The Dodd-Frank Act: Where Are We Now?

A year ago, Chesapeake Energy announced that its famously wealthy founding CEO, Aubrey McClendon, was retiring. What it didn't mention in the announcement was that Chesapeake had received one of the most negative shareholder votes on executive compensation in the short history of say-on-pay in the United States. Only 20 percent of shareholders supported the pay package in June 2012, compared to the 90 percent and better the majority of other companies saw.

Indirect as it may be, Chesapeake's CEO change may be one of the most tangible outcomes to emerge from the nearly 900 pages of Dodd-Frank Act legislation signed into law in July 2010. Indeed, many regulatory watchers say the non-binding shareholder vote on executive compensation may be the most successful provision of the landmark reform law. Chesapeake's stock rose in the immediate aftermath of news that Chesapeake was forcing out the entrenched CEO, and it has gone up about 30 percent since McClendon's successor was named in May.

Many of the other provisions are either too new to tell if they are working as intended, still being ironed out, or have yet to be proposed. Regulators have implemented just over 50 percent of the 398 required by the law, according to a Jan. 2 tally by law firm Davis Polk, and 27.6 percent have not yet even been proposed. Those that have come to fruition are creating a lot of administrative and compliance work, but so far show few real benefits, experts say. “The bottom line is that it's still early days,” says Hal Scott, director of the Center on Capital Markets Regulation, a research organization that has been tracking implementation closely.

Banking on Rules

Crafted in the wake of the 2008 financial crisis, the main point of Dodd-Frank was to stabilize the financial system, so that banks like Lehman Brothers wouldn't collapse again and others like AIG wouldn't find themselves in the position of needing billions of taxpayer dollars to survive. Whether the legislation is doing that—or even has the capacity to do it—is up for debate.

It's unclear what would happen if a big bank gets in trouble, for example, since the Federal Deposit Insurance Corp.'s “single point of entry” plan in which shareholders and unsecured creditors would be wiped out to foster an orderly liquidation of the assets remains untested. Momentum is gathering for banks around the world to face higher capital holding requirements as Dodd-Frank statutes overlap with Basel III efforts, but many loose ends remain.

Meanwhile, the repurchase agreements, or “repos,” that were at the heart of Lehman's problems in 2008 are still problematic. Dodd-Frank does not address them in much detail, but the daily amount outstanding declined from $7 trillion to less than $5 trillion over the course of 2008, and it has stayed in that range ever since, according to Federal Reserve data on the 21 primary dealers. That decline alleviates the original problem, but creates others, namely, decreased liquidity among banks that are operating in defense mode. “There are areas where there has been some significant improvement, but I would not say we're prepared for the next crisis,” says David Skeel, a professor at the University of Pennsylvania Law School and author of a 2011 book on the Dodd-Frank Act, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences.

One of the most contentious rules for banks that could have the broadest effect on corporate finance is the Volcker rule, approved in early December by the five regulatory agencies tasked with implementing it. In theory, it aims to stop banks from trading on their own account. In reality, “it is a complete mess, because it's really hard to distinguish the things that are not allowed, like proprietary trading, from what is allowed, such as market making and making trades for clients," Skeel says.

In recent testimony before the House Committee on Financial Services, Securities Industry and Financial Markets Association CEO Kenneth Bentsen pointed out that the rule is overly complex for banks to implement and lacks a clear enforcer, both of which contribute to high compliance costs that are likely to erode equity valuations. It is also likely to dampen activity within a wide range of corporate capital sources, such as venture capital, equity joint ventures, loan securitizations, and commercial lending via CLOs and CDOs, he said. Big banks, meanwhile, are seeking relief from some aspects of the Volcker Rule, and many are projecting minimal impact on earnings at this point. 

Sunshine and Swaps

“There are areas where there has been some significant improvement, but I would not say we're prepared for the next crisis.”

—David Skeel,

Professor,

University of Pennsylvania

Perhaps the most complete area of Dodd-Frank rulemaking revolves around derivatives oversight and, in particular, the swaps market. The law gave the Commodity Futures Trading Commission authority to require all standardized derivatives to trade on open exchanges or swap execution facilities, and move through central clearinghouses to increase transparency and reduce risk. All transactions must now be reported to the CFTC, as well, so regulators can track them.

The CFTC is still writing rules, but has finalized many of the major ones. The good news: Non-financial companies that use swaps for hedging avoided the very real possibility that they would have to take on the compliance-laden designation of swaps dealers. The bad news: Heavier compliance burdens on swaps dealers will make the transactions more expensive and in some cases impractical to execute. “The Dodd-Frank rules in this area took a market that had zero regulation and brought it to nearly 100 percent regulation,” says Susan Ervin, a partner with Davis Polk. “This really could not fail to affect some of the major ways people do business.”

A thorny area right now is who must report a swap transaction to the CFTC. Dealers who are subject to Dodd-Frank for other reasons will typically do it for clients, but those that aren't, particularly foreign ones, are balking. That's likely to lead to a market shift, says Andrea Kramer, a partner with the law firm McDermott Will & Emery, in which U.S. companies only trade with dealers who will report for them. At the same time, it's unclear to what extent overseas-based counterparties with some business in the United States will have to comply with Dodd-Frank, an issue the CFTC is expected to clarify in coming months.

                   ABOUT THIS SERIES

Compliance Week's exclusive four-part series on the Dodd-Frank Act will take a look at the state of rulemaking to carry out the 2010 landmark reform law. We'll explore how well some of the law's components are working and if it has had the intended effect of improving corporate governance and creating stability in the banking sector, along with what it is costing companies to comply and what's still to be done to finish rulemaking on the law.

Part 1: The Dodd-Frank Act: Where Are We Now, Feb. 4Part 2: How the Dodd-Frank Act Is Changing Corporate Governance, Feb. 11Part 3: The Costs of the Dodd-Frank Act, Feb. 19Part 4: Dodd-Frank Act Still a Work in Progress, Feb. 25

The larger question, of course, is what the CFTC will—and can—do with the data it receives. “There will be greater transparency, but it's going to be very hard to have meaningful regulatory surveillance over the entire market,” says Ervin. That's in part because the CFTC is a small, underfunded agency, and in part because many swaps will continue to be customized transactions with any number of variables that are hard to compare. One swap for oil could run for six months and involve 100,000 barrels, another could run 10 years and cover 10,000 barrels, and the type of oil could be different, Ervin explains. So while it might illuminate some issues, the data “will not be sufficient to preclude all disasters from happening,” Ervin predicts.

Other large parts of the Dodd-Frank Act, including a provision that created the Consumer Financial Protection Bureau, are still a work in progress. The CFPB, for example, has gotten in regulatory crosshairs for coming on too strong in some cases. On a mission to fight discrimination in auto financing, for example, CFPB director Richard Cordray has already had to answer questions from Congress about the fairness of the agency's methodology.  Even so, “it's too early to gauge its effect,” Scott says.

Copy Comp

Only loosely related to the strength of the financial system, but a key facet of the Dodd-Frank nonetheless is the idea that corporate governance needs strengthening. The aspect that took hold the fastest and most furiously is shareholder advisory votes on executive compensation, known as say-on-pay.

DODD-FRANK RULEMAKING PROGRESS BY AGENCY

The following graphs from Davis Polk estimate what progress has been made on Dodd-Frank Rule requirements by the SEC, CFTC, bank regulators, and others, as of Nov. 1, 2013.

*Values refer to number of rulemaking requirements.

Source: DavisPolk.

As McClendon's fate suggests, the votes have prompted companies to take some dramatic actions. While few companies have failed the non-binding votes, there is significant pressure to get high marks. “Dodd Frank has changed the game; directors spend more time on executive pay than they did five years ago by a significant margin,” says David Wise, a vice president with compensation consulting firm Hay Group. “That has led to greater emphasis on performance-vested equity programs, less use of executive perquisites, and a slowing in the rise of cash compensation.”

The problem is that's not always a good thing. Experts say that formulaically tying pay to performance doesn't take important differences into account, such as the phase of a company's growth, and whether or not it's in turnaround mode. “Good pay programs are designed in context of what a business is going through, but the impact of say-on-pay is to blur the context,” says Wise.

Still to Come

Yet to come in the executive compensation arena are some new rules that will make clawbacks, and bans on hedging company stock even more stringent than the Sarbanes-Oxley Act did.  Closer on the horizon is the requirement for firms to calculate and publish the ratio of CEO pay to the median employee pay. Though it won't take effect until 2015 at the earliest, based on the current timetable, criticism of the politically fueled statute is already flying. “What's the right number? We have no idea,” says David Larcker, a professor at the Stanford Graduate School of Business who studies executive compensation.

“Many folks are calling it the shame rule,” says Jean McLoughlin, a partner with Davis Polk, who says it would not be surprising to see eye-popping ratios such as 1 to 1000.  How CEO pay is calculated is complex on its own. How should the rule, for example, address elements that pay out over time? And calculating median employee pay is even more complex, now that the SEC ruled it should include overseas employees as well as U.S.-based ones.

Critics of Dodd-Frank certainly abound. Yet ten years ago, there was similar outrage over the burdens Sarbanes-Oxley created and how impotent it was to prevent another fraud. Now, with nary an Enron-esque incident to report in the ensuing decade and much of the compliance work automated, few are complaining. Could Dodd-Frank see a similar legacy? Perhaps. “Overall, I'd give it B,” says Skeel. “It's just one of these Bs where different sections of the test would have pretty significantly different grades.”