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Financial Reform Bill Strengthens PCAOB

June 28, 2010

In the aftermath of the Supreme Court’s decision on the constitutionality of the Public Company Accounting Oversight Board, a new report notes that the authority of the PCAOB would be strengthened under the financial reform bill currently pending in the Senate.

In a 5-4 decision Monday, the Supreme Court ruled that the process under which PCAOB board members can be removed by the Securities and Exchange Commission is unconstitutional as it violates the separation of powers doctrine in the Constitution (see Supreme Court Rules Against PCAOB).

However, the court severed that provision from the rest of the Sarbanes-Oxley Act, preserving the act as a whole. Instead of PCAOB board members being removable only for cause, they can now be removed at will by the Securities and Exchange Commission.

The financial regulatory reform bill is now known as the Dodd-Frank Act, named after the two lawmakers who steered the legislation through the House and Senate and presided over the conference committee deliberations, Senate Banking Committee Chairman Christopher Dodd, D-Conn., and House Financial Services Committee Chairman Barney Frank, D-Mass. The conference committee finalized its work on the bill last Friday (see Conference Committee Finalizes Financial Reform).

That was just in time to give the PCAOB a bit of a helping hand as it faced its long-awaited decision from the Supreme Court. The legislation, which emerged in the wake of the Madoff fraud, revealed that the PCAOB lacked the powers it needed to examine the auditors of broker-dealers like Bernard L. Madoff Investment Securities’s tiny auditing firm, Friehling & Horowitz. The legislation will bring broker-dealers under the PCAOB oversight regime.

Both houses of Congress still have to vote on the legislation, and that is expected to occur this week. President Obama is expected to have the legislation to sign by Independence Day.

“Once the legislation is signed, that still really is just the beginning,” said Wolters Kluwer Law & Business principal federal securities law analyst Jim Hamilton in a press release. “Many of the provisions require the adoption of new regulations to fill in the detail of the legislative framework and create a mosaic of complete financial regulatory reform.’’

Wolters Kluwer provides a handy sketch of some of the key provisions in the historic reform bill:

Creation of Systemic Risk Regulator: The legislation would enact an early warning system by creating a regulator to police systemically important firms.

Establish new Financial Stability Oversight Council: This council, chaired by the Treasury Secretary and comprised of key regulators such as the Fed, SEC and CFTC, would monitor emerging risks to U.S. financial stability, recommend heightened prudential standards for large, interconnected financial companies and require nonbank financial companies to heightened supervision by the Federal Reserve if their failure would pose a risk to U.S. financial stability.

New Office of Financial Research: The legislation establishes an executive agency to collect and standardize data on financial firms and their activities to aid and support the work of the federal financial regulators with the data and analytic tools needed to prevent and contain future financial crises by developing tools for measuring and monitoring systemic risk.

Regulation of Derivatives: The legislation would mandate, for the first time, the federal regulation of derivatives under a dual SEC-CFTC regime that emphasize transparency. The CFTC would regulate swaps and the SEC would regulate security-based swaps. The Act requires central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared.

Investment Protections for Consumers and Investors:

This includes:

•    Financial literacy: The legislation requires the SEC to conduct a financial literacy study and develop an investor financial literacy strategy intended to bring about positive behavioral change among investors

•    Creation of the Investor Advocate: The legislation strengthens the ability of the SEC to better represent the interests of retail investors by creating an Investor Advocate tasked with assisting retail investors to resolve significant problems with the SEC or the self-regulatory organizations.

•    Greater disclosure to retail investors: The legislation requires disclosures to retail investors prior to the sale of financial products and services. This provision will ensure that investors have the relevant and useful information they need when making decisions that determine their future financial condition.

•    More protection for underserved investors: The legislation intends to increase access to mainstream financial institutions for the unbanked and the underbanked.

Reform of Securitization: The legislation requires companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell toxic securities to investors, because they have to keep some of it for themselves.

Resolution Authority: The legislation’s new orderly liquidation authority would allow the FDIC to safely unwind a failing nonbank financial firms or bank holding companies, an option that was not available during the financial crisis.

Corporate Governance: The legislation gives shareholders a say on pay and proxy access, ensures the independence of compensation committees, and requires companies to set clawback policies to take back executive compensation based on inaccurate financial statements as important steps in helping shift management’s focus from short-term profits to long-term growth and stability.

Hedging Rules: The SEC is directed to adopt rules requiring a company to disclose whether any employee or director is permitted to purchase financial instruments designed to hedge the market value of equity securities granted to the employee or director as part of their compensation.

Executive Compensation Disclosure: The SEC is required to amend Item 402 of Regulation S-K to mandate disclosure of the median of the annual total compensation of all employees, except the CEO; the annual total compensation of the CEO; and the ratio of the two.

Voting by Brokers: Exchange rules must prohibit members that are not beneficial owners of a security from granting a proxy to vote the security in connection with a shareholder vote for the election of directors or executive compensation.

Hedge Fund and Private Equity Fund Advisers: Hedge funds and private equity funds will have to register with the SEC and be subject to heightened disclosure.

Federal-State Regulation of Advisers: The legislation raises the asset threshold above which investment advisers must register with the SEC from the $25,000,000 set in 1996 by the National Securities Markets Improvement Act to $100,000,000.

Added Credit Rating Agencies Oversight: The SEC will have a new office of credit ratings to regulate and promote accuracy in ratings, staffed with experts in structured, corporate and municipal debt finance. The legislation imposes tough new requirements on credit rating agencies. Rating agency boards are subject to new independence rules and rating analysts must be separated from those who sell the firm’s services.

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