While the regulation of the over-the-counter derivatives market required by the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act" or the Act, P.L. 111-203 (21 July, 2010)) has received a great deal of attention, other less-discussed provisions of the legislation impose additional restrictions on the treatment of derivatives as extensions of credit by banks where the bank is subject to counterparty credit risk.

When effective, these changes will likely require significant revisions to banking organisations' risk management systems for derivatives in particular, and credit exposures generally, and might result in a decrease in derivative volumes over time.

Banks in the US historically have been subject to limits on their total loans to a single borrower. Swaps and similar derivatives have not been included in the single-borrower lending limit for national banks. The Act amends the lending limit for national banks to include:

This provision is effective one year after the "transfer date", which is 21 July 2011 (one year after enactment of Dodd-Frank) or a later date, up to six months later, to the extent that the Secretary of the Treasury grants additional time to transfer the Office of Thrift Supervision into the OCC (the "Transfer Date"). There are various ambiguities attendant to the inclusion of derivatives under the national bank lending limit. The term "credit exposure" is not defined, so apparently it will be left to the OCC to provide a definition. How to calculate the amount of credit exposure will be a key element in understanding the impact of this provision.

Banks chartered under State law are not subject to national bank lending limits but rather the limits set by each State. However, the Dodd-Frank Act requires the States to include derivative exposures in their calculation of lending limits, or their banks will be disallowed from entering into any derivatives at all. It provides that a State bank insured by the Federal Deposit Insurance Corporation (FDIC) may engage in a derivative transaction, as defined in the provision applicable to national banks discussed above, "only if the law with respect to lending limits of the State in which the insured State bank is chartered takes into consideration credit exposure to derivatives transactions." Thus, unless State law in some way provides for consideration of credit exposure from derivatives, the banks chartered by that State cannot enter into derivatives. Effectively, this imposes on each State a requirement to assure that its law on lending limits complies with this provision.

The Act requires that the Fed issue regulations prohibiting systemically significant bank holding companies and non-bank financial companies from having credit exposure to any unaffiliated company that exceeds 25 percent of the company's capital and surplus; this limit may be set at a lower amount by the Fed if the it determines a lower amount "to be necessary to mitigate risks to the financial stability of the United States". Included in the definition of "credit exposure" for this purpose is "counterparty credit exposure to the company in connection with a derivative transaction…" Again, "credit exposure" in this context is undefined.

This provision is effective three years after the date of enactment, or 21 July 2013, and may be extended by the Fed for two additional years.

Section 23A of the Federal Reserve Act (Section 23A) imposes significant limitations on transactions between a US FDIC-insured bank and its affiliates. Generally, it requires that certain transactions between a bank and an affiliate, called "covered transactions", such as extensions of credit by the bank to the affiliate and purchases of assets by the bank from an affiliate, comply with quantitative and qualitative limits. A bank can engage in covered transactions with any one affiliate only up to 10 percent of the bank's capital and surplus, and may do so with all affiliates in the aggregate only up to 20 percent of capital and surplus. In addition, certain covered transactions, such as extensions of credit, must be fully collateralised.

In 2002, the Fed determined that a bank may enter into a derivative transaction with an affiliate without being considered a covered transaction, effectively exempting derivatives transaction between a bank and its affiliates from Section 23A limits. The Act reverses the Fed's earlier decision. It includes within the definition of "covered transaction" any derivative transaction, using the national bank definition provided above, with an affiliate "to the extent that the transaction causes a [bank] to have credit exposure to the affiliate." As with the national bank provision, there is no statutory definition of "credit exposure". This amendment is effective one year after the transfer date. Accordingly, it comes into effect some time in the second half of 2012.

The Section 23A amendment could have a serious effect on the manner in which major banking organisations centrally manage their derivatives businesses. The 10% limit would likely constrain a bank's back-to-back derivatives with a non-bank that serves as the central management point depending on the Fed's definition of "credit exposure". Also, such an exposure would have to be collateralised under existing Section 23A requirements. Conversely, if a bank is the central management point, the 20% limit would likely constrain its back-to-back derivatives with all affiliates.

The Act's so-called Volcker Rule generally imposes a prohibition on banks and bank holding companies from engaging in proprietary trading and in sponsoring and investing in private equity and hedge funds. It has a provision that incorporates the definition of "covered transaction", as used in Section 23A, in order to severely restrict the relationship between the bank holding company and certain private funds.

Under the Volcker Rule, a bank holding company is prohibited from "sponsoring" a private equity or hedge fund with specified exceptions, but not from advising such a fund sponsored by a third party. As to an advised fund or a permissible sponsored fund, the bank holding company and its affiliates are disallowed from entering into a transaction that would be a covered transaction under Section 23A with the fund, treating the fund as though it were an affiliate and the bank holding company (and all affiliates) as though they were banks. That is, the bank holding company and all of its subsidiaries are treated as though they are a "bank" subject to Section 23A, and the fund is an affiliate of the "bank".

This prohibition has a number of implications and difficult interpretive issues that will need to be addressed in rulemaking. However, for this purpose the important point is that, with the addition of derivatives to Section 23A and this new prohibition being keyed off of such coverage, a bank holding company that sponsors or advises private equity or hedge funds will be prohibited from entering into at least some derivatives with any such fund. As a result, such funds may be forced to obtain at least some derivatives from third parties.

The Volcker Rule becomes effective no later than two years after enactment, and then there is a period of at least two years during which covered entities will have to come into compliance.

The several provisions discussed above will require US and foreign banks subject to their requirements to make significant adjustments to their current compliance procedures and monitoring systems as the provisions become effective. While it might appear that the time periods prior to effectiveness are long enough that planning can be delayed, in practice, the amount of time available to take the necessary actions almost always turns out not to be long enough. It would be advisable for institutions to consider the effects of these provisions on their current operations and begin to plan how to make conforming adjustments. The regulatory process applicable to these provisions will also bear watching.

The US Securities and Exchange Commission recently adopted changes to Form ADV, the form used by investment advisers registered or registering with the agency. Form ADV is divided into two parts: Part 1 collects basic firm information and Part 2 (sometimes called the firm's brochure) provides more detail on the investment adviser's business. The changes, which are to Part 2 of the Form and related rules under the US Investment Advisers Act of 1940, represent a major overhaul of investment adviser disclosure practices.

As a result, investment advisers filing SEC registration forms in 2011 will encounter disclosure requirements that are more detailed and prescriptive than in the previous version of the form. For firms already registered with the SEC, transitioning to the newly required format, presumably as part of the required annual update of a firm's registration, means modifying almost every section of a firm's current Part 2 brochure.

New requirement highlights include:

In addition to the substantive changes discussed above, new Part 2 brochures will follow a new format. Every Part 2 brochure will have similar underlying architecture since the ordering and content of the brochure is required to be organised around 18 specified headings (referred to as "items" in the Form ADV instructions). If the subject matter of a particular heading is irrelevant to a firm, the heading is still required, with an explanation that the topic is not applicable to the business. Likewise, if information would be duplicated through the same or similar responses under multiple headings, cross references may be used.

That said, some steps may be taken to tailor the brochure to a firm's individual requirements, including that a firm may:

Currently registered investment advisers must follow the new format when they make annual updates to their registrations next year, which for most firms will be in March 2011. The new format also applies to forms filed by any investment adviser applying for SEC registration after 1 January 2011. Voluntary early compliance is also permitted.

For a more detailed summary of these matters, please click here.

At the midpoint of 2010, the SEC stood at a crossroads. It had announced a series of reforms designed to substantially strengthen the agency's ability to police the markets and had also adopted an increasingly aggressive posture towards insider trading, allegedly misleading and inadequate disclosures involving sub-prime investments, and "pay to play" practices.

Together, the agency's transformation and embrace of a more aggressive approach gave rise to some of the largest cases in its history. However, serious questions remained about whether the 'new' SEC's aggressive campaign would be successful, and for how long. The agency faced numerous obstacles, including limited resources and the fact that it had gambled on novel or expansive theories as the basis for prosecuting some of its higher profile cases (see Global Finance Update for February 2010).

Over the summer, Congress came to the SEC's aid. In July, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which contained numerous provisions intended to enhance regulatory enforcement and the remedies available to the agency. The new legislation not only effectively doubled the SEC's budget over the next five years, but also adopted new laws that give "teeth" to and, in many ways, complement, the agency's latest round of reforms. Three are particularly relevant to issuers and the lawyers, accountants, financial institutions and other secondary actors who work with publicly-traded companies:

What the SEC will do with its enhanced authority remains to be seen. One thing, however, is clear: Congress has removed many of the obstacles that prevented the SEC from taking full advantage of the reforms it recently adopted while also giving the agency even more new tools to use in its latest campaign. With more money and the ability to pursue a new class of cases in an administrative forum, one should expect that the SEC will continue to be aggressive in attempting to extract large settlements from high-profile defendants.

On 16 July 2010, the US Department of Labour (DOL) issued an interim final rule (the Rule) requiring the disclosure of compensation paid in connection with the performance of services to an employee pension plan. Compliance with the Rule is a condition to the statutory exemption from the prohibited transaction rules under the Employee Retirement Income Security Act of 1974, as amended (ERISA), for providing services to plans. The Rule will likely require many service providers to pension plans, in particular fiduciaries, to "plan asset" investment funds and recordkeepers, to make significant changes in their disclosure practices. The Rule is effective from 16 July 2011.

Disclosure must be provided by "covered service providers". Covered service providers fall into three broad categories:

Covered service providers must disclose the following:

Disclosure must be written, but need not be in any particular form or in a single document. There is no requirement that plans and service providers enter into formal written contracts setting out disclosure obligations or provide narrative conflict-of-interest disclosure, as contemplated by the proposed Rule.

While investment advisers to funds whose assets are considered plan assets are fiduciaries and thus, covered service providers subject to the Rule, investment advisers of non-plan asset funds generally will not be required to provide the disclosures.

The requirement that fiduciaries disclose indirect compensation and compensation among related parties will likely require investment advisers to provide additional and more detailed disclosure in their offering documents regarding the services that will be provided to the plan asset fund, the cost of those services, the source of the compensation (for example; from the assets of the fund) and the identity of the payer.

Recordkeepers for defined contribution plans are considered covered service providers under the Rule. If the recordkeeper reasonably expects to provide recordkeeping services without direct compensation, or if compensation for recordkeeping services is offset or rebated based on other compensation received by the recordkeeper (or a related party), the recordkeeper must provide the plan fiduciary with a reasonable, good faith estimate of the cost of the recordkeeping services.

Responsible plan fiduciaries must determine whether they have sufficient information regarding the arrangement to determine whether the cost is reasonable. As a result, plan fiduciaries need to identify covered service providers and be prepared to contact them so that they receive required disclosure in a timely manner. Plan fiduciaries will need to analyse the information provided, conduct any necessary follow-up inquiries, and evaluate whether to change service providers.

For more information, click here.