Outline of Dodd-Frank Act and JOBS Act
Director, Office of Investor Education and Advocacy
Charlotte, North Carolina
June 9, 2012
It is a pleasure to be here today to speak to you. I appreciate the opportunity to do so. I would like to spend my time addressing two recent landmark pieces of legislation that affect the area that I and my colleagues at the SEC oversee—the financial markets. They are the Dodd-Frank Act of 2010 and the JOBS Act of 2012.
First, however, I’d like to offer you a disclaimer about my remarks today. The SEC, as a matter of policy, disclaims responsibility for any of my statements to you today. The views that I express to you today are my own, and do not necessarily represent the views of the Commission, individual Commissioners, or any other member of the staff of the Commission.
We are slowly emerging from the greatest financial crisis to hit the United States since the Great Depression. Beginning in 2008, this crisis led to the loss of millions of jobs, saw the collapse of large financial firms and forced government bailouts of other large financial firms as well as bailouts and stimulus packages for the broader economy. Two packages, one signed by President Bush in 2008 and the other by President Obama in 2009, amounted to almost $1 trillion in government stimulus.
The exact causes of the crisis and recession will be studied and argued over in the years to come, but many can agree that the crisis revealed the following:
- Many large institutional investors, such as pension funds, banks, other financial firms, hedge funds, and even sovereign investors, invested in mortgage-backed securities with little understanding or visibility into the actual risks involved.
- Many of the mortgages, particularly those labeled as sub-prime, that underpinned the mortgage-backed securities market were taken out by borrowers that could no longer meet their obligations. Some attribute this to aggressive lending practices by banks and brokers, easy credit that seemed worthwhile for borrowers to take advantage of (particularly in what seemed like an ever-rising property market) and mortgage products other than the traditional 30-year fixed rate variety (such as ARMs) that borrowers may not have or were ambivalent to fully comprehending. It may be a combination of these factors.
- Some say that the credit ratings agencies provided the stamp of approval that may have led investors in mortgage-backed securities to be too confident in their investment decisions.
- Connected with this failure in the mortgage-backed securities market was the use of credit default swaps—a type of security called a derivative. Credit default swaps essentially insures the value of an asset. Those holding CDSs tied to mortgage-backed securities suddenly found themselves with large, sometimes unmanageable, exposure, and those relying on the guarantee could no longer do so.
- Many larger financial firms proved too invested and intertwined in the nation’s financial system that the risks to the system and the general economy of their failure made government-financed bailouts seem the prudent course—the so-called “too big to fail.”
- The federal government had little intelligence on the systemic weaknesses in the financial system that precipitated the crisis.
In response to the crisis and hoping to address the gaps and flaws in the regulatory landscape revealed by the crisis, and to enhance the stability and viability of our financial system, Congress passed the Dodd-Frank Act of 2010—legislation that affects almost all aspects of the financial system, touches all financial regulatory agencies and even creates some new ones. It has been described as a sweeping overhaul of our financial system. Since passage, we at the SEC have been working hard to produce the many rulemakings and studies required under the Act that we are responsible for.
The Dodd-Frank Act of 2010
I’d now like to first give a hopefully brief overview of the Act. Then, I’d like to more specifically note a couple of Dodd-Frank mandated studies that my office is responsible for.
One item learned from the crisis is the need to better see and manage the risks in our financial system. The crisis took many in industry and government by surprise, and measures and remedies had to be quickly formulated. If many of you recall the fall of 2008, from the bankruptcy of Lehman Brothers, to the steep drop in the market indices, to the passage of the TARP program, each one a milestone, happened in the span of a handful of months.
The Act created the Financial Stability Oversight Council. This council is charged with identifying threats to the stability of the financial system, promoting market discipline and responding to emerging risks. Before this, there wasn’t a formal mechanism to bring the numerous financial regulators, such as the SEC, the Treasury, the Federal Reserve, the FDIC and the CFTC, together to discuss and share information.
Orderly Liquidation Authority
I imagine most if not all of you have heard the term “too big to fail.” The Act seeks to keep such a situation from happening again by providing orderly wind-down authority. Under the Act, the FDIC can swoop in and become a receiver for any bank or other financial institution that is failing and is determined to be systemically important. That means that if the bank or institution poses a significant risk to financial stability upon its failure (for example, by being very large), then the FDIC can take over control of the company for purposes of the liquidation. Of course, there are procedures in place for the company to challenge such action. No taxpayer funds are to be used in the company’s liquidation. Instead, should the FDIC need money to pay for the liquidation process, the FDIC can ultimately assess the larger financial companies for the additional money.
Regulation of Hedge Funds
Although not directly implicated in the recent financial crisis by many, the Dodd-Frank Act sought to more directly regulate hedge funds and other private funds, which were an opaque and little regulated area of the financial system. Large net-worth individuals and institutional investors invest a lot of money in these funds. The concern is with finding out more about the funds and how much risk these funds may pose to the financial system in the future. Previously, many funds and related investment advisers operated under an exemption from reporting to the SEC. The Act, along with rulemaking by the SEC, requires registration and regular reporting by many of these funds.
Regulation of Derivatives
Derivatives are financial instruments derived from another underlying asset, security or index. Before Dodd-Frank, the derivatives market was largely unregulated and opaque.
In terms of the crisis, many financial participants held or wrote credit default swaps—a type of derivative—that were tied to mortgage-backed securities. Once the value of mortgage-backed securities began falling as a result of increasing defaults, those that had written credit default swaps that were meant to guarantee against such defaults found themselves with increasing and, for some, unmanageable exposure. Those holding the swaps as guarantee against default could no longer rely on them.
The Dodd-Frank Act creates a new regulatory framework for derivatives. Notably, the Act requires mandatory clearing and trading of certain derivatives through regulated clearing organizations and regulated exchanges. This will hopefully contribute to a more visible and transparent marketplace. The CFTC and SEC both are involved in rulemaking for this area.
Regulation of Consumer Finance
In response to concerns about consumer financial products, in particular the residential mortgages that became the center of the financial crisis, the Dodd-Frank Act created the Consumer Financial Protection Bureau to regulate consumer financial products and services. Included is the administration of new laws that will govern the residential mortgage industry that, for example, set minimum underwriting standards and appraisal requirements.
Regulation of SEC Matters
Lastly, a portion of the Dodd-Frank Act directly addresses the SEC itself and the matters regulated by the SEC, in addition to calling for a number of studies to be undertaken. The Act creates an Office of the Investor Advocate and an Investor Advisory Committee in order to increase the influence of investors. We have just recently determined the members of the committee and the first meeting of the committee will be on June 12.
The Act also increased the SEC’s role in regulating credit rating agencies as well as increased the regulation of asset-backed securities in order to address issues that were raised by the financial crisis. Mortgage-backed securities (that proved central in the crisis) are a type of asset-backed security. One regulation requires the entity creating the security to retain an economic interest in it before transferring or selling it.
OIEA Piece of Dodd-Frank
Now that I’ve given a brief overview of the Dodd-Frank Act, and I hope you can appreciate the breadth of what the Act covers and what is required of the federal regulators, I’d like to take a quick moment to more specifically mention two Dodd-Frank mandated studies that directly involve my office.
Last year, our office finished a study of ways to improve investor access to registration information about investment advisers, broker and dealers, and related persons. Currently, such information is contained in two databases—one administered by FINRA (for brokers and dealers) and one administered by the SEC (for investment advisers).
The Act specified that the study include an analysis of the advantages and disadvantages of further centralizing access to registration information, and identify data pertinent to investors and method and format for displaying and publishing the data to enhance accessibility and utility.
Our study made the following recommendations:
- Unify FINRA’s BrokerCheck and the SEC’s Investment Adviser Public Disclosure database search results, allowing investors to find registration information on both broker-dealers and investment advisers, regardless of whether investors are using BrokerCheck or IAPD.
- Add a ZIP code search function to both databases so that investors beginning to search for a broker or investment adviser can take advantage of the information in the databases.
- Add educational content to assist investors in using BrokerCheck and IAPD by, for example, providing definitions or other explanatory content to help a user better understand the significance of a particular technical term or reference.
The second study—mandated by Dodd-Frank and spearheaded by our office—relates to financial literacy among investors. The goal of the study is to identify:
- the existing level of financial literacy among retail investors;
- methods to improve the timing, content, and format of disclosures to investors with respect to financial intermediaries, investment products, and investment services;
- methods to increase the transparency of expenses and conflicts of interest in transactions involving investment services and products; and
- the most effective existing private and public efforts to educate investors.
The report on this study is due to Congress by July 2012 and we are hard at work on it. Unfortunately, I can’t elaborate more on this interesting study.
JOBS Act of 2012
Now I’d like to turn to the JOBS Act which was signed into law on April 5, 2012.
Unlike the Dodd-Frank Act, which generally relates to the financial system and the larger institutions in it, the JOBS Act generally seeks to support the smaller businesses in our general economy. With the economy appearing to slowly recover at the beginning of 2012, Congress saw the need to help our smaller businesses raise funds in our public capital markets. With bipartisan support, Congress passed the JOBS Act—which stands for the Jumpstart Our Business Startups Act—to lessen the regulatory requirements in accessing public capital.
The JOBS Act does a number of things. I would like to give you a quick overview on some of the items that may more directly impact you.
First, the Act revises the requirements for emerging growth companies to go public or, in other words, undertake an IPO. An IPO is subject to a number of requirements under federal securities law, including registering the offering with the SEC. The JOBS Act reduces some of these requirements for “emerging growth companies.” An “emerging growth company” is a company that has total annual gross revenue of less than $1 billion in its most recent fiscal year. This definition would actually cover a vast majority of the IPOs that have occurred and, for all practical purposes, this part of the JOBS Act should prove useful to most pre-IPO companies.
The Act reduces the requirements by:
- Allowing confidential review by SEC staff of draft registration statements prior to making the registration statement public. Before, if a company wanted to undertake an IPO, the company had to file its registration statement disclosing to the public what was once privately held information without first getting feedback from the SEC about its filing. Some companies may have considered this timing negatively when making their decision to raise public capital. Under this new allowance, if the emerging growth company decides to go forward with its IPO, it will have to file the initial confidential submission for the public to see at some point before it sells securities in its IPO.
- The Act also allows underwriters in IPOs to prepare research reports before and following the offering. The IPO ground rules before the JOBS Act included a “quiet period”—a term some of you may have heard before. The premise for a quiet period was that, in short, the first substantial information the public should hear about an offering should be in the form of a prospectus that presents all required information in a balanced manner giving the investing public an ability to make an informed investment decision. Now investors may be provided with research reports before the prospectus. One thing to keep in mind about these research reports is that they generally do not present all the information required in a prospectus. Also, the company by statute takes strict liability for what it says in a prospectus. The liability standard for a research report is less. There may also be a conflict of interest. The underwriters preparing the research report may be representing or seeking to represent the company in its IPO. You should never rely solely on a research report when deciding whether to invest. You should review the prospectus before deciding to invest.
- After the dot com bubble burst around 2003, rules were put in place creating firewalls to prevent research analysts from communicating with their own firm’s IPO bankers and their bank’s IPO clients. The concern was that during the dot com bubble many analysts were making recommendations on their firms’ IPO clients that may have been skewed toward helping the firm win IPO business. The JOBS Act eliminates these firewalls out of concern that the restrictions have limited research on IPO companies because of limited analyst access, constraining investor interest.
- In terms of disclosure, the Act provides for reduced requirements for up to five years after the IPO. Some of these disclosure changes include:
- Providing at least two years of financial information in the IPO prospectus when at least five years of financial information was previously required. This may mean that investors may not have more financial history to consider, but companies may find this revised requirement less of a burden.
- Another reduced requirement, is allowing for extended compliance periods for some new accounting standards. From time to time, new accounting standards are issued by the accounting industry’s standard-setting board that may apply just to public companies or to both public and private companies. Often private companies may get a longer period of time to comply if the new standard applies with both types of companies. The Act allows emerging growth companies to follow the private company deadline rather than the usually earlier deadline for public companies. The emerging growth company will have to disclose whether it wants to take advantage of this delay. When investing in newly public companies, you will have to keep in mind this possible difference with the financial statements. New standards can be very technical in nature or have significant ramifications to how a company reports its results.
- The Act also reduced the requirements as it relates to executive compensation disclosure. Currently, large public companies must include a compensation discussion and analysis section that’s suppose to give management a place to explain how they came to decide on the compensation of the company’s officers. In addition, under Dodd-Frank, the SEC now requires public companies to offer shareholders the ability to vote on an advisory basis on executive compensation, the so-called “say-on-pay” votes. Emerging growth companies are not required to do either of these as they transition to being public companies.
- These reduced disclosure requirements apply so long as the company is an emerging growth company. A company is no longer an emerging growth company on the earlier of: (1) the fifth anniversary of its IPO; (2) its annual revenue is $1 billion or more; (3) its public float is $700 million or more; or (4) it issues more than $1 billion in non-convertible debt in the previous three years.
These IPO changes apply immediately and are the one piece of the JOBS Act that isn’t subject to SEC rulemaking.
Another part of the JOBS Act that you may have heard about is the part that deals with crowdfunding. For those that are unfamiliar, crowdfunding is a means to raise money by enticing relatively small individual contributions from a large number of people. The Internet and social media has made crowdfunding possible and, in the last few years, a number of crowdfunding websites have proliferated. The websites range from seeking small donations for charitable to artistic endeavors to contributions to help launch a business in return for the product being made or a thank-you item, like a T-shirt.
The one thing that crowdfunding could not do as a result of restrictions under the federal securities law was to offer an ownership interest, or a share in the profits of the business or venture, in other words a security. The JOBS Act creates a special exemption for crowdfunding so that companies can sell securities by way of crowdfunding.
Generally, under the Act, companies will be limited to raising $1 million in any 12-month period using crowdfunding. Companies cannot crowdfund on their own, but will have to engage an intermediary that’s registered with the SEC as a broker or funding portal. These intermediaries will be required to do some vetting of the company seeking funding.
Individual investors will be limited in the amount they can invest by way of crowdfunding in any 12-month period to:
- if your annual income or net worth is less than $100,000 – the greater of $2,000 or 5 percent of annual income or net worth, or
- if your annual income or net worth is more than $100,000 – 10 percent of annual income or net worth up to a maximum of $100,000.
When calculating net worth, you should not count the value of your primary residence or any loans secured by the residence (up to the value of the residence).
The SEC must first write rules that govern how companies can use crowdfunding to raise money from investors and set out the responsibilities of intermediaries. These rules will include what must be disclosed to prospective investors before they decide to participate. As a result, companies cannot use crowdfunding to raise funds from investors until the SEC issues these rules. Obviously, you should be wary of any crowdfunding investment opportunities that are offered before these rules are in place. Once the rules are in place, my office will be issuing an Investor Bulletin that will highlight aspects of crowdfunding investing that you should keep in mind when deciding whether to invest or not. The SEC is required under the JOBS Act to have rules in place by the end of the year.
A lot has been written about the possibility of fraud with this new crowdfunding exemption. Our office plans to be diligent in watching this area once crowdfunding gets underway.
Rule 506 General Solicitation
Now, I’d like to highlight one last part of the JOBS Act that may directly change your investing landscape, particularly if you are an accredited investor. Currently under the federal securities law, certain exemptions exist for companies to sell securities to investors without having to register with the SEC, such as what’s required in the case of an IPO.
A frequently used exemption is what’s called a Rule 506 exemption. Many start-ups, such as those in Silicon Valley, use this exemption to raise money from investors, like venture capital firms. The two principal limitations for using the exemption are that the offering be principally limited to accredited investors and that there is no general solicitation.
First, the restriction on general solicitation means that the company can’t advertise the offering, such as on TV or in a print publication. Otherwise, this would be a public offering and registration would be required. The other limitation is that it mostly be for accredited investors. The exemption does allow for a limited number of non-accredited investors. From the standpoint of individual investors, accredited investors in short are high income or net worth individuals. The premise for the exemption is that these investors are capable of fending for themselves—principally because of their presumed ability to bear the loss or otherwise understand the risks involved—and do not need all the protections of the federal securities laws that would be afforded in a registered offering.
An accredited investor, in the context of an individual investor, is a person:
- who has a net worth over $1 million, either alone or together with a spouse, or
- who’s income exceeded $200,000 (or $300,000 together with a spouse) in the prior two years, and reasonably expects the same for the current year.
When calculating net worth, you should not count the value of your primary residence or any loans secured by the residence (up to the value of the residence). This exclusion of primary residence was a change made by the Dodd-Frank Act. Otherwise, the definition hasn’t changed since it was conceived in 1982 and $200,000 in income is still a lot today but was more so 30 years ago. Under Dodd-Frank, the SEC can revisit the definition every four years and make changes.
These limitations, for all practical purposes, limited the pool of investors in any particular company’s exempt offering.
Now, under the JOBS Act, companies can conduct general solicitation and advertising for a Rule 506 offering. This means that you may see a TV or newspaper advertisement to buy the common or preferred stock of a private company. You may also see a proliferation of websites that, similar to crowdfunding, offer a platform for companies to raise money with a Rule 506 offering online. However, only accredited investors may participate in these offerings that take advantage of general solicitation. This is unlike the existing exemption which allows for up to 35 non-accredited investors.
If you are an accredited investor and find yourself interested in investing in a private company, you should bear in mind the reasons that such offerings are limited from the public. These offerings are not for everyone and carry a very high degree of risk. For every successful venture, there are more numerous failed ventures.
You will not be seeing such advertising immediately as this area is again contingent on SEC rulemaking. The SEC is required under the JOBS Act to have rules in place by around the Fourth of July.
Once the rules are in place, our office intends to put out a bulletin that generally informs you about some of these private offerings.