On October 6, 2017, the US Department of the Treasury released a 220-page report on reforming the US regulatory system for the capital markets (Capital Markets Report).1 The Capital Markets Report includes 91 recommendations directed at financial regulators and Congress, but with a focus on the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
The Capital Markets Report represents the Administration's first formal and most detailed statement regarding capital markets reform. Many of the specific recommendations in the Capital Markets Report are not new. We have seen versions of these recommendations before—most recently as part of the Financial Choice Act of 2017 that the House of Representatives passed on June 8, 2017.2 The recommendations align with the direction of the Choice Act and the sentiment regarding capital markets reform expressed by many Republicans in Congress. Interestingly, the Chairs of the SEC and CFTC have issued statements reflecting that their agencies worked with the Treasury Department in preparing the Capital Markets Report and are largely in support of the recommendations.3 Although it is expected that Democrats in Congress, investor advocacy groups and some institutional investors will call into question certain of the recommendations proposed in the Capital Markets Report, the broadening support for a defined set of capital markets reforms makes movement in many of these areas more likely than ever before. One of the biggest challenges facing movement on these recommendations will be whether and how quickly the SEC and CFTC will be able to advance regulatory changes in support of the recommendations.
The Capital Markets Report is the second report in a series of four reports on financial regulation that the Treasury Department is delivering in response to the President's executive order on Core Principles.4 The first report,5 issued on June 12, 2017, focused on depository institutions, savings associations, and credit unions (Banking Report). In the coming months, the Treasury Department is expected to issue reports on (a) the asset management and insurance industries, including retail and institutional investment products and vehicles, and (b) nonbank financial institutions, financial technology, and financial innovation.
The Capital Markets Report
The Capital Markets Report provides an overview of the regulatory landscape in the following areas: access to capital, equity market structure, the Treasury market, corporate bond liquidity, securitization, derivatives, financial market utilities, regulatory structure and process, and international aspects of capital markets regulation. The 91 recommendations in the Capital Markets Report are organized in the following categories:
- Promoting access to capital for all types of companies, including small and growing businesses, through reduction of regulatory burden and improved market access to investment opportunities;
- Fostering robust secondary markets in equity and debt;
- Appropriately tailoring regulations on securitized products to encourage lending and risk transfer;
- Recalibrating derivatives regulation to promote market efficiency and effective risk mitigation;
- Ensuring proper risk management for central counterparties and other financial market utilities because of the critical role they play in the financial system;
- Rationalizing and modernizing the US capital markets regulatory structure and processes; and
- Advancing US interests by promoting a level playing field internationally.
Reducing Public Company Obligations
For public companies and companies considering an IPO, included are familiar recommendations to (a) repeal Dodd-Frank Act rulemaking mandates directed to the SEC related to conflict minerals, resource extraction payments, mine safety and pay ratio disclosures, (b) reform the shareholder proposal process to make it harder for shareholders to submit proposals to be voted on at annual shareholder meetings and (c) review the role and regulation of proxy advisory firms. The Capital Markets Report also recommends that the regulatory flexibility provided to newly public companies and smaller already reporting companies be extended, including by broadening the eligibility requirements for the scaled disclosure and reporting requirements applicable to smaller reporting companies from $75 million public float cap to a $250 million public float cap. The Capital Markets Report encourages the SEC to move forward on the various rule proposals and reports it has prepared related to its project to revise and reform its disclosure rules to make public company disclosures more effective. The Capital Markets Report also recommends that state governments and the SEC investigate ways to reduce the costs of securities litigation, including through the use of arbitration.
Promoting Capital Formation
In the capital formation area, a series of recommendations focuses on revising the recent SEC rules related to the crowdfunding and Regulation A+ private offering exemptions, including increasing caps on the amount of capital that can be raised. Additionally, the Capital Markets Report recommends that the SEC review the definition of "accredited investor" with the goal of expanding the pool of eligible investors able to invest in private placements, as well as the ways in which private offering rules may unnecessarily restrict unaccredited investors from participating in private placements. Treasury also recommends that the SEC and FINRA undertake a holistic review of the rules related to research analysts.
In the public funds area, the recommendations focus on encouraging investments from certain registered funds into generally less liquid, small public and private companies. This would be achieved by the review of interval fund rules to determine whether or not more flexible provisions might make such investments more feasible and appealing.
Reassessing Market Structure
In the equity market structure area, the recommendations focus on secondary market activity and how the current equity market structure is not serving the interests of less liquid companies, which are often the smaller and "newer" companies, and, some believe, has contributed to the decline in the number of IPOs. The challenges faced by these companies and how the current rules can be tailored to less liquid companies have been the focus of discussions that Congress, market participants and others have been having with the SEC over the last few years. The recommendations in the Capital Markets Report include asking the SEC to (a) consider amending Regulation NMS to allow issuers of less liquid stocks to elect to have their securities trade on a limited number of trading venues in an effort to consolidate trading activity, (b) evaluate allowing issuers to determine the tick size for trading of their securities across all exchanges, (c) propose rules to mitigate the potential conflicts of interest that arise due to maker-taker and payment for order flow compensation arrangements and (d) amend the Order Protection Rule to give protected quote status only to those national securities exchanges that offer meaningful liquidity and opportunities for price improvement.
In the Treasury market, the recommendations focus on closing the gaps in trading and market data available to the Treasury Department and other regulators in an effort to strengthen rule changes relating to reporting of certain transactions in Treasury securities. These rules were implemented by the SEC and FINRA following the high volatility experienced in the US Treasury market on October 15, 2014.6
Addressing the Impact of Prudential Regulation on Markets
One of the interesting aspects of the Capital Markets Report is the discussion of the impact of post-financial crisis capital and liquidity and other prudential requirements imposed on banking organizations on capital markets. These enhanced prudential standards, which were intended to align incentives at banking organizations with safe and sound business practices, are now areas that Treasury suggests may need to be reformed in order to alleviate certain adverse consequences for the financial markets. For example, in line with the Banking Report, the Capital Markets Report suggests that the banking regulators should review the impact of the Supplemental Leverage Ratio (SLR) and the enhanced Supplemental Leverage Ratio on secured repo funding. Similarly, both the Banking Report and the Capital Markets Report suggest that the market-making restrictions in the Volcker Rule are reducing liquidity in the secondary markets. The Capital Markets Report also reiterates the recommendation from the Banking Report calling for the deduction of initial margin for centrally cleared derivatives from the SLR denominator, and generally recommends banking regulators calibrate the capital and liquidity rules in light of the impact of those rules on incentives to centrally clear derivatives.
Resetting Regulation in the Securitization Market
In the securitization markets, Treasury found that the post-crisis reforms have gone too far in penalizing securitizations relative to other funding sources. A number of the recommendations are aimed at achieving a more neutral treatment of funding through securitizations, so that securities issued through such structures are subject to a treatment similar to corporate securities with similar risk profiles. As such, a number of the recommendations relate to bank regulatory capital and liquidity requirements. Recommendations in this area are aimed at revising portions of the capital rules that are viewed as being unduly punitive to securitizations and to adjust the capital requirements based on the retained exposure rather than the amount that is consolidated for accounting purposes. Additionally, the Capital Markets Report recommends that senior securitized bonds with a proven track record should be treated similarly to corporate debt for purposes of the liquidity requirements.
The Treasury Department also recommends a more nuanced risk retention regime, including expanding the qualifying exemptions from risk retention based on the specifics of each asset class and the relevant underwriting and documentation criteria. In particular for collateralized loan obligations (CLOs), the recommendations include a proposal to create a set of loan-specific requirements that would enable CLO managers to be relieved of the risk retention requirement. The Capital Markets Report also recommends a review of the five-year holding period applicable to third-party purchasers and sponsors to determine whether the emergence period for underwriting-related losses could warrant a shorter holding period. The Capital Markets Report highlights the challenge of coordination among all the agencies responsible for the risk retention rules and recommends the designation of a single lead agency to be responsible for issuing interpretive guidance and exemptive relief.
On securitization offerings, the Capital Markets Report recommends changes to the SEC rule governing the offering process, disclosure and reporting for registered offerings of asset-backed securities, in the form of a reduced number of mandatory reporting fields, more standardization in the reporting in the remaining fields and, with this standardization, a reconsideration of the mandatory three-day waiting period. The Capital Markets Report also recommends that the SEC indicate that it will not extend the disclosure and registration requirements in the SEC rule to additional asset classes or to unregistered transactions.7
Recalibrating Derivatives Regulation
In the derivatives area, the recommendations focus on a number of concerns identified by market participants, but do not propose major changes in the overall post-Dodd-Frank Act derivatives regulatory structure. The Capital Markets Report recommends that margin requirements for uncleared swaps be relaxed in certain respects, including to provide an exemption from initial margin requirements for transactions between affiliates of a bank or bank holding company, to reduce the size of initial margin requirements for certain products and to provide more flexibility as to the timing of margin requirements. The Capital Markets Report also recommends greater harmonization of derivatives regulatory requirements between the CFTC and SEC (and completion of the SEC's derivatives rulemakings) and between the US regulators and those of other jurisdictions, with greater scope for substituted compliance and similar approaches. As discussed above, the Capital Markets Report recommends changes to capital requirements for cleared transactions to facilitate clearing of derivatives. The Capital Markets Report suggests that the CFTC reevaluate its requirements for trading derivatives on swap execution facilities to provide greater flexibility as to means of execution and to avoid market fragmentation. The Capital Markets Report would maintain the current exemption level from swap dealer registration, and would give the CFTC and SEC greater authority to exempt parties from Dodd-Frank requirements.
Strengthening Oversight of Financial Market Utilities
The Capital Markets Report calls for increased involvement of the Federal Reserve and other regulators in the oversight of systemically important financial market utilities (SIFMUs) (central counterparties, central securities depositories and payment and settlement systems). The Capital Markets Report recommends that supervision of SIFMUs be enhanced and suggests that the Federal Reserve should consider expanding deposit account access for SIFMUs at the Federal Reserve in order to address risks to US financial stability created by central clearing.
Rationalizing the Regulatory Structure
The Capital Markets Report makes a number of recommendations relating to regulatory process and policy decision making at the SEC and the CFTC. The Capital Market Report recommends, among other things, that the SEC and CFTC be guided by the Core Principles and other Presidential Executive Orders in rulemaking activity, enhance the use of cost-benefit analysis in rulemaking (including with respect to rules of the self-regulatory organizations (SROs) they oversee) and moderate the use of staff guidance and other mechanisms that do not follow the notice and comment process employed in rulemaking. The Capital Markets Report also recommends that the SEC and CFTC conduct comprehensive reviews of the roles, responsibilities and capabilities of SROs in order to evaluate and improve the SRO framework, including with respect to regulatory, surveillance and enforcement responsibilities delegated to SROs.
Finally, the Capital Markets Report recommends that federal and state financial regulators and self-regulatory organizations should work together to centralize reporting of persons that have been subject to adjudicated disciplinary proceedings and/or criminal convictions in a format that can be easily accessed and used by the investing public.
What Is Next?
The Treasury Department's recommendations rests almost entirely outside its scope of authority, so action by the SEC, the CFTC and, to a lesser extent, the other financial regulators will dictate whether these recommendations serve as a blueprint for financial regulatory change or serve as just another list of possible reforms.
1 The U.S. Department of the Treasury published its report, entitled "A Financial System That Creates Economic Opportunities – Capital Markets" on October 6, 2017, available at https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf. Along with the Capital Markets Report, the Treasury Department posted a five-page fact sheet, available at https://www.treasury.gov/press-center/press-releases/Documents/2017-044856_CAPITALMRKTS_factsheet_v1%20FINAL-FINAL.pdf .
2 See Financial Choice Act of 2017, available at https://www.congress.gov/bill/115th-congress/house-bill/10. For an overview of the Financial Choice Act of 2017, you may wish to refer to our client publication "CHOICE Act 2.0 Passes the House: What is the 'CHOICE'?" available at http://www.shearman.com/en/newsinsights/publications/2017/07/choice-act-2-passes-the-house-what-is-the-choice.
3 See "U.S. Treasury Outlines Sweeping Reform of Capital Markets," Reuters, October 6, 2017, available at https://www.reuters.com/article/us-usa-treasury-regulations/u-s-treasury-outlines-sweeping-reform-of-capital-markets-idUSKBN1CB1RD.
4 Presidential Executive Order on Core Principles for Regulating the United States Financial System, available at https://www.whitehouse.gov/the-press-office/2017/02/03/presidential-executive-order-core-principles-regulating-united-states. For an overview of President Trump's executive order on financial regulation, you may wish to refer to our client publication: "An Annotated Guide to Trump's Executive Order on Financial Regulatory Reform," available at http://www.shearman.com/en/newsinsights/publications/2017/02/guide-to-trump-order-on-financial-reg-reform.
5 The U.S. Department of the Treasury published its report, entitled "A Financial System That Creates Economic Opportunities – Banks and Credit Unions" on June 17, 2017, available at https://www.treasury.gov/press-center/press-releases/Documents/A%20Financial%20System.pdf.
6 See U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, and U.S. Commodity Futures Trading Commission, Joint Staff Report: The U.S. Treasury Market on October 15, 2014 (July 13, 2015), available at: https://www.treasury.gov/press-center/press-releases/Documents/Joint_Staff_Report_Treasury_10-15-2015.pdf.
7 See Asset-Backed Securities Disclosure and Registration, available at https://www.sec.gov/rules/final/2014/33-9638.pdf. The SEC rule adopted significant revisions to the disclosure and other requirements related to the prospectuses used in public offerings for, and ongoing reporting of, asset-backed securities backed by real estate assets, auto-related assets or by debt securities. The SEC rule left open, and subject to further rulemaking, applying certain of the disclosure requirements to other asset classes, such as equipment loans, student loans and floorplan financings. It also left open whether the SEC would apply similar disclosure requirements in private placements of asset-backed securities.
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