservation, home foreclosure prevention and tenancy associated with home foreclosure.

 

Transparency for the Extraction Industry

H.R. 4173 requires public disclosure to the SEC of payments made to the U.S. and foreign governments relating to the commercial development of oil, natural gas and minerals.

The SEC must require those engaged in the commercial development of oil, natural gas or minerals to include information about payments they, or their subsidiaries, partners or affiliates have made to the U.S. or a foreign government for such development in an annual report and posted online.

 

Congo Conflict Minerals

The bill requires those who file with the SEC and use minerals originating in the Democratic Republic of Congo in manufacturing to disclose measures taken to exercise due diligence on the source and chain of custody of the materials and the products manufactured.

The State Department will be required to submit a strategy to address the illicit minerals trade in the region and a map to address links between conflict minerals and armed groups and establish a baseline against which to judge effectiveness.

Further, the Administration will be required to evaluate proposed loans by the International Monetary Fund to a middle-income country if that country’s public debt exceeds its annual Gross Domestic Product, as well as to oppose loans that are unlikely to be repaid.

 

 

 

 

Should you have any comments or questions, please contact Colodny Fass.