Dodd-Frank, One Year Later: A Look at States’ Role in Financial Services Regulation under the Landmark Legislation

July 21, 2011 marked one year since Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, the most significant retooling of the financial system since the Great Depression.  This policy brief considers states’ regulatory role under Dodd-Frank, with attention to two issues:  1) the standard governing federal preemption of state consumer finance laws, and 2) state oversight of mid-sized investment advisors.  Each is an example of how Dodd-Frank sought to “reset” the balance between state and federal financial regulators, and to preserve states’ regulatory authority in the financial services industry.      

Issue One:  Federal Preemption of State Consumer Finance Laws

Background:

Some observers claim federal preemption of state anti-predatory lending laws disrupted the mortgage market, contributing to increased cases of mortgage default, especially in the subprime sector.[1]

Dodd-Frank emphasized preservation of states’ regulatory authority over national banks (those with a charter from the federal government), particularly with respect to the application of consumer financial protection laws (e.g. anti-predatory lending laws).  In Section 1044, the bill states that a state consumer financial law is preempted only if it “prevents or significantly interferes with the exercise by the national bank of its powers,”[2] in accordance with the U.S. Supreme Court’s decision in Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner et al.[3]  

In May, the Office of the Comptroller of the Currency (OCC), a federal bank regulator, proposed a rule summarizing its interpretation of the preemption standard in Sec. 1044.[4]  Treasury Department officials and the Conference of State Bank Supervisors (CSBS), an organization representing state bank regulators, criticized the rule, claiming it runs afoul of Dodd-Frank in three respects:

  • The rule misinterprets the “prevents or significantly interferes” standard, and broadens the standard in a manner inconsistent with legislative intent.  In written comments, Treasury and CSBS argued:  1) The authors of Dodd-Frank clearly intended “prevents or significantly interferes” to be the unique standard governing federal preemption determination, and therefore 2) OCC’s insistence that Sec. 1044 codifies the whole Barnett decision, and by implication permits continued use of a broader “obstruct, impair, or condition” standard laid out in a 2004 rule,[5] is incorrect. 
  • The rule fails to acknowledge new procedural requirements governing preemption determination.  Treasury and CSBS also criticized OCC’s failure to acknowledge case-by-case treatment of preemption questions, another requirement of Dodd-Frank.[6]  According to Treasury, the omission implies OCC may preempt whole categories of state consumer finance laws, instead of preempting them one at a time. 
  • The rule defines visitorial powers (powers of a regulator to examine or inspect an entity) in a manner that constrains states’ ability to redress national bank infractions.  Under an historical OCC rule, state officials may not exercise visitorial powers over national banks – including prosecution of enforcement actions – except in limited circumstances authorized by federal law.[7]  CSBS urged OCC to rescind this regulation, given the Supreme Court excluded prosecution from the definition of visitorial powers in Cuomo v Clearing House Assn.[8]  CSBS also disapproved of OCC’s decision to include “investigating” in the definition of visitorial powers in its new rule, claiming compliance investigations are well within the authority of state Attorneys General.

Outlook:

The OCC finalized its May ruling on preemption and visitorial powers on July 20, 2011, addressing (in part) concerns raised by Treasury and CSBS.  Among other actions, the finalized rule:  removes “obstruct, impair, or condition” language from existing regulations to “eliminate ambiguity concerning preemption standards;” and revises the visitorial powers definition in accordance with Cuomo, thereby granting state Attorneys General authority to prosecute enforcement actions for violation of “applicable law.”[9]     

Issue Two:  State Oversight of Midsize Investment Advisors

Background:

Dodd-Frank raised the SEC registration threshold for investment advisors, creating a new class of investment advisors called “mid-sized advisors.”  Mid-sized advisors are generally investment advisors with between $25 and $100 million in assets under management.  Per Dodd-Frank, these advisers must withdraw their SEC registration and register with an appropriate state securities regulator.[10]

  • In a statement, SEC chairman Mary L. Schapiro claimed “the switch,” as the regulatory shift has come to be known, would move about 3,200 of 11,500 SEC-registered advisors to the states.[11]
  • Upon registration, a group representing state securities regulators claims the advisors will be subject to greater scrutiny.  According to the National Association of State Securities Administrators (NASAA), there “are about 3,000 investment advisors that have never been examined by the SEC, and these firms will go to the top of the state examination priority list.”[12]  Whether the 3,000 advisors in NASAA’s statement references the 3,200 SEC expects to migrate to the states cannot be confirmed.  However, the Wall Street Journal reported that through September, 2010, the SEC had examined only nine percent of the 11,000 plus advisors it oversees – a figure home-state registration advocates would no doubt cite as justification for greater state oversight. 
  • Still, some have criticized “the switch.”  The Financial Services Institute (FSI), an organization representing broker-dealers, warned the SEC that “the states are not adequately prepared to take on the inspection, examination and enforcement role assigned to them under Dodd-Frank.”[13]  The Financial Industry Regulatory Authority (FINRA), a private broker-dealer regulator, concurred, suggesting the SEC set up an industry-funded enforcer instead of relying on the states.[14]
  • Warnings that states are not adequately equipped to address the influx of advisors may be motivated by the advisors’ primary destinations under a switch.  According to National Regulatory Services (NRS), just four states – California, New York, Texas, and Florida – will absorb about 35 percent of the midsize registrants.  These states have dealt with severe budget shortfalls in the last few years, and may not recover for several more.  Hence, finding money for new examiners could be difficult.[15]

Outlook:

Federal officials intended the crossover to be complete by Dodd-Frank’s one year anniversary date.  However, in recognition of implementation delays, the SEC extended mid-sized advisors’ registration deadline to June 28, 2012. 

Conclusion

July 21, 2011 marked one year since Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The Act sought to reset the balance between state and federal financial regulators, with the aim of preserving states’ regulatory authority.  Such is evidenced by efforts to 1) harden the standard governing federal preemption of state consumer finance laws, and 2) task state securities regulators with oversight of a new class of investment advisors.   


[1]For example, see Quercia and Ratcliffe (2010).  “The Impact of Federal Preemption of State Anti-Predatory Lending Laws on the Foreclosure Crisis.”  Center for Community Capital, University of North Carolina at Chapel Hill.  The authors found mortgages originated by “OCC-preempted” lenders to be of lower quality and higher default risk than mortgages originated by lenders that remained subject to state laws following implementation of 2004 OCC preemption rule.  

[2]Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1044(b)(1)(B)

[3] Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner et al., 517 U.S. 25 (1996).  

[6]Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1044(b)(3)

[7]Bank Activities and Operations, 69 F.R. 1895 (13 January 2004). 

[8]Cuomo v. Clearing House Assn., L.L.C., 129 S. Ct. 2710, 2711 (2009)

[10] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 410

[11]SEC Adopts Dodd-Frank Amendments to Investment Advisors Act.”  Statement of Chairman Mary L. Schapiro, Securities and Exchange Commission (SEC).  June 22, 2011. 

[12] Eaglesham, Jean.  “States, Industry in Oversight Flap.”  Wall Street Journal.  January 3, 2011. 

[13]Ibid. 

[14]Ibid.  

[15]At least for three, that is.  New York does employ individual securities examiners.  Instead, the state relies on potent anti-fraud legislation to prosecute financial crimes.