US Regulatory Update
FY 2018 Appropriations Bills
On 28 June, the House Appropriations Committee’s Subcommittee on Agriculture, Rural Development, Food and Drug Administration, and Related Agencies voted out of the Subcommittee a Fiscal Year (“FY”) 2018 Agriculture, Rural Development, Food and Drug Administration, and Related Agencies appropriations bill. The bill would provide $248 million in funding for the CFTC for FY 2018. This is $33 million less than the CFTC’s requested budget and $2 million less than its FY 2017 budget.
On 29 June, the House Appropriations Committee’s Subcommittee on Financial Services and General Government voted out of the Subcommittee a Financial Services and General Government appropriations bill. The bill would: (i) provide $1.6 billion in funding for the SEC for FY 2018, $3 million less than its FY 2017 budget; and (ii) eliminate the SEC’s reserve fund, but provide $50 million in additional funding for the SEC’s information technology initiatives. As Bloomberg reports, the bill also contains several provisions that reflect language included in the Financial CHOICE Act (H.R.10).
SEC and CFTC FY 2018 Budget Request Hearing
On 27 June, the House Appropriations Subcommittee on Financial Services and General Government held a hearing on the FY 2018 budget requests for the SEC and CFTC. Among other things, SEC Chairman Jay Clayton and CFTC Acting Chairman and Chairman Nominee J. Christopher Giancarlo discussed how the SEC and CFTC intend to use the resources they requested in their FY 2018 budget requests.
- SEC: SEC Chairman Clayton indicated that: (i) “more 50% of the resources will be invested in the agency’s enforcement and examination programs” and that the SEC “anticipates that it will deliver a further five percent increase in the number of investment advisory exams”; (ii) the SEC will focus in FY 2018 on issues related to “retail investor fraud, investment professional misconduct, insider trading, market manipulation, and accounting fraud”; (iii) the SEC will “pursue rulemaking initiatives aimed at promoting firms’ access to capital markets”; and (iv) the SEC hopes to maintain “access to the SEC’s reserve fund which will allow the SEC to commit to critical long-term IT initiatives.” When questioned by Senator Gerald Moran (R-KS) about the Department of Labor’s (“DOL”) Fiduciary Duty Rule, Chairman Clayton stated that the DOL’s and SEC’s rulemaking initiatives relating to the fiduciary duty rule “[are] not separate” and that the SEC intends to cooperate with the DOL while fulfilling its investor protection mission. When questioned by Senator John Boozman (R-AR) about the impact of the EU’s Markets in Financial Instruments Directive II (“MiFID II”) on the ability of market participants to provide research, Chairman Clayton indicated that this was an issue the SEC staff are looking into but that he is not “certain that the power [the SEC has] will be able to facilitate all the relief” requested by market participants, and that the amount of relief granted will be related to the actions of European regulators.
- CFTC: Acting Chairman Giancarlo indicated that the CFTC’s requested $31.5 million increase from its current funding will be used to prioritize funding: (i) for the Office of Chief Economist to “conduct more thorough cost-benefit and econometric analysis”; (ii) for a more robust examination process for derivatives clearinghouses; and (iii) to “keep pace with emerging technologies.” When questioned by Sen. Moran about whether the CFTC will allow the de minimis threshold for swap dealer registration to drop from $8 billion to $3 billion as anticipated, Acting Chairman Giancarlo indicated he has requested that the CFTC’s Division of Swap Dealer and Intermediary Oversight to conduct a thorough analysis of the issue using recent data and that he intends to make an informed decision guided by a “pure data analysis” prior to the anticipated drop of the threshold.
U.S. Equity Market Structure Hearing
On 26 June, the House Financial Services Committee’s Subcommittee on Capital Markets, Securities, and Investment held a hearing on U.S. equity market structure. Head of Global Trading Research at Instinet John Comerford noted that market structure issues are “complex and interrelated” and that a holistic review of the system, rather than focusing on individual issues, is necessary to bring about “material changes.” Mr. Comerford also noted that the European Securities and Markets Agency (“ESMA”) is creating a tick size schedule under MiFID II based on tick size and liquidity, which will lead to a system that is more “uniform in their trading.” President of the NYSE Thomas Farley stated that the SEC has delegated too much Reg NMS rulemaking authority to the NMS committees without the proper “public comment” process. President and CEO of the CBOE Chris Concannon agreed that there has been a “heavy use” of such delegated authority.
Assistant Secretary of the Treasury for Financial Institutions Nominee
On 27 June, President Donald Trump announced his intent to nominate Christopher Campbell, current Majority Staff Director for the Senate Committee on Finance, for Assistant Secretary of the Treasury for Financial Institutions, which coordinates Treasury’s legislative and regulatory efforts related to financial institutions and securities markets.
Financial Stability Oversight Council (“FSOC”) Insurance Member Continuity Act
On 28 June, Senate Committee on Banking, Housing and Urban Affairs Chairman Mike Crapo (R-ID) and Ranking Member Sherrod Brown (D-OH) introduced the FSOC Insurance Member Continuity Act to allow the FSOC’s independent member with insurance expertise to continue serving on the Council. The Dodd-Frank Act does not currently allow the independent insurance member to continue serving on the Council after his term has expired and the term of the current independent insurance member will expire on 30 September 2017. The bill would amend the Dodd-Frank Act to allow him “to continue serving and voting on FSOC at the end of his/her term in the same capacity until the earlier of: (A) 18 months or (B) the nomination and confirmation of a new individual.” In a press release, Chairman Crapo stated that the bill “provides much-needed clarity regarding the independent insurance member’s term, and ensures that FSOC will continue to have the benefit of insurance expertise on the Council.”
On 29 June, House Financial Service Committee member Rep. Randy Hultgren (R-IL) and Committee Ranking Member Maxine Waters (D-CA) introduced the same legislative proposal, the FSOC Insurance Member Continuity Act, in the House of Representatives. In a press release, Rep. Hultgren stated that he was “proud to work in a bipartisan manner to ensure insurance expertise maintains a strong voice with financial regulators in Washington so those regulators can make informed and prudent policy determinations.”
National Flood Insurance Program
On 21 June, the House Financial Services Committee passed five legislative proposals regarding the reauthorization of the National Flood Insurance Program (“NFIP”). The Committee passed: (i) the National Flood Insurance Program Administrative Reform Act of 2017 (H.R. 2875) by a vote of 58-0; (ii) Repeatedly Flooded Communities Preparation Act (H.R.1558) by a voice vote; (iii) Flood Insurance Market Parity and Modernization Act (H.R.1422) by a vote of 58-0; (iv) the Taxpayer Exposure Mitigation Act of 2017 (H.R. 2246) by a vote of 36-24; and (v) an act to “require the use of replacement cost value in determining the premium rates for flood insurance coverage under the National
Flood Insurance Act” (H.R. 2565) by 34-25.
o National Flood Insurance Program Administrative Reform Act of 2017: As the bill’s section-by-section summary explains, it would, among other things: (i) “authorize the [Federal Emergency Management Agency (“FEMA”)] Administrator to create a pilot NFIP program to authorize Write Your Own (‘WYO’) insurance companies to inspect pre-existing structural conditions of insured and pre-insured properties that could result in a denial of a flood insurance claim”; (ii) “require the FEMA Administrator to prohibit false or fraudulent statements connected to the preparation, production, or submission of claims adjustment or engineering reports”; (iii) “provide the FEMA Administrator with additional authorities and responsibilities for overseeing litigation conducted by WYO insurance companies acting on behalf of the NFIP”; and (iv) “create a new Technical Insurance Advisory Council consisting of federal, state, and local experts to review the NFIP’s insurance practices and propose new standards to FEMA.”
o Repeatedly Flooded Communities Preparation Act: According to the bill’s section-by-section summary, it would, among other things: (i) “require any covered flood prone areas to develop a community-specific plan for mitigating continuing flood risks if they have 50 or more repetitive loss structures or 5 or more severe repetitive loss structures”; and (ii) require the FEMA Administrator to “submit a report to Congress regarding the progress of implementation plans developed pursuant to this bill” within six years of the enactment of the bill, and every two years thereafter.
o Flood Insurance Market Parity and Modernization Act: According to the bill’s section-by-section summary, it would, among other things: (i) clarify that “flood insurance provided by private sector insurance carriers shall be accepted and considered similar to those polices offered by the NFIP” so as to satisfy the mandatory purchase requirement; and (ii) require FEMA to consider “any period during which a property was continuously covered by private flood insurance to be a period of continuous coverage.”
o Taxpayer Exposure Mitigation Act of 2017: According to the bill’s section-by-section summary, it would, among other things: (i) “eliminate the NFIP’s mandatory [flood insurance] purchase requirement for all commercial properties, while preserving the eligibility of commercial properties voluntarily to purchase NFIP coverage if they so choose”; and (ii) require FEMA to annually transfer a “portion of the risk of the NFIP to the private reinsurance or capital markets . . . in an amount that” both is sufficient enough to enable the program to pay claims and “manages and limits the annual exposure of the NFIP to flood losses in accordance with the probable maximum loss target established each such year.”
o Use of Replacement Cost in Determining Premium Rates Act: According to the bill’s section-by-section summary, it would, among other things, require FEMA to “conduct a study to evaluate insurance industry best practices for risk rating and classification, including practices related to replacement cost value in premium rate estimations and developing a feasible implementation plan and projected timeline for including replacement cost value in the estimates of risk premium rates for flood insurance made available under the NFIP.”
SEC & SECURITIES
SEC’s Response to MiFID II’s Potential Impact
On 16 June, Sen. Thom Tillis (R-NC) sent a letter to SEC Chairman Jay Clayton raising concerns regarding the “conflicts between U.S. regulation and the obligations to unbundle or otherwise identify separate charges for research” under MiFID II, which is scheduled to go into effect on 3 January 2018. Noting that “absent some regulatory relief from either the EU or U.S., conflicts between the two regulatory regimes will arise,” Sen. Tillis requested that the SEC provide information regarding: (i) steps the SEC has taken to “evaluate the potential impacts of MiFID II”; (ii) whether the SEC is considering “regulatory relief for U.S. broker-dealers that would be forced to receive ‘hard dollar’ payments for research as a result of MiFID II”; (iii) whether the SEC has considered issuing “guidance or no-action relief as it relates to U.S. broker-dealers’ receipt of unbundled payments for research”; (iv) the impact MiFID II would have over “analyst coverage of smaller and mid-cap companies”; and (v) whether the SEC believes that “MiFID II presents a competitive advantage to the EU.”
SEC Investor Advisory Committee Meeting
On 22 June, the SEC’s Investor Advisory Committee held a meeting to discuss capital formation, IPOs, and certain provisions of the Financial CHOICE Act related to the SEC. In remarks to the Committee, SEC Chairman Jay Clayton expressed “great concern” for the recent decline in U.S. IPOs, and remarked that “we have to look at our mission in light of a changed market and see what adjustments need to be made.” Clayton did not discuss any particular plans, but said that the SEC is looking at ways to “improve the attractiveness of listing on public markets, while maintaining important investor protections.”
- Capital Formation and IPOs: Jackie Kelley, E&Y Americas IPO Markets Leader, provided for discussion an E&Y study published in May 2017 on the declining numbers of public companies in the U.S. capital markets. Professor of Finance at Brigham Young University Jim Brau provided for discussion his responses to SEC questions on U.S. IPO market trends and the impact regulation has had on IPOs. Jeffery Solomon, President of Cowen Inc., provided for discussion a presentation on the decline of IPOs in the U.S., in particular with regards to small and mid-sized companies. Associate Professor at Duke University School of Law Elisabeth Fontenay provided for discussion her article titled “The Deregulation of Private Capital and the Decline of the Public Company.” Managing Partner at Andreesen Horowitz Scott Kupor provided written testimony on the trends relating to IPOs and capital formation.
- Financial CHOICE Act Provisions: As SIFMA reports, Distinguished Professor at the University of Virginia School of Law Paul Mahoney indicated that the Financial CHOICE Act would benefit the U.S capital markets and promote capital formation. Executive Director of the North American Administrators Association Joseph Brady expressed his support for Section 391 of the Financial CHOICE Act, which requires agencies to implement policies and procedures to: (i) “minimize duplication of efforts [in] administrative or judicial actions”; (ii) determine when “joint . . . actions or the coordination of law enforcement activities are necessary and appropriate and in the public interest”; and (iii) for joint actions, “establish a lead agency to avoid duplication of efforts and unnecessary burdens and to ensure consistent enforcement.” Professor of Law at Columbia Law School John Coffee Jr. provided a statement on several SEC-related provisions of the CHOICE Act. He called the CHOICE Act an “adverse omen for the future of administrative enforcement” and argued that “SEC enforcement is under legal and political attack.”
Whistleblower Protection – Supreme Court
On 26 June, the Supreme Court announced that it would hear the appeal in Digital Realty Trust, Inc. v. Paul Somers, which asks whether the SEC’s anti-retaliation provisions cover a whistleblower who reports alleged violations internally within a company but not to the SEC. The Court of Appeals for the Ninth District held in Digital Realty that such persons are protected by the anti-relation provisions because “[i]n view of the language of the text, and the overall operation of the statute . . . the SEC regulation correctly reflects congressional intent to provide protection for those who make internal disclosures as well as for those who make disclosures to the SEC.” The circuits are currently split, with the Ninth Circuit in Digital Realty and Second Circuit in Berman v. Neo@Ogilvy LLC holding that such persons are protected, and the Fifth Circuit in Asadi v. G.E. Energy United States, LLC holding that such persons are not.
Office of the Investor Advocate Annual Report
On 29 June, the SEC Office of the Investor Advocate filed its annual report for FY 2018. The Office stated that it “will focus on the following issues during FY 2018: Public Company Disclosure, Equity Market Structure, Municipal Market Reform, Accounting and Auditing, [and] Fiduciary Duty.” With respect to equity market structure, the Office said it would “encourage the Commission” to proceed with the SEC’s July 2016 proposal to enhance Rule 606 on order routing, as well as to “formally propose a pilot program” for access fee caps under Rule 610. With respect to the DOL’s fiduciary duty rule, the Office stated that “[w]hile we believe that a bona fide fiduciary duty for broker-dealers would benefit investors, we are concerned that the conflicting mandates could lead to harmful outcomes for investors in at least two ways.” According to the Office, the rule “could dilute the existing standard for investment advisers in a misguided attempt to adopt a ‘harmonized’ standard for broker-dealers,” and the rule “could cause even greater confusion by purporting to give investors the protection of a ‘fiduciary duty’ that would, in fact, be less stringent than the traditional fiduciary duty.” The Office said it “will continue to monitor the developments with the [DOL]’s fiduciary rule and consider its impact on investors.”
CFTC & DERIVATIVES
Nomination of Acting Chairman Giancarlo as CFTC Chairman
On 29 June, the Senate Committee on Agriculture, Nutrition, and Forestry voted 16-5 in favor of the nomination of CFTC Acting Chairman Giancarlo as CFTC Chairman. The nomination will now go to the Senate floor for a final vote, which has not yet been scheduled. The vote follows the Senate Committee’s 22 June 2017 hearing on Mr. Giancarlo’s nomination, in which, as SIFMA reports, Acting Chairman Giancarlo stated that: (i) he is committed to completing the CFTC’s reproposed position limits rule without further delay; (ii) cybersecurity will be a top priority for the CFTC; and (iii) the CFTC currently lacks the analytical capacity to determine the severity of any harm potentially caused by high-frequency trading, but hopes his request for additional staff will allow the CFTC to produce data-driven analyses to inform policy decisions.
CFTC Market Risk Advisory Committee Meeting
On 20 June, the CFTC Market Risk Advisory Committee held a meeting to discuss: (i) “risk surveillance activities of CFTC’s Division of Clearing and Risk”; (ii) “an economic perspective on the clearing regulatory framework”; and (iii) “Brexit’s effects on markets.” In his opening statement, Acting Chairman Giancarlo addressed issues regarding the supplemental leverage ratio (“SLR”) as it relates to central counterparties (“CCPs”), although the topic was not on the agenda. He also clarified that “whatever the outcome of the Brexit negotiations and the EU’s internal discussions about how to supervise CCPs, we do not contemplate any change to the CFTC-EC Equivalence Agreement.”
- Risk Surveillance Activities of CFTC’s Division of Clearing and Risk: Acting Associate Director of the Division of Clearing and Risk Glenn Schmeltz described the Division’s approach to market surveillance and discussed the responsibilities and structure of the Division’s Risk Surveillance Branch. The participants also discussed issues relating to: (i) information sharing between regulators; (ii) oversight of the clearinghouse margin models; and (iii) expectations related to clearing member liquidation models and back-testing performed by CCPs.
- Economic perspective on the clearing regulatory framework: Chief Economist from the Office of the Chief Economist Sayee Srinivasan discussed research regarding policy proposals for CCP “skin-in-the-game” requirements and noted that while there has been a significant amount of research in this area, he has not encountered research that addresses this topic in “a systematic manner,” and that what could constitute an appropriate “objective measure of resilience” (such as a particular capital ratio metric) remains unclear. Economist Richard Haynes, from the Office of the Chief Economist, argued that academic literature tends to be “one-sided” such that it fails to appropriately consider trade-offs between safety-and-soundness and market access. The participants also discussed issues relating to: (i) CCP capital requirements; (ii) whether regulators can retain the benefits of the clearing systems while lowering the liquidity requirements for market participants; (iii) whether resolution authority and bankruptcy provisions provide any additional benefits to CCPs beyond the CCPs’ own resilience and recovery tools; and (iv) the “robustness” of assessment powers, such as variation margin haircutting, partial tear-ups, and initial margin haircutting.
- Brexit’s effects on markets: The participants discussed issues relating to four topics: (i) “whether the markets have accurately accounted for the risks posed by Brexit,” with most participants agreeing that the market has adequately accounted for such risks; (ii) what would be the effects of ESMA’s recent proposal to “deny third country recognition to CCPs of ‘substantial systemic importance’ unless they relocate to within the EU 27,” with participants’ greatest concerns being liquidity fragmentation, market disruption, and other potential unintended consequences; (iii) whether businesses are moving to the EU 27 or elsewhere and the challenges they face; and (iv) how “the derivatives markets will look post-Brexit.”
CFTC’s Cost-Benefit Consideration for the Margin Rule for Uncleared Swaps
On 16 June, the CFTC’s Office of the Inspector General published a report (dated 5 June 2017) evaluating the “CFTC’s cost-benefit consideration for the margin rule for uncleared swaps.” The Office of the Inspector General evaluated the CFTC’s cost-benefit analysis in the 2016 final rule and indicated that it: (i) “lacks a clear discussion of the market failure justifying regulatory intervention; (ii) “makes no attempt to discern the magnitude of the risk reduction or to quantify any costs other than the cost of maintaining margin collateral”; and (iii) fails to consider several “issues and unintended consequences that might undercut the asserted systemic risk-mitigating effects of margin.” These “issues and unintended consequences” include: (1) the “possibility that the rule will reduce market liquidity and undermine efficient risk hedging by market participants”; (2) the “procyclical effects of margin requirements and the possibility that the Margin Rule could exacerbate systemic risk in times of market stress”; (3) the “likelihood that systemic risk may be heightened by an industry-wide homogeneous approach toward risk-modeling in response to the Margin Rule’s initial margin modeling specification”; (4) the “potential behavioral responses of market participants or interaction effects with other laws and regulations” that could result in contagion and increased systemic risk; and (5) “possibility that interpretation, implementation, and enforcement of the rule may differ from what was assumed by the rulemaking team.” The report also critiques the CFTC’s data infrastructure as “inadequate, particularly with respect to the market for uncleared swaps.” The report recommends that, when providing a cost-benefit analysis, the CFTC: (i) “establish a baseline understanding of the marketplace”; (ii) “specify the market failure justifying regulatory intervention”; (iii) “consider whether the market failure stems from existing regulations”; and (iv) “apply assumptions symmetrically across policy options.” The report also recommends that the CFTC “focus resources on improving its data infrastructure, particularly with regard to uncleared swaps” to ensure that the CFTC has the data it needs to conduct its analysis.
DOL FIDUCIARY DUTY RULE
On 29 June, the DOL issued a request for information regarding the Fiduciary Duty Rule. The DOL requested public input with respect to: (i) “possible additional exemption approaches or changes to the Fiduciary Rule,” such as “build[ing] upon recent innovations” in the industry; and (ii) “the advisability of extending the January 1, 2018 applicability date of certain provisions in the Best Interest Contract Exemption” and other provisions related to certain transactions involving insurance agents and brokers, pension consultants, insurance companies, and investment company underwriters. The comment period regarding the extension of the applicability date for certain provisions will close 15 days after publication of the Request for Information in the Federal Register and the comment period regarding all other topics will close 30 days after publication.
On 27 June, the Senate Appropriations Committee’s Subcommittee on Labor, Health, and Human Services held a hearing on the DOL’s FY 2018 budget request. When questioned by Senator James Lankford about the DOL’s cooperation with the SEC on addressing issues related to the Fiduciary Duty Rule, Labor Secretary Acosta indicated that “the SEC has important expertise and that they need to be part of the conversation” and that both he and SEC Chairman Clayton have expressed a willingness to cooperate on this issue.
On 3 July, lawyers from the DOL and the Department of Justice filed a brief in Chamber of Commerce v. Dept. of Labor in the Fifth Circuit on behalf of the DOL regarding the Fiduciary Duty Rule. The brief argues that the plaintiffs’ arguments fail to effectively challenge DOL’s authority to “identify any reason why the fiduciary rule, including its associated exemptions, should be vacated in full.” The brief focuses on two exemptions related to the Fiduciary Duty Rule: (i) the Prohibited Transaction Exemption, the scope of which is narrowed by the Rule; and (ii) the Best-Interest Contract Exemption (“BICE”), which allows some products to be sold to clients on a commission, rather than fee, basis upon entering a related signed agreement. Although the 3 July brief largely supports the Fiduciary Duty Rule, it also states that the BICE’s restriction of “class-litigation waivers should be vacated insofar as it applies to arbitration clauses.”
UPCOMING EVENTS AND DEADLINES
- 13 July: FINRA Blockchain Symposium in New York City.
- 27 July: SEC 2017 National Compliance Outreach Program for Broker-Dealers.