The Dodd-Frank Act: Legislative sunshine during an economic hurricane?

It’s been said that “if a window of
opportunity appears, don’t pull down the shade” but, as the offshore industry
gazes out over yet another new statutory landscape, do we reach for the blinds
or enjoy a new ray of sunshine? Benjamin Wrench, attorney at Higgs &
Johnson in Cayman reports.

On 21 July, President Obama signed into law
the Dodd-Frank Wall Street Reform and Consumer Protection Act with the
intention of enhancing the safety and soundness of US financial markets. Most
of the Act will come into force on 21 July 2011 and is designed to strengthen
financial market infrastructure by: restricting the ability of US banks to
operate proprietary trading desks, requiring central clearing and transparency
for most “over-the-counter” derivative transactions, mandating the registration
of advisers to hedge funds and other private investment funds and regulating
credit rating agencies.  

Hedge funds

Although the Act’s so called “Volker Rule”
generally prohibits any US banking entity from sponsoring or investing in hedge
funds or private equity funds, the rule is never-the-less subject to a large
number of complex exemptions and has a lead-time of at least three years before
it comes fully into force. 

From 21 July 2010 the Act amends the
definition of “accredited investor” in regulation D of the Securities Act of
1933 by removing the net value of a primary residence from net worth
calculations: the disclosures in many private placements and subscription forms
will therefore have to be amended accordingly.  

The Act also amends the definition of
“qualified client” under the Investment Advisers Act of 1940, and as a
consequence some advisers will be prevented from charging performance
fees. 

The new swaps market

The insolvency of Lehman Brothers in 2008,
and the subsequent bailout of AIG by the US government, dramatically
illustrated the potential that OTC swaps have for creating systemic risk. The
answer from US legislators has been to insist upon centralised clearing,
real-time public reporting and the payment of initial and variation margin for
most OTC swaps. For less standard transactions there is no clearing requirement
but there must still be real-time public reporting (albeit in such a manner
that market participants can have confidence that their individual positions
remain confidential) and significant capital, in addition to margin, must be
placed with the swap dealer or major swap participant. Interestingly, from July
2012, the Act will prohibit Federal assistance to swap dealers or major swap
participants (with the exception of insured depository institutions). 

Inevitably swaps will become more
expensive, but the removal or reduction of credit counterparty risk is expected
to revive the market from its stupor.

Non-US asset managers

The Act will require non-US asset managers
to register with the SEC if they:

  • have a place of business in the US; or
  • have 15 or more clients and investors in
    the US in private funds managed by the asset manager; or
  • have assets under management from investors
    in the US of more than $25 million; or
  • hold themselves out to the US public as an
    asset manager.

Any non-US manager falling into any one of
the above categories must register with the SEC and:

  • comply with applicable SEC filings;
  • develop a compliance manual, code of
    ethics, employee investment policy (personal account dealing policy) and a
    compliance monitoring programme that meet with SEC requirements and industry
    best practices;
  • undertake an annual review and testing of
    the compliance programme; and
  • undertake annual compliance training. 

Asset managers around the globe are
questioning whether the Act applies to them and whether it represents fine
providence or a further impediment to business.

US securities

The Act requires that US listed companies
that have had to re-state their financial statements must “clawback” incentive
and bonus payments made to all executives, regardless of culpability.

hese
arbitrary clawback provisions are expected to have a real impact on corporate
America: more than 600 US public companies re-state their accounts each year.
It is worth noting that re-stating accounts is much less frequent under IFRS
than US GAAP, because an adjustment is usually made in the current year rather
than a re-statement of previous financial periods.

Onerous disclosure requirements imposed by
the Act will mean that companies engaged in extracting natural resources (such
as oil, natural gas or minerals) will be less likely to wish to list on US
exchanges.

Anti-manipulation provisions will protect
all options and non-government securities, and not just exchange traded options
and listed securities. The scope of transactions covered by these provisions is
now therefore even larger than for transactions involving market abuse of EU
securities.

Whistle-blowing bounty hunters

Under the Act, the SEC and the CFTC are to
establish and operate “bounty programs” in which whistle-blowers may be awarded
between 10 and 30 per cent of fines received by the US Government (regardless
of the citizenship of either the whistle-blower or the defendant). Recent SEC
fines have reached $800m for a single case, so there is little surprise that
the SEC are reported as expecting a “tremendous response” and have systems in
place to deal with thousands of tip-offs every year.

When combined with the SEC’s ability to
prosecute for aiding and abetting (not just under the Exchange Act but now also
under the Securities Act of 1933, the Investment Adviser’s Act of 1940 and the
Investment Company Act of 1940) whistle-blowing may become something of a sport
that has more extra-territorial influence than baseball’s World Series.

EU Alternative Investment Fund Managers
directive

Similar discussions arise from the EU’s
proposed Alternative Investment Fund Managers Directive which will restrict
trading strategies of European investment managers as well as burden custodians
with increased liabilities (thereby increasing costs significantly). 

Industry journals have recently compiled
online surveys that confidently predict that not only will Cayman be able to
meet the challenges of the Directive but that the island will have the most to
gain of all offshore financial centres.


Industry consolidation

Optimism in the face of adversity perhaps
also helps to explain the current fashion for consolidation in the asset
management industry: particularly the recently announced proposals such as
Man’s purchase of GLG, and F&C’s purchase of Thames River.

Conclusion

The above discussion is intended as
commentary on the legislative changes, from an offshore perspective, rather
than as legal advice. Professional advice is therefore critically important,
but if good fortune is the time when preparation and opportunity meet, then
those with global ambition will choose to see the light of opportunity through
a window of enhanced regulatory governance.  

Cayman can enter the next phase of the
regulatory reaction to the global credit crisis with some confidence that it
has the tools to meet the challenge: banking groups with offshore operations
may wish to restructure in the light of exemptions to the Volker rule;
executives of mining and other companies might be persuaded to list on the
Cayman Stock Exchange in preference to the regulatory burden (and personal
risk) associated with US listings; the trend for investment managers to leave
London for Geneva could stimulate growth in the use of Cayman management
companies and consolidation in the asset management industry is likely to lead
to fund restructuring work.  

As and when the SEC and other US agencies
produce regulations under the Act there will no doubt be other opportunities
for the Cayman Islands. Even in the current climate, regulatory clouds have
silver linings.

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Benjamin Wrench

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