1. AN INTRODUCTION TO THE DODD-FRANK ACT:
Congress Addresses Systemic Risk
John C. Coffee, Jr.
Adolf A. Berle Professor of Law
Columbia Law School
June 7, 2012
Second Circuit Judicial Conference
The Boom/Bust Cycle Slide 1

2. I. Unlike Most Securities Reform Legislation (Which
Principally Addresses Investor Protection and Disclosure
Issues), the Dodd-Frank Act chiefly addresses systemic
risk. Thus, the inevitable question is: What Do We Mean
By Systemic Risk?
II. Although There Is No Universally Accepted Definition, the
Core Idea Is That Because of Interconnections A Local
Crisis Can Become a Global Crisis, Causing In Effect A
Cascade of Falling Financial Dominoes
III. We Saw Systemic Risk Produce a World-Wide Crisis in
2008 When a Localized Problem In the U.S. Subprime
Mortgage Market Paralyzed the World’s Financial Markets
Because Asset-Backed Securitizations and Derivatives
Had Knitted Together the World’s Financial Institutions In
a Web of Interdependency
Slide 2

3. Systemic Risk Has Three Faces:
(1) A Financial Institution Can Be Too Big to Fail (Lehman
Wasn’t, But Citigroup Probably Is).
(2) A Financial Institution Can Be Too Interconnected to Fail
Because Many Institutions Are Its Counterparties (AIG is
the paradigm as it tied together many institutions through
credit default swaps)
(3) Financial Institutions Can Be Too Risk Correlated to Fail
(Because the Prospective Failure of One Causes Prices to
Fall In a Market In Which Many Have Invested) For
example, if Bear Stearns desperately needs to liquidate its
portfolio of CDOs to avoid insolvency, its sales drive down
prices in a thin market and forces larger TBTF institutions to
mark down or liquidate similar investments. Market
pressures and globalization have probably increased the
level of risk correlation over the last decade.
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4. I. WHAT CAUSED THE 2008 CRISIS?
Why did all major financial institutions seemingly become insolvent at once?
II. FOUR CREDIBLE SCENARIOS EXIST:
A. The Moral Hazard Story: “Executive Compensation Caused the Crash.” Here, the
claim is that a rapid shift toward incentive-based compensation at financial
institutions focused senior managers on short-term results. For example, if you can
make $100 million in Year 1 if a sufficient number of securitization deals close,
why worry about what happens to those deals in Year 5?
B. The Perverse Subsidy Story: Because Creditors Believed that “Too Big to Fail
Banks” (“TBTF”) Would Always Be Bailed Out, They Advanced Too Much Credit
and Too Cheaply. Because of this perception, TBTF banks received an implicit
subsidy, as investors lent too cheaply. Exploiting this subsidy, financial institutions
took on excessive leverage (often under shareholder pressure to do so).
C. Bounded Rationality: The Industry and Regulators Are Subject to The Same
Cognitive Limitations. For example, no one truly understood the risk potential in
Credit Default Swaps. Both in the case of AIG (and more recently in the case of
MF Global), the potential for a “run on the bank” through margin calls was not
adequately recognized.
D. “Shadow Banking” Was Exempt From The Regulatory Scrutiny That Applied to
Traditional Banks. This disparity caused the crisis to begin at investment banks.
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5. What Prescriptions Follow From These Diagnoses?
A. If “Excessive” or “Short-Term” Executive Compensation is the Problem,
Then the Following Responses Seem Relevant:
1) Regulatory Controls on Compensation at Large Financial
Institutions
2) Mandatory Deferral of Bonuses
3) Clawbacks
4) Corporate Governance Reforms Giving Shareholders
Greater Power (“Say on Pay” Votes and “Access to the
Proxy Statement”).
B. If an Implicit Subsidy Based on Expectations of a Bailout is the Problem,
Then The Following Reforms Seem Responsive:
1) Restrict Banking Regulators from Making Bailouts
2) Resolution Authority (an expedited procedure for liquidating
failing TBTF institutions prior to insolvency without the use
of bankruptcy)
3) Higher Capital Adequacy Standards
4) Mandatory or Permissive Use of Contingent Capital
Slide 5

6. C. If Panic and Cognitive Failures Are the Key Problem (as in AIG),
Then Policymakers Might Consider:
1) Mandating the Use of Clearinghouses and Exchanges in
the OTC Derivatives Market
2) Restrict Risk-Taking by TBTF Banks by Proscribing
Certain Higher Risk Activities (i.e. the “Volcker Rule”)
D. To the Extent “Shadow Banking” Was Exempt from Prudential
Oversight, Then Appropriate Reforms Would Include:
1) A Centralized Systemic Risk Oversight Body
2) Ending the Exemptions for OTC Derivatives
3) Subjecting Hedge Funds to Regulation
4) Closer Regulation of Credit Rating Agencies
As Will Next Be Seen Dodd-Frank Attempts All of the Above —
Incompletely and In Broad Brushstrokes
Slide 6

7. The New Financial Architecture
1. Although the U.S. has the most fragmented system of financial regulation in the
developed world, with a different regulator for each class of investments,
Dodd-Frank did little to change this:
1. The SEC and CFTC were not merged.
2. Only the unlamented Office of Thrift Supervision was terminated.
3. But new agencies were created (e.g., Consumer Protection).
2. The major new player is the Financial Stability Oversight Council (“FSOC”), which is
intended to monitor systemic risk. (See Sections 111 to 121 of Dodd-Frank). It has
ten voting members (consisting primarily of the chairs of the major financial
regulators), is chaired by the Secretary of the Treasury, and five non-voting members
(e.g., the Director of the Office of Financial Research, the Director of the Federal
Insurance Office, and several representatives of state financial regulators).
3. The FSOC’s purposes are (1) “to identify risks to the financial stability of the United
States that could arise from the material financial distress or failure or ongoing
activities of large, inter-connected” financial institutions; (2) “to provide market
discipline, by eliminating expectations . . . that the Government will shield [institutions
and creditors] from losses in the event of failure”; and (3) “to respond to emerging
threats to the stability of the U.S. financial system” (Section 111(a) ).
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8. 1. In overview, the FSOC is a beefed-up successor to the President’s Working Group,
with a significantly enhanced research capacity, but only limited powers. Its powers
are largely advisory or limited to information gathering, except that it may determine
by a 2/3’s vote (which majority must include the Secretary of the Treasury) that a
U.S. nonbank financial company (or a foreign nonbank financial company) is to be
supervised by the Board of Governors of the Federal Reserve and subjected to the
latter’s prudential standards if the FSOC finds that the institution’s activities “could
pose a threat to the financial stability of the United States” (Section 113(a)).
2. This means that the FSOC could determine that certain insurance companies, broker
dealers, mutual fund managers (e.g., Fidelity), hedge funds (e.g., Citadel), or
industrial companies (e.g., GE) should be subject to the same standards of capital
adequacy, leverage and risk-taking as a major bank holding company is.
3. The FSOC has recently specified the criteria (and some of the procedures) that it will
use in determining which nonbank financial institutions are systemically significant,
but has not yet acted to designate any institution as systemically significant.
4. When it does, there will predictably be appeals that will reach the courts.
5. Evaluation: The FSOC emerged from Dodd-Frank a slightly weaker body than
originally intended. Had it been given an independent chair, it would have been led
by an independent and politically accountable figure with exclusive responsibility for
systemic risk. Instead, the Secretary of the Treasury has multiple responsibilities and
must balance financial stability against economic growth and political consensus.
Slide 8

9. The End of the Central Bank As Lender of Last Resort?
1. Dodd-Frank Restricts the Power of the Federal Reserve to advance funds to a failing TBTF
bank.
2. Specifically, Section 1101(a)(6) of Dodd-Frank eliminates the Federal Reserve Board’s
former authority under Section 13(3) of the Federal Reserve Act to make emergency loans
to a failing bank. Now, the FRB can no longer lend to a single firm but can only make
emergency loans “for the purpose of providing liquidity to the financial system, and not to a
failing financial company.” Such lending must be pursuant to a “program or facility with
broad-based eligibility” and must be adequately collateralized in a manner that “is sufficient
to protect taxpayers from losses.”
3. Clearly, neither Lehman nor AIG could have met this standard. Indeed, Section 1101(a)(6)
expressly denies the FRB the power to make loans under its emergency lending authority
“for the purpose of assisting a single and specific company to avoid bankruptcy [or]
resolution authority under Title II” of the Dodd-Frank Act.
4. Similarly, Section 212 (“No Other Funding”) bars the FDIC from lending to TBTF banks
outside of a Title II receivership. The language is clear that the FDIC can lend to, or
guarantee debts of, the institution only once the financial institution has entered liquidation
and is being wound down.
Bottom Line: The intent of Dodd-Frank is to end the Central Bank As Lender of Last Resort to
Failing TBTF Banks because bailouts have become politically unacceptable. The FRB may
find ways to avoid this proscription, but its hands are significantly tied and it will have to face
Congress, and maybe the courts, if it seeks to outflank these provisions.
Slide 9

10. Resolution Authority
1. In place of Central Bank lending to avert a banking crisis, Dodd-Frank intends to
substitute “resolution authority,” which is largely modelled after the procedures the
FDIC has used to liquidate smaller banks outside of bankruptcy.
2. Although expeditious liquidation of a systemically significant financial institution is
clearly desirable (and the Lehman bankruptcy shows that liquidation under the
Bankruptcy Code is interminable), the problem with Title II (“Orderly Liquidation
Authority”) of Dodd-Frank is that it requires a very high level of consensus among
financial regulators to begin the process and then subjects their determination to a
uniquely truncated form of judicial review.
3. To illustrate, let’s suppose that a major bank is in trouble (the procedures are
different for a broker-dealer or insurance company). What happens? Sections 203
and 202 of Dodd-Frank outline the following procedures:
Step One. On their own initiative (or at the request of the Secretary of the Treasury),
the FDIC and the FRB determine to request the Secretary to appoint the FDIC as
receiver for this financial institution — by not less than a two-thirds vote of each of
the FRB Governors and the FDIC board of directors. (If the troubled institution is a
broker, 2/3s of the SEC’s five Commissioners must also approve — i.e., four
Commissioners).
Step Two. The FRB and the FDIC submit an elaborate report to the Secretary,
containing the findings specified in Section 203(a)(2) of Dodd-Frank, which must
describe the effect of the default upon the financial stability of the U.S. and the
likelihood of any “private sector alternative.”
Slide 10

11. Step Three. The Secretary, in consultation with the President, must determine
that the financial company is in “danger of default,” which term is elaborately
defined in Section 203(c)(4). Under Section 203(b), the Secretary must make a
total of seven overlapping findings, including the “danger of default” finding.
Step Four. The Secretary notifies the “covered financial company” that it
intends to appoint the FDIC as receiver. If the company does not consent, the
Secretary must petition the United States District Court for the District of
Columbia for an order authorizing the Secretary to so appoint the FDIC as
receiver. The Court must determine if the Secretary’s decision is “arbitrary and
capricious” after a hearing, but under Section 202(a)(1)(v), if “the Court does
not make a determination within 24 hours of receipt of the petition, . . . the
petition shall be granted by operation of law.”
Step Five. An appeal may be taken to the D.C. Circuit within 30 days, and the
D.C. Circuit “shall consider any appeal . . . on an expedited basis.” A petition
for a writ of certiorari to the Supreme Court is also authorized, and the Court is
instructed to “consider any petition on an expedited basis.” However, the scope
of the Court’s review “shall be limited to whether the determination of the
Secretary that the covered financial company is in default or in danger of
default (and is within the statute’s coverage) . . . is arbitrary and capricious.”
(Section 202(a)(2)(iv). (This seems to eliminate judicial review of five of the
seven findings that the Secretary must make).
1. Some law professors have already suggested that this procedure is constitutionally
suspect.
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12. 1. More importantly, these are determinations that no Secretary of the Treasury (or President) will
want to make as liquidation will suggest a failure of adequate supervision on their watch. An
immediate report must also be provided to Congress, where the opposition party will eagerly
second guess the Secretary. A possibility exists that any such liquidation may trigger a financial
panic (as Lehman’s bankruptcy did).
2. Bottom Line: Although “resolution authority” contemplates an early intervention and early
liquidation of a TBTF institution, this is unrealistic, and the odds are high that financial regulators
will prefer to “kick the can down the road” and hope for the best — until actual insolvency
occurs.
3. As a result, if (1) the FRB and FDIC cannot advance funds to a major financial institution facing
a liquidity crisis and (2) the Government will be reluctant to liquidate early,
Dodd-Frank may have painted the U.S. financial system into the proverbial corner where
nothing can or will be done.
4. If “orderly liquidation” under Title II is in fact ordered, Section 204(a) of Dodd-Frank mandates
that (1) “creditors and shareholders will bear the losses,” (2) “management will not be retained,”
and (3) all parties “having responsibility for the condition of the financial company will bear
losses consistent with their responsibility.” This sounds retributive, and Section 210(f) authorizes
the FDIC, as receiver, to sue officers and directors of a failed financial company for gross
negligence. (It is unclear whether corporate charter provisions eliminating monetary liability for
breach of the duty of care will be respected — See Delaware §102(b)(7)).
5. A Final Irony. The FDIC is authorized to makes loans to, and purchase debt obligations of, a
covered financial company placed in Title II liquidation. As a result, creditors may still be spared.
(See Section 204(d)). The most likely procedure will involve the FDIC creating a “bridge
company” to buy the assets of the failed company by paying off the creditors. If the FDIC
decides to pay off debt holders in full, the same expectation of a bailout may persist, and the
perverse subsidy may survive. But the FDIC’s funds are limited, and it probably cannot bailout
an AIG alone.
Slide 12

13. EXECUTIVE COMPENSATION
1. Given the strong perception that incentive compensation can produce “short termism”
and moral hazard, Dodd-Frank takes two divergent and possibly contradictory routes
to cure this problem:
A. It federalizes some aspects of corporate governance in order to give
shareholders greater power; and
B. In Section 956, it authorizes regulators to prohibit excessive incentive-band
compensation at “covered financial institutions” that “could lead to material
financial loss.”
1. Overview: There is much evidence that the more closely the incentives of senior
executives were aligned with those of shareholders, the worse the financial institution
did in 2008! Banks with “shareholder friendly” corporate governance performed more
poorly than banks with “unfriendly” corporate governance.
2. Bottom Line: Empowering shareholders may not be the answer, but instead may be
part of the problem, in terms of systemic risk. Shareholders appear to push managers
to accept higher risk.
Slide 13

14. The Corporate Governance Prong
1. Section 971 authorized, but did not mandate, the SEC to adopt “proxy access” — a
corporate governance reform that it had previously proposed, but never adopted.
Other provisions mandated advisory shareholder votes on executive compensation
(Section 951), required additional disclosures on CEO compensation (Section 953),
required compensation committee independence (Section 952), and eliminated
“broker votes” in director elections (Section 957).
2. Pursuant to this authority, the SEC adopted Rule 14a-11 (the proxy access rule)
permitting low cost proxy contests to elect 1, 2, or at most 3 directors by investors
holding 3% if they were not seeking control.
3. The Business Roundtable and the Chamber of Commerce sued to invalidate the rule
on the grounds that the SEC had not done an adequate cost/benefit analysis – and
won (Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011)). The D.C. Circuit
found that the lack of an adequate cost/benefit study made the rule arbitrary and
capricious; it particularly emphasized the SEC’s failure to consider the costs that
corporations would incur in resisting “proxy access” in its cost/benefit calculus.
Slide 14

15. IMPACT
1. Far more than earlier statutes (such as SOX), Dodd-Frank relies on administrative
implementation through risk-making.
2. That process is seriously behind.
3. As of June 1, 2012, a total of 221 Dodd-Frank rulemaking deadlines have passed,
and 148 (or 67.0%) have been missed, while only 73 (33.0%) have been met with
finalized rules (Source: DavisPolk Progress Report 6/1/2012).
4. Multiple factors may explain this slowness, but the Business Roundtable decision
appears to have traumatized the SEC, which may lack the resources or capacity to
engage in cost/benefit analysis that will satisfy the D.C. Circuit
5. Highly Debatable Policy Issue: Can Cost/Benefit Analysis Be Used to Return Us to a
Lochner-like era in which regulation is presumptively disfavored?
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16. The Paternalistic Prong
1. Section 956 (“Enhanced Compensation Structure Reporting”) instructs Federal
regulators to jointly prescribe regulations requiring “covered financial institutions” to
disclose “the structure of all incentive-based compensation arrangements offered by
such covered financial institutions sufficient to determine whether the compensation
structure —
A. provides an executive officer, employee, director, or principal shareholder
with excessive compensation, fees, or benefits, or
B. could lead to material financial loss to the covered financial institution . . .”
1. Section 956(b) then authorizes federal regulators to bar “any type of incentive-based
payment arrangement that . . . encourages inappropriate risks by covered financial
institutions. . . .”
2. The initial issue was how broadly to read this disclosure obligation. Although it was
clear that individual identities were not to be disclosed, this language could have
been read to require disclosure of aggregate incentive compensation paid to
executives and its distribution.
Slide 16

17. 1. This is exactly what then New York Attorney General Cuomo required in 2009 when he published the
following chart:
2008 Bonus Compensation at Selected Financial Institutions of
No. of No.
Employees Employees
Receiving Receiving
Bonus ≥ $3 Bonus ≥ $1
Institution Earnings / (Losses) Bonus Pool million million
Bank of America $4 billion $3.3 billion 28 172
Citigroup, Inc. $(27.7 billion) $5.33 billion 124 738
Goldman Sachs Group $2.322 billion $4.823 billion 212 953
J.P. Morgan Chase & Co. $5.6 billion $8.693 billion >200 1,626
Merrill Lynch $(27.6 billion) $3.6 billion 149 696
Morgan Stanley $1.707 billion $4.475 billion 101 428
1. As the above chart makes clear, even when financial institutions lost billions, they still paid out bonuses
totaling in the billions to hundreds of employees (see Citigroup and Merrill Lynch in the above chart).
2. When the firm did profit, the bonus pool was often a multiple of earnings (see Goldman, J.P. Morgan,
and Morgan Stanley’s in the above chart).
3. Practices varied, thus making firm-specific disclosure more important. At Merrill Lynch, 14 employees
received over $10 million in bonuses in 2008; 10 at J.P. Morgan Chase; but only 3 at Citigroup.
BOTTOM LINE: THE BONUS CULTURE HAS DEEP ROOTS.
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18. What Happened to Section 956?
1. Section 956 will not produce anything like the foregoing disclosures. This is
because, notwithstanding its broad statutory language, the industry has already
won this battle — and on several levels.
2. First, rather than requiring quantitative disclosures relating to executive
compensation, federal regulators have required only an annual report that
“describes the structure of the covered financial institution’s incentive-based
compensation arrangements . . . that is sufficient to allow an assessment” of
whether those arrangements could lead to “excessive compensation.” This
compromise means no numbers need be disclosed, and boilerplate will suffice.
3. Second, although more was required in the case of very large TBTF banks with
$50 billion in assets or more, it was left to the board of each such TBTF
institution to decide who (other than its executive officers) had the ability to
expose the institution to substantial losses. In short, regulators decided to let
each firm determine for itself who could expose the firm to substantial loss.
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19. What Is Going On Here?
2. Under this rule, a TBTF bank could employ a 100 or more persons, each
receiving a bonus of well over $1 million, and still disclose nothing – so long
as the employees were not executives and did not occupy a position that the
board detrmined could cause it a substantial loss.
3. Third, although the rules require a deferral of at least 50% of the annual
incentive-based compensation paid to senior executives for a period of at
least three years, they require no deferral even in the case of those other
persons that the board does identify as being able to cause substantial loss to
the firm.
Bottom line:
(2) No quantitative aggregate disclosures are required.
(3) Each institution decides for itself who could cause it a substantial loss and discloses
only its general arrangements in those cases.
(4) No deferral for even those persons (other than executives) who a TBTF institution
acknowledges could cause it loss.
What Explains This?
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20. 1. The most plausible answer is that the industry did not want the executive
compensation rules to apply to its “star” traders.
2. If the rules required disclosure and deferral of bonus compensation in their
case, the industry likely feared a migration of these traders from TBTF banks
to hedge funds or offshore institutions.
3. But “star” traders are exactly the persons who can cause substantial losses to
financial institutions: Witness Nicholas Leeson at Barings in 1995 and
Jerome Kerveil at Societe Generale.
4. Bottom Line: The executive compensation rules have been hollowed out by
the regulators to protect TBTF banks from competitive injury.
Irony: A General Counsel at such a bank will have to
defer his incentive compensation for 3 years (although he
is innocuous in terms of the bank’s solvency), but the star
trader betting billions each week will not.
Slide 20

21. CLAWBACKS
1. Section 954 of Dodd-Frank vastly expands the scope of mandatory clawbacks
beyond that originally provided in Sarbanes-Oxley (“SOX”).
2. While SOX required recovery of incentive-based bonuses from the CEO and
CFO, Dodd-Frank specifies that the “issuer will recover from any current or
former executive officer of the issuer who received incentive-based
compensation (including stock options awarded as compensation) during the 3-
year period preceding the date on which the issuer is required to prepare an
accounting restatement based on the erroneous data in excess of what would
have been paid to the executive office under the accounting restatement.”
3. Still, there must be “an accounting restatement due to the material
noncompliance of the issuer with any financial reporting requirement under the
securities laws.” Thus, a bonus paid to the “London Whale” would not be
recoverable if no restatement were necessary.
4. No enforcement mechanism is provided. To date, clawbacks have been
primarily enforced by the SEC (although a derivative action is possible if
demand can be excused).
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22. Restricting Risk-Taking
1. If some financial institutions are “too big to fail,” it follows that they need to be
regulated so that they do not fail.
2. The leading attempt made by Dodd-Frank toward this end is Section 619
(“Prohibitions on Proprietary Trading And Certain Relationships With Hedge Funds
and Private Equity Funds”). Known as the “Volcker Rule,” this provision has touched
off the largest lobbying campaign in modern financial history.
3. Section 619 (which amends the Bank Holding Company Act) starts with broad
prohibitions:
“Unless otherwise provided in this section, a banking entity shall not —
A. engage in proprietary trading, or
B. acquire or retain any equity, partnership, or other
ownership interest in or sponsor a hedge fund or a
private equity fund.”
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23. Exemptions
1. Some ambiguous exemptions, however, may undercut the scope of § 619. Section
13(d)(1)(C) of the amended Bank Holding Company Act (“BHCA”) permits:
“Risk-mitigating hedging activities in connection with and related to
individual or aggregated positions, contracts, or other holdings of a
banking entity that are designed to reduce the specific risks to the banking
entity in connection with and related to such positions, contracts or other
holdings.”
Does this authorize the type of “portfolio hedging” engaged in by JPMorgan’s “London
Whale”? Although the above statutory language seems narrow, the proposed rules are
broader, and the answer will lie in the final rules.
1. Another important exemption is in Section 13(d)(1)(B) of the BHCA for “underwriting
or market-making activities to the extent that any such activities . . . are designed not
to exceed the reasonably expected near term demands of dealers, customers or
counterparties.”
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24. The Lobbying Battle
1. The banking industry wants broad permission to trade sovereign debt. After Greece,
the failure of MF Global, and JPMorgan’s problems, such trading is no longer self-
evidently safe, but other European countries, Japan, and Canada have all asked the
U.S. to permit such trading by U.S. banks.
2. A legal battle will likely arise regarding the extraterritorial scope of Dodd-Frank’s
Section 619. Can, for example, federal regulators prohibit the London office of U.S.
banks from engaging in proprietary trading (as in the case of the London Whale)? Or
does this overlook the presumption against extraterritoriality in Morrison v. Nat’l.
Australia Bank Ltd., 130 Sup. Ct. 2860?
3. If regulators cannot restrict overseas operations, Section 619 may simply produce a
migration of traders to offshore offices.
4. The lobbying imbalance is reaching record proportions. A study by Duke Law
Professor Kimberly Krawiec finds that between July 2010 and October 2011,
representatives of financial institutions met with federal agencies to discuss the
Volcker Rule some 351 times, while public interest groups met with regulators some
19 times over the same period — a better than 18 to 1 ratio.
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25. Regulating Over-The-Counter Derivatives
1. AIG’s failure showed the dangers of opacity in a major market.
2. Had counterparties understood the degree to which AIG was serving as the counterparty
to the entire market of Credit Default Swap users and was thus insuring the entire market
against financial risk, counterparties might have required that greater collateral and margin
be posted (or might simply have sought other counterparties).
3. To prevent the default of a single counterparty creating a wave of falling financial
dominoes, Section 723 of Dodd-Frank mandates the use of clearinghouses (which means
that each party’s transaction is with a clearinghouse backed by the market) and the use of
exchanges and “swap execution facilities” (to create greater transparency).
4. But there are numerous exceptions. The most important is the “end user exemption” that is
now set forth in Section 2(h)(7) of the Commodity Exchange Act, which applies to non-
financial entities using swaps “to hedge or mitigate commercial risk.” Under it, a United
Airlines is, for example, exempt so long as it is hedging its own fuel costs. But if it is
exempt, so also is its counterparty, and thus much trading will remain off market and
opaque.
5. Additionally, customized swaps need not be cleared through clearinghouses or traded on
exchanges, and here the definitions in the rules will be critical. How little does it take to
make a swap “customized” and thus exempt?
6. New Division of Jurisdiction: Swaps are Covered; SEC has “Security-Based” Swaps
(defined in Section 761); CFTC, the rest. Registration is required of “swap execution
facilities,” major dealers and “swap participants.”
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26. Credit Rating Agencies
1. SEC administrative oversight of the credit rating agencies has been tightened,
but the “issuer pays” model for credit ratings seems likely to persist.
2. The one area where courts will encounter a potentially significant legal change
is the revised pleading standard in Section 933 (“State of mind in private
actions”). It provides both that (i) credit ratings shall not qualify for the PSLRA’s
“safe harbor for forward-looking information” and (ii) the PSLRA’s “strong
inference of fraud” pleading standard shall not apply to credit ratings. Instead,
“[I]t shall be sufficient for purposes of pleading any required state of mind
in relation to such actions that the complaint state with particularity facts
giving rise to a strong inference that the credit rating agency knowingly or
recklessly failed —
(i) to conduct a reasonable investigation of the rated security with
respect to the factual elements relied upon by its own
methodology for evaluating credit risk; or
(ii) to obtain reasonable verification of such factual elements
(which verification may be based on a sampling technique that
does not amount to an audit) from other sources that the credit
rating agency considered to be competent and that were
independent of the issuer and underwriter.”
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27. Meaning and Impact
1. Does this language replace the normal scienter standard of Rule 10b-5 with a
negligence standard? Answer: NO!
2. Instead, it is simply providing a substitute pleading standard for the motion to
dismiss, which requires plaintiffs to plead a lack of adequate due diligence.
3. The plaintiff who survives the motion to dismiss because of this softened standard
can obtain discovery, but, by trial or summary judgment, plaintiffs must show
scienter.
4. For the future, in light of this Circuit’s decision in Fait v. Regions Fin. Corp., 655 F.3d
105 (2d Cir. 2011), it will likely be necessary for plaintiffs to show not only that a
rating was inflated but that defendants did not subjectively believe the rating was
accurate at the time it was published.
5. Credit Rating Agencies commonly assert a First Amendment Defense. In Section
951, Congress states a finding that “the activities of credit rating agencies are
fundamentally commercial in character and should be subject to the same standards
of liability and oversight as apply to auditors, securities analysts, and investment
bankers.” Will this have any impact?
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28. Summary
1. This tour has not covered many topics, including:
1. Whistleblowers and bounties;
2. Asset-Backed Securitizations and mandatory risk retention;
3. New SEC and SIPC powers;
4. the Bureau of Consumer Protection (Sections 1011 to 1051);
5. Hedge fund registration;
6. “Predatory” Mortgage lending; and
7. Conflict Minerals.
2. But, more than other “reform” statutes, Dodd-Frank depends on administrative
implementation. To date, that implementation has been slow and equivocal, and
early steps have been judicially contested. Nothing suggests that this will change.
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