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Client Alert: The Dodd-Frank Wall Street Reform and Consumer Protection Act

          The Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as the Dodd-Frank Act (for purposes hereof, the Act), is a massive piece of financial reform legislation representing the most significant legislative change to financial supervision and regulation since the 1930s.  Its effect on banks, bank holding companies, securities firms, insurance companies and other providers of financial services operating within the U.S. will be far reaching and long lasting.  While the Act’s most stringent requirements are intended to apply to large, interconnected bank holding companies with $50 billion or more in consolidated assets (referred to as systemic bank holding companies, or simply Systemic BHCs) and large, nonbank financial companies to be supervised by the Board of Governors of the Federal Reserve System (referred to as Systemic Nonbanks), we will focus our discussion to the impact of the legislation on non-Systemic BHCs (i.e., bank holding companies with consolidated assets of less than $50 billion).  As you will see, the Act impacts such diverse topics as regulatory capital requirements, deposit insurance assessments, executive compensation and residential mortgage lending, among others.

            The Act is complicated and contains substantial ambiguities.  A technical follow-on bill is expected, and the Act provides for and requires the exercise of broad rulemaking authority by various federal regulators over the next 6 to 18 months in order to implement certain provisions of the Act and clarify others.  By some counting, as many as 243 rulemakings and 67 studies are mandated by the Act.  Even after the regulations are adopted, many questions are likely to persist.  As a result, market participants will need to make strategic decisions in an environment of regulatory uncertainty.

Leverage and Risk-Based Capital Requirements (Collins Amendment)

            Two of the most significant changes are derived from the Collins Amendment, a provision of the Act sponsored by Sen. Collins (ME), and originally drafted by FDIC staff.  The Collins Amendment imposes, over time, the risk-based and leverage capital requirements currently applicable to banks on bank holding companies.  One of the effects of the Collins Amendment is to eliminate trust preferred securities as an element of Tier 1 capital.  Implementing regulations must be issued within 18 months from the Act’s effective date.

            The Collins Amendment echoes changes that have been proposed but not yet adopted by the Basel Committee on Banking Supervision in the “Basel III” process.  In addition, the Act requires banking regulators to make capital requirements counter cyclical, so that the amount of capital required to be maintained by a company increases in times of economic expansion and decreases in times of economic contraction.

            New Minimums for BHCs.  The Act requires the establishment of minimum leverage and risk-based capital requirements applicable to bank holding companies that are not less than those currently applicable to insured depository institutions (currently 5%, 6% and 10% to be “well capitalized”, and 4%, 4% and 8% to be “adequately capitalized).

            Capital requirements are to address risks arising out of certain activities to “other public and private stakeholders,” and must address risks that relate to:  (i) significant volumes of activity in derivatives, securitized products, financial guarantees, securities borrowing and lending and repos; (ii) concentrations in assets for which reported values are model based; and (iii) concentration in market share for any activity that would substantially disrupt financial markets if unexpectedly discontinued by the institution.  The Financial Stability Oversight Council has authority to recommend heightened prudential standards to apply to certain activities and practices whether or not the institution in which they take place is systemically important.

            Hybrid Capital Instruments.  Hybrid capital instruments, such as trust preferred securities, issued on or after May 19, 2010 will be excluded from Tier 1 capital.  While large bank holding companies will be required to phase in regulatory capital deductions for existing hybrid capital (in essence, incrementally excluding such capital from Tier 1 capital over a three year period), hybrid capital issued by bank holding companies with less than $15 billion in total consolidated assets as of December 31, 2009 prior to May 19, 2010 will be exempt from such phase in (i.e., may continue to be treated as Tier 1 capital).  TARP preferred securities are exempt and will continue to be treated as Tier 1 capital regardless of size of the institution.

            Small Bank Holding Companies.  The Collins Amendment does not apply to small bank holding companies (i.e., those with less than $500 million in assets), which will continue to be able to benefit from the exemption from the risk-based and leverage capital minimums applicable to bank holding companies as set forth in the Federal Reserve’s Small Bank Holding Company Policy Statement.

Summary of Collins Amendments
Risk-Based and Leverage Capital Requirements

General Risk-Based and Leverage Capital Requirements

Exclusion of Hybrid Instruments issued before May 19, 2010 from Tier 1 Capital

Bank Holding Companies

$15 billion plus @12/31/09

Effective upon implementing regulation within 18 months

Phase-in incrementally from 1/1/13 to 1/1/16

Less than $15 billion @ 12/31/09

Effective upon implementing regulation within 18 months

Grandfathered

Small BHC – less than $500 million

Exempt

Exempt

Thrift Holding Companies

$15 billion plus @ 12/31/09

Effective 5 years after enactment

Phase-in incrementally from 1/1/13 to 1/1/16

Less than $15 billion @ 12/31/09

Effective 5 years after enactment

Grandfathered

Mutual Holding Companies

Thrift Holding Companies

Effective 5 years after enactment

Grandfathered

Bank Holding Companies

Effective upon implementing regulation within 18 months

Grandfathered

            GAO Studies and Reports.  The Collins Amendment requires the GAO, in consultation with the federal banking agencies, to conduct three studies and submit the reports to Congress within 18 months, two of which may be of particular interest to our clients: 

Deposit Insurance Reforms

            The Act significantly alters the current federal deposit insurance regime by changing the base on which assessments are computed, increasing the minimum reserve ratio and making the $250,000 maximum deposit insurance amount permanent.

            Assessments Based on Assets.  The FDIC must base deposit insurance assessments on a depository institution’s “average consolidated total assets” less the institution’s “average tangible equity,” rather than on its deposit base.  This provision is expected to result in a shift in the distribution of assessments to larger banks that tend to rely more heavily on funding sources other than domestic deposits.

             Increased Minimum Reserve Ratio.  The minimum reserve ratio is increased from 1.15% to 1.35% of estimated deposits with no upward limit.  The FDIC is required to “offset the effect” of the increased minimum reserve ratio on institutions with less than $10 billion in total consolidated assets.  The intent appears to be to require the FDIC to impose higher premiums on larger banks in order to get from the old minimum of 1.15% to the new 1.35%, but that is not clear from the language of the Act.  Given the current reserve ratio of negative 0.38%, all institutions can expect assessments to remain significant for the foreseeable future.  The Act allows the FDIC until September 30, 2020 to reach 1.35%.

            FDIC Deposit Insurance Increase.  The Act makes permanent the 2008 increase in the maximum deposit insurance amount to $250,000.

            Extension of Transaction Account Insurance.  Full deposit insurance coverage for qualifying noninterest-bearing transactions accounts has been extended until December 31, 2012.  This extension does not apply to all accounts currently covered by the FDIC’s Transaction Account Guarantee program, which is set to expire December 31, 2010, such as NOW Accounts.

Sections 23A and 23B of the Federal Reserve Act

            Among the key regulatory changes is an expansion of the types of transactions that are deemed “covered transactions” within the meaning of Sections 23A and 23B of the Federal Reserve Act, generally applicable to depository institutions and their affiliates.

            Expansion of Covered Transactions.  Effective one year after the transfer date, the following transactions between a bank and an affiliate will now constitute a covered transaction for purposes of Section 23A: (i) credit exposure resulting from derivative transactions; and (ii) credit exposure resulting from securities borrowings or lending transactions. 

            Collateral Requirements.  Collateral is now required for credit exposure on repurchase agreements, as well as the expanded transactions identified above.  Collateral required for covered transactions now must be maintained at all times, rather than only at the time of entering into the transaction.  Debt issued by affiliates is no longer permitted collateral for purposes of Section 23A.

            Asset Purchases and Sales with Insiders.  The Act prohibits an insured depository institution from purchasing an asset from, or selling an asset to, any executive officer, director, or principal shareholder, or any of their related interests, unless the transaction is (i) on market terms, and (ii) if the transaction exceeds 10 percent of the institution’s capital and surplus, is approved in advance by a majority of disinterested board members.

 Bank Regulation, Generally 

            Elimination of OTS.  The Act abolishes the OTS.  The Federal Reserve assumes OTS powers with respect to thrift holding companies and their non-depository institution affiliates.  The OCC assumes all OTS powers with respect to federal thrifts and rulemaking authority over all thrifts except as vested in the Federal Reserve (transactions with affiliates, loans to insiders and tying arrangements).  The FDIC assumes OTS powers, other than rulemaking, with respect to state thrifts.  The transfer of powers is to occur one year after enactment, but may be extended by the Treasury Secretary to a date not later than 18 months after enactment.

            Although the federal thrift charter is retained, the Act eliminates most important advantages of the thrift charter and imposes new penalties for failure to comply with the qualified thrift lender test.  Holders of a thrift charter may now have greater incentive to convert to a bank charter.

            Interest-Bearing Transaction Accounts.  Effective 1 year after enactment, the prohibition against paying interest on demand deposits is to be eliminated, thereby effectively repealing Regulation Q and permitting the payment of interest on commercial checking accounts.

            Truth in Lending Act.  The ceiling for application of the requirements of the Truth in Lending Act to non-real estate secured consumer credit transactions and leases has been raised from $25,000 to $50,000.

            Interchange Transaction Fees.  Within nine months after enactment, the Federal Reserve must prescribe regulations to establish standards for determining that interchange transaction fees meet the new statutory standard of reasonable and proportional to the cost.  Card issuers which, together with their affiliates, have less than $10 billion in assets are exempt.

            Lending Limits to Include Derivatives.  Effective one year after the transfer date, credit exposure arising from a derivative transaction, repurchase agreement, securities lending transaction or securities borrowing transaction must be treated as a “loan or extension of credit” for purposes of lending limits applicable to national banks and thrifts.  Effective 18 months after the transfer date, Pennsylvania state chartered banks are prohibited from engaging in derivative transactions unless Pennsylvania’s lending limit laws take into consideration credit exposure related to derivative transactions.

            Source of Strength Doctrine.  The Act codifies and expands the FRB’s source of strength doctrine, which requires that all bank holding companies serve as a source of financial strength for the subsidiary bank.  The Act defines “source of strength” as the ability of a company that directly or indirectly owns or controls an insured depository institution to provide “financial assistance” to such insured depository institution in the event it experiences “financial distress.”  The Act mandates that the FRB require a bank holding company to provide such financial assistance in times of “financial distress.”  Regulations are to be issued within one year after the transfer date.

            Charter Conversions by Troubled Institutions.  The Act prohibits charter conversions during any period in which the subject bank is subject to a formal enforcement action (such as a cease and desist order) or a memorandum of understanding concerning a “significant supervisory matter.”  This provision is apparently in response to “charter shopping” by banks subject to OCC enforcement actions during 2007-2009, which resulted in a number of national banks converting to state-chartered banks in order to eliminate the enforcement action.  Charter conversions by troubled institutions will be permitted where a plan to address the items contained in the enforcement action is submitted to the regulator issuing the enforcement action and such issuing regulator does not object to the conversion.

            Lending to Small Businesses by Credit Card Banks.  The Act permits a credit card bank to make credit card loans to small businesses that are eligible for loans issued by the SBA, while retaining its exemption from the definition of “bank” under the BHC Act.

 Impact on Expansion

            The Act imposes new requirements that must be considered in light of proposed acquisitions, proposals to engage in new financial activities, and de novo interstate branching.

            Impact on Financial Stability.  The Federal Reserve now must consider the impact of proposed bank and nonbank acquisitions on U.S. financial stability.

            Nationwide Deposit Cap and Concentration Limits.  The Act prohibits acquisitions by insured depository institutions and their holding companies of additional depository institutions where the applicant would control more than 10 percent of the total amount of deposits of insured depository institutions.  The Act also prohibits a financial company from merging with or acquiring substantially all of the assets or control of another company if the resulting company’s total consolidated liabilities would exceed 10 percent of the aggregate consolidated liabilities of all financial companies at the end of the prior calendar year.  There are exemptions from both the deposit cap and concentration limit when the target is in default or danger of default.

            Bank Acquisitions.   An application to acquire control, or substantially all of the assets, of a bank may be approved by the Federal Reserve only if the bank holding company is well capitalized and well managed.  Further, an interstate merger transaction may only be approved if the resultant bank will be well capitalized and well managed.

            Financial Holding Companies.  The Act requires that financial holding companies be well-capitalized and well-managed on a consolidated basis at both the holding company and depository institution level in order to engage in, or acquire any company engaged in, activities not permissible for a bank holding company under Section 4(c)(8) of the Bank Holding Company Act of 1956, as amended (the BHCA).  Prior law required only that the subsidiary bank be well-capitalized and well-managed for purposes of such activities and acquisitions. 

            Financial holding companies now must provide prior notice to the Federal Reserve before acquiring a company engaged in financial activities that has $10 billion or more of consolidated assets.

            De Novo Interstate Branching.  The Act expands the de novo interstate branching authority of state and national banks by eliminating the state “opt-in” election.  Applications for out-of-state de novo branches are subject to approval if, under the law of the state in which the branch is to be located, a host state bank would be permitted to establish the branch.  Accordingly, the Act preserves such laws as the New York home bank protection rule, which precludes New York and out-of-state banks alike from branching into certain rural areas in which a bank already maintains its headquarters.

            Moratorium on Nonbank Applications.  The FIDIC may not approve any application for deposit insurance received after November 23, 2009 for an industrial bank, credit card bank or trust bank that is directly or indirectly owned or controlled by a commercial firm (derives less than 15 percent of its consolidated gross revenues from activities that are financial in nature).  In addition, the appropriate federal banking agency must disapprove any change in control that would result in direct or indirect control by a commercial company of an industrial bank, industrial loan company, credit card bank or trust bank.  These provisions sunset three years after enactment.

 Executive Compensation and Corporate Governance

            Reports and Prohibitions on Executive Compensation.  Federal banking regulators are required to adopt regulations within nine months after enactment requiring covered financial institutions to report the structures of all incentive-based compensation arrangements to the regulators and prohibit incentive-based payment arrangements that encourage inappropriate risks by providing employees, directors or principal shareholders with excessive compensation or that could lead to a material financial loss to the covered financial institution.  Covered financial institution does not include a financial institution with less than $1 billion in assets.

            Say on Pay.  At least once every three years, at any annual or other meeting of shareholders occurring six months after enactment, publicly traded companies must provide their shareholders with a non-binding shareholder vote to approve the compensation of the company’s named executive officers.  Further, a separate non-binding vote must be held at least once over six years to determine whether the say on pay vote should be occur every one, two or three years. 

            Advisory Vote on Golden Parachutes.  Public companies will be required to provide a non-binding shareholder vote to approve golden parachutes to be paid to named executive officers in connection with a merger or acquisition at any shareholder meeting held to approve such merger or acquisition transaction.  Institutional investors are required to report annually how they voted on Say on Pay and say on golden parachute votes.

            Clawback.  The SEC is required to ensure that national listing exchanges, such as the NYSE and NASDAQ, prohibit the listing of any companies that fail to adopt claw-back policies pursuant to which incentive-based compensation paid to executives will be subject to clawback based on financial results which were subsequently restated within three years of such payment.  The amount of the clawback is the amount in excess of what would have been paid under the restated results.

            Pay and Performance.  The SEC is required to issue rules requiring companies to disclose the relationship between executive compensation paid and the company’s financial performance, including any change in the value of the company’s shares, dividends and distributions.  The new disclosure will require quantitative analysis to accompany the narrative disclosure already required in the company’s CD&A.

            Internal Pay Equity.  The SEC is required to issue rules requiring companies to disclose in its annual proxy statement the median annual total compensation of all employees (not including the CEO); the annual total compensation of the CEO; and the ratio of the median employee annual total compensation to that of the CEO.  The new disclosure will require quantitative comparison to accompany the narrative disclosure already required in the company’s CD&A.

            Compensation Committee and Advisors.  Within one year after enactment, the SEC is required to issue rules directing national securities exchanges to require that all compensation committee members be independent and to require that the committee consider the independence of an advisor when selecting a consultant, legal counsel or other advisor.  The committee shall disclose whether the committee engaged a compensation consultant and whether any conflict of interest arose in connection with the engagement.  Compensation committees shall have authority to hire compensation consultants and advisors, and will be directly responsible for the appointment, compensation and oversight of such advisors. 

            Hedging Disclosure.  Public companies will be required to disclose whether employees and directors are allowed to hedge against a decrease in the value of any equity securities of the company granted to such individuals as compensation.

 Corporate Governance

            Proxy Access.  The SEC is authorized to issue rules requiring public companies to include shareholder nominees for director in the company’s proxy solicitation materials.

            Chairman and CEO Structure.  The SEC must issue rules requiring public companies to disclose in the proxy statement the rationale for choosing a single individual or different individuals to serve as Chairman and CEO.

            Risk Committee.  The Act requires risk committees for Systemic Nonbanks as well as any publicly traded bank holding companies with total consolidated assets of $10 billion or more.  In addition, the Act also authorizes the Federal Reserve to require publicly traded bank holding companies with total consolidated assets of less than $10 billion or more to establish a risk committee, as determined necessary or appropriate to promote sound risk-management practices.  If required, risk committees shall be responsible for the oversight of the enterprise-wide risk management practices of the company.  The Federal Reserve will determine the number of independent directors required to comprise the committee, which shall include at least one risk management expert having experience in risk management at large complex institutions.  The rules must be issued within one year after the transfer date and must take effect within 15 months after the transfer date.

            Elimination of Broker Discretionary Vote.  National securities exchanges must maintain rules prohibiting brokers from voting without customer instructions with respect to the election of directors (already prohibited by NYSE rules), executive compensation or any other significant matter (as defined by the SEC).  Accordingly, brokers will not be permitted to vote on say on pay proposals without instructions.  Unless deemed a significant matter, it remains a best practice to include in any annual meeting a proposal for shareholders to ratify the selection of the company’s independent registered public accounting firm in order to ensure quorum requirements are met.

            Majority Voting.  A provision that would have required directors at public companies to be elected by majority, rather than plurality, vote was stricken from the final bill.

            Sarbanes-Oxley Exemption for Nonaccelerated Filers.  The Act exempts small issues that are neither a large accelerated filer nor an accelerated filer from complying with the Section 404(b) internal control rules of Sarbanes-Oxley.  The Act also directs the SEC to conduct a study to determine how to reduce the burden of complying with Section 404(b) for companies whose market capitalization is between $75 million and $250 million.

 Residential Mortgage Reform

            Within the Act is the Mortgage Reform and Anti-Predatory Lending Act (Mortgage Reform Act), a broad piece of legislation intended to curtail abusive residential mortgage lending practices that contributed to the mortgage/housing crisis.  While a full discussion of the Mortgage Reform Act is beyond the scope of this summary, it should be noted that the Act imposes new responsibilities on virtually all parties engaged in the business of residential mortgage origination, brokerage and lending, including (i) requiring that lenders ensure a borrower’s ability to repay (there is a presumption that a borrower has the ability to repay certain loans defined as “qualified mortgages”); (ii) prohibiting certain lending practices; (iii) limiting yield spread premiums paid to mortgage originators; (iv) expanding the scope of regulations that apply to “high cost” mortgage loans; (v) requiring various additional disclosures; (vi) limiting certain prepayment penalties; and (vii) imposing tougher restrictions on appraisals.

             Origination Standards.  The Mortgage Act establishes certain origination standards to be applied by lenders in the underwriting of residential mortgage loans intended to address some of the concerns exposed by the subprime lending crisis, including inadequate supervision of mortgage originators, the steering of consumers into products that generated higher fees and the inability of borrowers to repay their loans.

            Prohibition on Steering and Mortgage Originator Compensation.  No mortgage originator can receive from any person, and no person can pay a mortgage originator any direct or indirect compensation that varies based upon the terms of the loan.  While not expressly mentioning yield spread premiums, this provision is intended to preclude YSPs where the mortgage originator is likely to steer a borrower to a particular loan because the originator receives additional compensation based upon the borrower’s rate of interest.

            Ability to Repay.  Lenders now are required to make a reasonable and good faith determination that the consumer has the reasonable ability to repay the mortgage loan.  This would include consideration of credit history, current income, expected income the consumer is reasonably assured of receiving, current obligations, debt-to-income ratio, employment status and other financial resources other than equity in the dwelling securing the proposed loan.  Further, the creditor will have to verify the information on which it relies to determine a borrower’s ability to repay (proof through W-2s, tax returns, payroll receipts, etc.).  The Act also provides guidance on how to calculate the proposed monthly payment for purposes of making an ability to repay determination (e.g., it requires the application of certain assumptions, such as a fixed rate equal to the fully indexed rate at the time of the closing, without regard to any introductory or teaser rate).

            Presumption of Ability to Repay.  Borrowers are presumed to have the ability to repay certain loans deemed “qualified mortgage” loans.  Qualified mortgages would generally include:  (i) a fixed rate conventional mortgage loan with total points and fees of three percent or less; (ii) an adjustable rate mortgage loan if the loan underwriting is based on the maximum interest rate permitted during the first five years and the payment schedule fully amortizes the loan by the final maturity date; and (iii) mortgage loans with balloon payments if certain conditions are met.

            Prepayment Penalties.  The Act generally prohibits or, with respect to lower priced, fixed rate qualified mortgages, strictly limits prepayment penalties.

            Penalties for Violations.  A violation of the new rules may permit a borrower to bring an action against the offending lender and/or mortgage broker for as much as three-years of interest payments and damages plus attorneys’ fees (if any).  A violation of the new rules may also provide a defense for borrowers against foreclosure.

 Other Provisions of Note

            Bureau of Consumer Financial Protection (BCFP).  The Act requires the formation of the BCFP as a new, independent bureau within the Federal Reserve.  The BCFP will have very broad rulemaking and supervisory authority with respect to federal consumer financial laws, and will have exclusive examination and primary enforcement authority with respect to banking organizations with assets of $10 billion or more.  Small banking organizations will not escape BCFP rulemaking authority, but will be largely free of BCFP supervision and enforcement authority.

            Volcker Rule.  Subject to certain exemptions, banks and bank holding companies are prohibited from (i) trading in securities (including derivatives and options) for its own account principally for the purpose of selling in the near term; and (ii) acquiring or retaining an ownership interest in or sponsoring a hedge fund or private equity fund.  With respect to the ban on proprietary trading (clause (i) above), the ban is not applicable to, among other identified types of securities, U.S. government, government sponsored entity (GSE), state or municipal obligations, securities held for investment rather than trading, or transactions in securities on behalf of customers.

            Financial Stability Oversight Council.  The Act establishes the Council to serve as an early warning system identifying risks in firms and market activities, to enhance oversight of the financial system as a whole and to harmonize prudential standards across agencies.  The Council is empowered to identify “systemically important” nonbank financial companies, bringing such companies under regulation by the Federal Reserve and to recommend heightened prudential standards for the Federal Reserve to impose on these companies.  The Council also has the power to recommend heightened prudential standards to primary federal regulators to apply to any activity the Council identifies as contributing to systemic risk.  The vast majority of the systemic risk provisions require implementing regulations and many give regulators discretion to modify the statutory standards or issue exemptions.

            Bank holding companies with $50 billion or more in assets are automatically “systemically important” and subject to enhanced prudential standards.  As of March 31, 2010, there were 36 domestic bank holding companies that exceeded the $50 billion threshold.

            The Federal Reserve is authorized in prescribing enhanced prudential standards, to differentiate among companies on an individual basis or by category, taking into account their size, capital structure, riskiness, complexity, financial activities and other risk-related factors the Federal Reserve deems appropriate.

            Systemically important nonbank financial companies and large interconnected bank holding companies must prepare and maintain extensive rapid and orderly resolution plans, which must be approved by the Federal Reserve and the FDIC.

            All financial companies with $10 billion or more in assets that are regulated by a primary federal financial regulatory agency must conduct annual internal stress tests and publish a summary of the results.

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