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AN INTRODUCTION TO THE DODD-FRANK ACT: Congress Addresses Systemic Risk

John C. Coffee, Jr.Adolf A. Berle Professor of Law

Columbia Law SchoolJune 7, 2012

Second Circuit Judicial Conference

The Boom/Bust Cycle

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

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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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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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What Prescriptions Follow From These Diagnoses?

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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 Bailouts2) Resolution Authority (an expedited procedure for

liquidating failing TBTF institutions prior to insolvency without

the use of bankruptcy)

3) Higher Capital Adequacy Standards4) Mandatory or Permissive Use of Contingent Capital

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 Body2) 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

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The New Financial Architecture

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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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4. 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)).

5. 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.

6. 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.

7. When it does, there will predictably be appeals that will reach the courts.

8. 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.

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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.

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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.”

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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).

3. Some law professors have already suggested that this procedure is constitutionally suspect.

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4. 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).

5. 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.

6. 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.

7. 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)).

8. 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.

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:

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2. 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.

3. 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.

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.”

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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.

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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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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 . . .”

2. Section 956(b) then authorizes federal regulators to bar “any type of incentive-based payment arrangement that . . . encourages inappropriate risks by covered financial institutions. . . .”

3. 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.

2. 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).

3. 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).

4. 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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Institution Earnings / (Losses) Bonus Pool

No. of Employees Receiving Bonus ≥ $3 million

No. of Employees Receiving Bonus ≥ $1 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

2008 Bonus Compensation at Selected Financial Institutions

1. This is exactly what then New York Attorney General Cuomo required in 2009 when he published the following chart:

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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What Happened to Section 956?

What Is Going On Here?

1. 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.

2. 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.

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Bottom line:

(1) No quantitative aggregate disclosures are required.

(2) Each institution decides for itself who could cause it a substantial loss and discloses only its general arrangements in those cases.

(3) No deferral for even those persons (other than executives) who a TBTF institution acknowledges could cause it loss.

What Explains This?

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.

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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.

CLAWBACKS

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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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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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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.

2. 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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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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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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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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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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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.