Dodd-Frank, Plus Four
The sponsors have moved on. After 36 years in Congress, mostly in the Senate, Connecticut Sen. Christopher J. Dodd left in 2011 to become chairman and chief lobbyist of the Motion Picture Association of America. Rep. Barney Frank of Massachusetts retired in early 2013 following 32 years in the U.S. House of Representatives. Both were Democratic mainstays.
But their eponymous joint production continues to loom large over the U.S. economy: the Dodd-Frank Wall Street Reform and Consumer Protection Act. The complex, 848-page bill, both celebrated and condemned, turned four years old this summer. The law was a response to the 2007-2009 Great Recession, which entailed the meltdown, bailout, takeover or forced sale of large financial institutions—including Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac and assorted banks and hedge funds. Its main purpose was to prevent future “too-big-to-fail” financial institutions by reining in their risk-taking and even growth, and giving regulators more authority over troubled big banks. Other goals included improving consumer protections on financial products.
The result was a massive bill that still prompts heated debate over what it means and what it will accomplish. Even proponents acknowledge they really won’t know for sure until the next financial crisis takes place.
That said, the sweeping law—which relies on administrative regulations, perhaps a quarter of which have yet to be issued in final form—has affected industries far beyond banking and investing, and not always for the better. At a minimum, Dodd-Frank has added to the costs that companies must shoulder for lawyers, accountants, auditors and other experts to show compliance with the law. On a very basic level, its impact also can be felt in the reluctance of a significant number of lenders to make anything but the safest loans, and the extra workload on borrowers to make their case. It’s a burden that permeates all industries that need financing, including manufacturing and metals servicing.
Even proponents acknowledge they really won’t know for sure what the bill will accomplish until the next financial crisis takes place.
Two Main Pain Points
But certain provisions of Dodd-Frank have become especially vexatious to metals and the companies that use them. Perhaps the most notable have been the reporting requirements on so-called conflict minerals and the regulation of over-the-counter (OTC) financial derivatives. The often-onerous conflict minerals regulations are by now a well-known aggravation throughout the metals industry. The derivatives issue, however, may be just as problematic and burdensome.
A derivative is a financial instrument whose underlying value is pegged to an asset (like, say, a metal) or a benchmark like an exchange or interest rate. Derivatives can be used to speculate—to bet on the course of future prices—or as a hedge to risk, like locking into a specific price. While some derivatives are traded on exchanges, OTC derivatives are private contracts negotiated between parties, tailored to a specific circumstance.
While all derivatives entail some risk, it goes without saying that derivatives used for hedging have much less potential for mischief than derivatives used to speculate on, or profit from, future price movements.
Trying to Tamp Down Speculation
In passing Dodd-Frank, Congress essentially was worried about derivatives used for speculation. (Speculators buying credit default swaps, a derivative that paid off in the event of a loan default, were held to be an aggravating cause of the Great Recession since not all the derivative sellers could make good on the massive claims filed against them.) So the law directed major regulators to write rules mitigating risk. These five agencies are the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Farm Credit Administration and the Federal Housing Finance Agency.
But once early drafts of the new rules began coming out, they caused considerable alarm among manufacturers. One way to mitigate risk in derivatives is to impose or increase the margin requirement, the amount of money that has to be put up as collateral to cover the potential liability. That’s money that can’t be used for other corporate purposes. And the early margin rules promulgated under Dodd-Frank now seem likely to be applied to end users like manufacturers, even though they are only hedging their own risk rather than speculating and incurring vast liabilities they might not be able to cover.
The Coalition for Derivatives End-Users, a lobbying group established to fight Dodd-Frank restrictions that is backed by some of the biggest players in metals and manufacturing, estimated the margin rules could reduce annual capital spending among S&P 500 companies alone by as much as $6.7 billion.
The rules on OTC derivatives “were not intended to apply to end users,” says Christina Crooks, director of tax policy for the National Association of Manufacturers (NAM). She says specific language making that clear “fell between the cracks” while the House-Senate conference committee hashed out differences in the bill.
Now the Biggest Issue?
Crooks calls the end user derivatives problem the biggest issue in Dodd-Frank facing nonfinancial institutions. NAM has been leading a charge to get the rules rolled back, possibly by a language fix in a bill reauthorizing the Commodity Futures Trading Commission.
In September the coalition praised—with caution—what it described as a new proposal by the Federal Reserve and other regulators to ease the margin rules: “We still need to pore through the fine print to determine whether the proposal applies to all of our end users and whether margin legislation is still necessary.”
“Manufacturers and other businesses that use derivatives to hedge normal risk are still up in the air about whether they will have to set aside millions of dollars to comply with proposed margin requirements,” Blanche Lincoln, a former Arkansas senator and Democrat whose firm Lincoln Policy Group is a paid advocate for NAM, wrote earlier this year. She voted for Dodd-Frank while in the Senate.
Jim Colby, assistant treasurer of Honeywell International Inc., one of the major backers of the coalition, explained some of the potential impact in testimony last year to the U.S. House of Representatives Committee on Agriculture. Honeywell, one of the world’s most-diversified manufacturing companies in both product lines and geography, is an end user of derivatives.
At the end of 2012, the company had $2 billion outstanding in hedging contracts (derivatives) designed to convert a portion of fixed-rate debt into lower floating-rate debt, but with a longer-term maturity, Colby explained. Such interest-rate swaps, as they are called, fall under Title VII of Dodd-Frank, which mandates margin cushion requirements.
“Applying 3% initial margin and 10% variation margin implies a potential margin requirement of $260 million,” he said. “Cash deposited in a margin account cannot be productively deployed in our businesses and therefore detracts from Honeywell’s financial performance and ability to promote economic growth and protect American jobs.”
Earlier this year, Thomas C. Deas Jr., vice president and treasurer of FMC Corp., the world’s largest producer of soda ash, told another congressional committee that the Dodd-Frank-mandated rules on derivatives “will result in higher costs to Main Street companies that will limit their growth, harm their international competitiveness and ultimately hamper their ability to sustain and, we hope, grow jobs.”
And Then There’s the CTU
Another sticky issue tied to Dodd-Frank and derivatives has been that of the centralized treasury unit (CTU). That’s the not-unreasonable practice at many large companies of consolidating all financial risk-management operations in one office, often at the corporate headquarters. The idea is that a single office can watch the entire enterprise and, among other things, assess and offset risks.
The problem is that under certain circumstances, Dodd-Frank mandates requirements on the clearing and trade execution of credit default swaps because CTUs may be considered a covered “financial entity.”
Legislation to clarify that end users are not subject to most Dodd-Frank requirements has been introduced in Congress. But things on Capitol Hill move slowly and, at press time, chances of its passage seemed poor.
Then there is the so far more-publicized Dodd-Frank issue plaguing metals and manufacturing: the provisions concerning conflict minerals. (See Forward, March/April 2013.) These are high-value substances—tin, tantalum, tungsten and gold—found in the Democratic Republic of the Congo (DRC) and nine surrounding African nations that are plagued by human rights abuses, such as forced labor.
The conflict mineral rules don’t actually prohibit use of conflict minerals, also known as 3TG, but they do require publicly traded companies in the United States to disclose their use to the Securities and Exchange Commission on a new specialized form. The idea seems to be that the shame of disclosure might make companies shy away from using these materials mined in these countries.
There were predictions that the staff, legal and audit work necessary to comply with what amounts to documenting a paper trail could cost U.S. businesses as much as $16 billion and open firms to lawsuits by contingent-fee lawyers claiming securities-law violations.
“Cash deposited in a margin account cannot be productively deployed in our businesses and therefore detracts from Honeywell’s financial performance and ability to promote economic growth and protect American jobs.”
Companies Begin Reporting
An estimated 1,300 companies began filing the first set of reports for calendar year 2013 earlier this year—far fewer than the 6,000 companies the SEC had projected, meaning the $16 billion estimate might also be overblown. At this writing, the SEC, which is charged with administering the conflict minerals rules, has not challenged any of the disclosures, even though observers say they varied widely in scope, detail and degree of due diligence displayed.
Nevertheless, NAM and two other big-business lobbying groups, the U.S. Chamber of Commerce and the Business Roundtable, are suing in federal court to block the disclosure rules. Among their targets was a provision requiring companies using conflict minerals to put in SEC reports and on their websites the specific phrase that they have “not been found to be DRC conflict free.” The business groups argued that requirement was compelled commercial speech in violation of the First Amendment protection of freedom of speech.
Earlier this year, a three-judge panel of the U.S. Court of Appeals for the District of Columbia upheld the Dodd-Frank provisions requiring companies to review their supply chains and to file reports with the SEC. But the judges struck down the specific-phrase mandate as a free-speech violation.
Parties on the other side, including the SEC and Amnesty International, have asked the full 11-judge court to review the decision.
Whatever the case’s ultimate outcome, issues stemming from Dodd-Frank promise to persist—at least until the next big financial crisis forces another re-evaluation of governmental policy.
William P. Barrett is a veteran business journalist. He can be reached at email@example.com.