[Senate Hearing 111-58]
[From the U.S. Government Publishing Office]



                                                         S. Hrg. 111-58
 
 ENHANCING INVESTOR PROTECTION AND THE REGULATION OF SECURITIES MARKETS

=======================================================================



                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

EXAMINING WHAT WENT WRONG IN THE SECURITIES MARKETS, HOW WE CAN PREVENT 
  THE PRACTICES THAT LED TO OUR FINANCIAL SYSTEM PROBLEMS, AND HOW TO 
                           PROTECT INVESTORS

                               __________

                             MARCH 10, 2009

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html



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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
JON TESTER, Montana                  DAVID VITTER, Louisiana
HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                 Colin McGinnis, Acting Staff Director

              William D. Duhnke, Republican Staff Director

                     Dean Shahinian, Senior Counsel

                Brian Filipowich, Legislative Assistant

                   Julie Chon, Senior Policy Advisor

                  Drew Colbert, Legislative Assistant

            Mark Oesterle, Republican Deputy Staff Director

                    Andrew Olmem, Republican Counsel

                   Hester Peirce, Republican Counsel

                    Jim Johnson, Republican Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                        TUESDAY, MARCH 10, 2009

                                                                   Page

Opening statement of Chairman Dodd...............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     4
    Senator Crapo................................................     5

                               WITNESSES

John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia 
  University Law School..........................................     6
    Prepared statement...........................................    51
    Response to written questions of:
        Senator Dodd.............................................   231
        Senator Crapo............................................   235
        Senator Vitter...........................................   236
T. Timothy Ryan, Jr., President and Chief Executive Officer, 
  Securities
  Industry and Financial Markets Association.....................     9
    Prepared statement...........................................    79
    Response to written questions of:
        Senator Dodd.............................................   237
        Senator Crapo............................................   269
Paul Schott Stevens, President and Chief Executive Officer, 
  Investment
  Company Institute..............................................    11
    Prepared statement...........................................    83
    Response to written questions of:
        Senator Dodd.............................................   271
        Senator Crapo............................................   301
Mercer E. Bullard, Associate Professor, University of Mississippi 
  School of Law, and President, Fund Democracy, Inc..............    13
    Prepared statement...........................................   104
        Senator Dodd.............................................   309
        Senator Crapo............................................   312
Robert Pickel, Executive Director and Chief Executive Officer, 
  International Swaps and Derivatives Association................    15
    Prepared statement...........................................   129
    Response to written questions of:
        Senator Dodd.............................................   312
        Senator Crapo............................................   313
Damon A. Silvers, Associate General Counsel, AFL-CIO.............    18
    Prepared statement...........................................   133
        Senator Dodd.............................................   314
        Senator Crapo............................................   321
Thomas Doe, Chief Executive Officer, Municipal Market Advisors...    20
    Prepared statement...........................................   144
    Response to written questions of:
        Senator Dodd.............................................   328
        Senator Crapo............................................   337
Lynn E. Turner, Former Chief Accountant, Securities and Exchange
  Commission.....................................................    22
    Prepared statement...........................................   220
        Senator Dodd.............................................   338
        Senator Crapo............................................   341
        Senator Vitter...........................................   341

                                 (iii)


 ENHANCING INVESTOR PROTECTION AND THE REGULATION OF SECURITIES MARKETS

                              ----------                              


                        TUESDAY, MARCH 10, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:38 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order. Let me 
thank our witnesses for being here this morning, and colleagues 
as well, and just to notify the room how we will proceed. 
Again, there are only a handful of us here, but we have eight 
witnesses, and so we have got a long morning in front of us to 
go through these issues. And what I would like to do is I will 
make some opening remarks, turn to Senator Shelby, and then as 
long as the room does not all of a sudden get crowded with a 
lot of Members here, I will ask Senator Reed and Senator Bennet 
if you would like to make a couple of opening comments, and we 
will get right to our witnesses, who have supplied very 
thorough testimony. And if they each read all of their 
testimony, we are going to be here until Friday, in a sense. 
But it is very, very good and very helpful to us. So we will 
proceed along those lines and hopefully have a good, engaging 
morning here on a very, very critical issue.
    So I welcome all of you to the hearing this morning 
entitled ``Enhancing Investor Protection and the Regulation of 
Securities Markets.'' The purpose of today's hearing is to 
examine what went wrong in the securities markets and to 
discuss how we can prevent irresponsible practices that led to 
our financial system seizing up from ever happening again and 
how to protect investors, including small investors, from 
getting burned by the kinds of serious abuses and irresponsible 
behavior that we have seen in certain quarters of the markets 
in recent years.
    We are going to hear about proposals to regulate the 
securities market so that it supports economic growth and 
protects investors rather than threatens economic stability. As 
important, today we will begin to chart a course forward--a 
course that acknowledges how complex products and risky 
practices can do enormous damage to the heart of our financial 
system, the American people as well, absent a strong foundation 
of consumer and investor protections.
    Half of all U.S. households are invested in some way in 
securities, meaning the path we choose for regulating this 
growth and growing segment of our financial system will 
determine the futures not only of traders on Wall Street but of 
families, of course, across the country. A year ago this coming 
Saturday, the collapse of Bear Stearns underscored the 
importance role that securities play in our financial system 
today.
    When I was elected to the Senate in 1980, bank deposits 
represented 45 percent of the financial assets of the United 
States and securities represented 55 percent. Today, the 
securities sector dominates our financial system, representing 
80 percent of financial assets, with bank deposits a mere 20 
percent.
    As the securities market has expanded, so, too, has its 
influence on the lives of average citizens. Much of that 
expansion has been driven by the process known as 
``securitization,'' in which everyday household debt is pooled 
into sophisticated structures, from mortgages and auto loans to 
credit cards and student loans.
    In time, however, Wall Street not only traded that debt, it 
began to pressure others into making riskier and riskier loans 
to consumers. And lenders, brokers, and credit card companies 
were all too willing to comply, pushing the middle-class family 
in my State of Connecticut and elsewhere across the country who 
would have qualified for a traditional secure product into a 
riskier subprime mortgage or giving that 17-year-old college 
student, who never should have qualified in the first place, a 
credit card with teaser rates that were irresistible but terms 
that were suffocating.
    As one trader said of the notorious subprime lender, they 
were moving money out of the door to Wall Street so fast, with 
so few questions asked, these loans were not merely risky, they 
were, in fact, built to self-destruct.
    As we knew it, securitization did not reallocate risk. It 
spread risk throughout our financial system, passing it on to 
others like a high-stakes game of hot potato. With no incentive 
to make sure these risky loans paid off down the road, each 
link in the securitization chain--the loan originators, Wall 
Street firms and fund managers, with the help of credit rating 
agencies--generated more risk. They piled on layers of loans 
into mortgage-backed securities, which were piled into 
collateralized debt obligations, which were in turn piled into 
CDO squared and cubed, severing the relationship between the 
underlying consumer and their financial institutions.
    Like a top-heavy structure built on shoddy foundations, it 
all, of course, came crashing down. I firmly believe that had 
the Fed simply regulated the mortgage lending industry, as 
Congress directed with the law passed in 1994, much of this 
could have been averted. But despite the efforts of my 
predecessor on this Committee, myself, and others over many 
years, the Fed refused to act.
    But the failure of regulators was not limited to mortgage-
backed securities. As many constituents in Connecticut and 
elsewhere have told me, auction rate securities, misleadingly 
marketed as cash equivalents, left countless investors and city 
pension funds across the country with nothing when the actions 
failed and the securities could not be redeemed.
    As this Committee uncovered at a hearing about AIG last 
week, the unregulated credit derivatives market contributed to 
the largest quarterly loss in history.
    In recent months, we have unearthed two massive Ponzi 
schemes, bilking consumers, investors, charities, and municipal 
pension funds out of tens of billions of dollars that two 
separate regulators failed to detect in their examinations. In 
January, I asked Dr. Henry Backe of Fairfield, Connecticut, to 
address this Committee about the losses suffered by the 
employees at his medical practice in the Bernard Madoff fraud. 
His testimony prompted Senator Menendez and me to urge the IRS 
to dedicate serious resources to helping victims like Linda 
Alexander, a 62-year-old telephone operator from Bridgeport, 
Connecticut, who makes less than $480 a week and lost every 
penny of her retirement savings. In an instant, the $10,000 she 
had saved over a lifetime evaporated because regulators has no 
idea a massive fraud was occurring right under their noses.
    This crisis is the result of what may have been the 
greatest regulatory failure in human history. If you need any 
further evidence, consider this: At the beginning of the credit 
crisis in 2008, the SEC regulated five investment banks under 
the Consolidated Supervised Entity Program: Lehman Brothers, 
Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan 
Stanley--names synonymous with America's financial strength, 
having survived world wars and the Great Depression. And though 
the seeds of their destruction have been planted nearly a 
decade ago, each was sold, converted to a bank holding company, 
or failed outright inside of 6 months--every single one of 
them.
    Our task today is to continue our examination of how to 
begin rebuilding a 21st century financial structure. We do so 
not from the top down, focusing solely on the soundness of the 
largest institutions, with the hope that it trickles down to 
the consumer but, rather, from the bottom up, ensuring a new 
responsibility in financial services and a tough new set of 
protections for regular investors who thought these protections 
were already in place.
    The bottom-up approach will create a new way of regulating 
Wall Street. For the securities markets, that means examining 
everything, from the regulated broker-dealers and their sales 
practices, to unregulated credit default swaps. It means 
ensuring that the creators of financial products have as much 
skin in the game when they package these products as the 
consumers do when they buy them, so that instead of passing on 
risk, everyone shares responsibility. And that means we need 
more transparency from public companies, credit rating 
agencies, municipalities, and banks.
    We are going to send a very clear message that these 
modernization efforts, the era of ``don't ask''--in these 
modernization efforts, the era of ``don't ask, don't tell'' on 
Wall Street and elsewhere is over. For decades, vitality, 
innovation, and creativity have been a source of genius of our 
system, and I want to see that come back. It is time we 
recognized transparency and responsibility are every bit as 
paramount, that whether we are homebuyers, city managers, 
entrepreneurs, we can only make responsible decisions if we 
have the accurate and proper information. We want the American 
people to know that this Committee will do everything in its 
power to get us out of this crisis by putting the needs of 
people first, from constituents like Linda Alexander, who I 
mentioned a moment ago, to millions more whose hard-earned 
dollars are tied up in our securities markets.
    Today's hearing will provide an opportunity to hear ideas 
and build a record upon which this Committee can legislate a 
way forward for the American people to rebuild confidence in 
these securities markets, and to put our country back on a 
sound economic footing.
    With that, I thank our witnesses again for being here, and 
let me turn to my colleague, former Chairman, Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Chairman Dodd.
    I think the greatest challenge in dealing with this 
financial crisis is understanding its multiple, complex, and 
interrelated causes. This hearing provides us an opportunity to 
examine some of the causes that relate to our securities 
markets and securities regulation.
    Without presupposing the specific causes of the financial 
crisis, I think it is appropriate to conclude that a broad 
failure of risk management in the financial system led us to 
where we are today. It appears that everybody assumed that 
someone else was monitoring the risk. Regulators assumed that 
financial institutions had properly assessed the risk of their 
own activities or assumed that other regulators were watching 
what those entities were doing.
    Financial institutions failed to adequately monitor risks 
across business units and failed to thoroughly understand the 
risks associated with new financial products. They did not 
adequately assess either their exposures to or the health of 
their counterparties.
    Very sophisticated investors assumed that someone else had 
done their due diligence. Less sophisticated investors assumed, 
unreasonably, that asset prices would only climb. The excessive 
reliance on credit ratings and the failure of the market to 
develop a clearinghouse for credit default swaps are just two 
examples of this widespread market failure. The disastrous 
consequences of this nearly universal passing of the buck 
should serve as the guidepost for us and the SEC as we consider 
reforms.
    I think there should be clear lines of responsibility for 
regulators. Only then can Congress hold regulators accountable 
for their performance. It is also important not to make changes 
to the statutory and regulatory framework that would further 
lull market participants into believing that regulators or 
other market participants are doing their work for them.
    We cannot build a regulator big enough to be everywhere at 
all times. Market participants need to do their own due 
diligence before and after they make an investment decision. 
They need to bear the costs of an unwise investment, just as 
they reap the benefit of a wise investment. In the end, I 
believe our markets will be best served by the combined efforts 
of diligent regulators and responsible market participants 
working under rules that are clear and consistent.
    Uncertainty about the rules impedes the market from working 
as it should. Ad hoc Government actions lead private capital to 
sit on the sidelines because a change in rules can radically 
change a market participant's expected return. A consistent 
legal framework is an essential component of a competitive 
capital market. Investors will avoid a market if they believe 
the rules may change in the middle of the game. A clear example 
of this dynamic is the world of accounting where many are 
calling for the suspensions of mark-to-market because of the 
adverse impact that it is presently having on the books of so 
many companies.
    Accounting rules should be designed to ensure that a firm's 
disclosures reflect economic reality, however ugly that reality 
may be. Changing the accounting rules now will simply compound 
investors' wariness about investing in a market where many 
firms have bad or illiquid assets on their books.
    I will be interested in hearing from today's witnesses on 
this topic and how the SEC can improve its efforts to protect 
our securities markets while also facilitating continued 
innovation and responsible risk taking.
    Chairman Dodd, I thank you for calling this hearing. I 
think you are on to something here.
    Chairman Dodd. Well, Senator, thank you very, very much. We 
have got quite a row here of witnesses to testify. Let me turn 
to Jack Reed or Michael Bennet. Any opening quick comments, 
Jack?
    Senator Reed. Mr. Chairman, I am very interested in hearing 
the witnesses assembled. We have an impressive panel. Thank 
you.
    Chairman Dodd. Senator Bennet.
    Senator Bennet. Mr. Chairman, thanks for holding the 
hearing. It is from this perspective truly a row of witnesses.
    [Laughter.]
    Senator Bennet. So I will wait until we are done.
    Chairman Dodd. Let me invite you as well, Senator, unless 
others show up, we are more than willing to have you--I am 
sorry I did not see you. If you want to move on up and join us 
here.
    [Laughter.]
    Chairman Dodd. If not, I am fearful I may call on you as a 
witness here.
    Senator Bennet. Well, I have a point of view. I would be 
happy to----
    Chairman Dodd. I am sure you do--I know you do.
    Senator Shelby. We have all sat there.
    Chairman Dodd. Senator Shelby just pointed out, we have 
been in that chair before. In fact, I think I was a chair 
further back in the room a long time ago along the way.
    Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. I was in that chair on this side. I know 
very much what it is like.
    Thank you very much, Mr. Chairman. I will be very brief. I 
really appreciate your holding this and the other hearings that 
you have scheduled. As you know, I am very interested in this 
issue, and I look forward to working with you. And let's get on 
with the witnesses.
    Chairman Dodd. You bet. And I appreciate it. Senator Crapo 
has had a longstanding interest in reg reform issues, and he 
has expressed to me on numerous occasions his desire to be 
involved in this discussion, as has Senator Bennet and others. 
So we have some very interested Members on the Committee who 
want to work together on this issue as we move forward in the 
coming weeks to put together a bill.
    I was listening this morning to the speech by Ben Bernanke 
talking about his ideas--and maybe some of our witnesses--I 
know you have prepared statements, but certainly feel free in 
your comments to react to some of his thoughts this morning. 
That would be welcomed as well, since he made the speech this 
morning--where was it? Brookings?
    Senator Shelby. Foreign Relations.
    Chairman Dodd. Oh, Council on Foreign Relations.
    With that, let me briefly--again, I think most of our folks 
here know our witnesses. Very briefly, we have Professor John 
Coffee, who has been before us many times. He is the Adolf A. 
Berle Professor of Law at Columbia's Law School; Timothy Ryan, 
President and CEO of Securities Industry and Financial Markets 
Association; Paul Schott Stevens, President and CEO of 
Investment Company Institute; Professor Mercer Bullard, 
Associate Professors, University of Mississippi School of Law; 
Robert Pickel, who is the Executive Director and CEO of 
International Swaps and Derivatives Association; Damon Silvers, 
the Associate General Counsel of the AFL-CIO; and Thomas Doe, 
CEO of Municipal Market Advisors; Lynn Turner, the former Chief 
Accountant, U.S. Securities and Exchange Commission.
    So a good row of witnesses here to testify, and we will 
begin in the order that I have introduced you. Dr. Coffee, you 
seem to occupy that chair every time you come here.

 STATEMENT OF JOHN C. COFFEE, JR., ADOLF A. BERLE PROFESSOR OF 
              LAW, COLUMBIA UNIVERSITY LAW SCHOOL

    Mr. Coffee. Well, good morning, and thank you, Chairman 
Dodd, Ranking Member Shelby, and fellow Senators. I have 
prepared an overly long, bulky, 70-page memorandum for which I 
apologize for inflicting on you. It attempts to synthesize a 
good deal of recent empirical research by business school 
scholars, finance scholars, and even law professors, about just 
what went wrong and what can be done about it.
    I cannot summarize all that, but I would add the following 
two sentences to what Senators Dodd and Shelby very accurately 
said at the outset. The current financial crisis is unlike 
others. This was not a bubble caused by investor mania, which 
is the typical cause of bubbles. It was not a demand-driven 
bubble; rather, it was more a supply driven bubble. It was the 
product of a particular business model, a model known as the 
``originate-and-distribute model,'' under which financial 
institutions, including loan originators, mortgage lenders, and 
investment banks, all behaved similarly and went to the brink 
of insolvency and beyond, pursuing a model.
    What is the key element of this originate-and-distribute 
model? You make lax loans. You make non-creditworthy loans 
because--because you do not expect to hold those loans for long 
enough to matter. You believe that you can transfer these loans 
to the next link in the transmission chain before you will bear 
the economic risk.
    When everyone believes that--and they correctly believed 
that for a few years--then all standards begin to become 
relaxed, and we believe that as long as we can get that 
investment grade rating from the credit rating agencies, we 
will have no problem, and weak loans can always be marketed. 
There is no time for statistics here, but let me add just one.
    Between 2001 and 2006, a relatively short period, some of 
the data that I cite shows you that low-document loans in these 
portfolios went from being something like 28 percent in 
mortgage-backed securities in 2001 to 51 percent in 2006--
doubling in 4 or 5 years. Investment banks and credit rating 
agencies are not responding to that change. That is the 
essential problem.
    This gives rise to what I will call and economists call a 
``moral hazard problem,'' and this moral hazard problem was 
compounded by deregulatory policies that the SEC and other 
institutions followed that permitted investment banks to 
increase their leverage dramatically between 2004 and 2006, 
which is only just a few years ago. This is yesterday we are 
talking about. They did this pursuant to the Consolidated 
Supervised Entity Program that you have already been 
discussing, and it led to the downfall of our five largest, 
most important investment banks.
    All right. Essentially, the SEC deferred to self-
regulation, by which these five largest banks constructed their 
own credit risk models, and the SEC deferred to them. The 2008 
experience shows, if there ever was any doubt, that in an 
environment of intense competition and under the pressure of 
equity-based executive compensation systems that tend to be 
very short-term oriented, self-regulation alone simply does not 
work. The simplest way for a financial institution to increase 
profitability was to increase its leverage, and it did so to 
the point where they were leveraged to the eyeballs and could 
not survive the predictable downturn in the economic weather.
    So what should be done from a policy perspective? Well, 
here is my first and most essential point: All financial 
institutions that are too big to fail, which really means too 
entangled to fail, need to be subjected to prudential financial 
oversight, what I would call ``financial adult supervision,'' 
from a common regulator applying a basically common although 
risk-adjusted standard to all these institutions, whether they 
are insurance companies, banks, thrifts, hedge funds, money 
market funds, or even pension plans, or the financial 
subsidiaries of very large corporations, like GE Capital. In my 
judgment, this can only be done by the Federal Reserve Board. 
That is the only person in a position to serve as what is 
called the ``systemic risk regulator.''
    I think we need in this country a systemic risk regulator, 
and specifically to define what this means, let me say there 
are five areas where their authority should be established. The 
Federal Reserve Board should be authorized and mandated to do 
the following five things:
    One, establish ceilings on debt-to-equity ratios and 
otherwise restrict leverage for all major financial 
institutions.
    Two, supervise and restrict the design and trading of new 
financial products, including, in particular, over-the-counter 
derivatives and including the posting of margin and collateral 
for such products.
    Three, mandate the use of clearinghouses. The Federal 
Reserve has already been doing this, formulating this, trying 
to facilitate this, but mandating it is more important. And 
they need the authority to supervise these clearing houses, and 
also if they judge it to be wise and prudent, to require their 
consolidation into a single clearinghouse.
    Four, the Federal Reserve needs the authority to require 
the writedown of risky assets by financial institutions, 
regardless of whether accounting rules mandate it. The 
accountants will always be the last to demand a writedown 
because their clients do not want it. The regulator is going to 
have to be more proactive than are the accounting firms.
    Last, the Federal Reserve should be authorized to prevent 
liquidity crises that come from the mismatch of assets and 
liabilities. The simple truth is that financial institutions 
hold long-term illiquid assets which they finance through 
short-term paper that they have to roll over regularly, and 
that mismatch regularly causes problems.
    Now, under this ``Twin Peaks'' model that I am describing, 
the systematic risk regulator--presumably, the Federal 
Reserve--would have broad authority. But the power should not 
be given to the Federal Reserve to override the consumer 
protection and transparency policies of the SEC. And this is a 
co-equal point with my first point, that we need a systemic 
risk regulator. Too often, bank regulators and banks have 
engaged in what I would term a ``conspiracy of silence'' to 
hide problems, lest investors find out, become alarmed, and 
create a run on the bank.
    The culture of banking regulators and the culture of 
securities regulators is entirely different. Bank regulators do 
not want to alarm investors. Securities regulators understand 
that sunlight is the best disinfectant. And for the long run, 
just as Senator Shelby said, we need accounting policies that 
reveal the ugly truth.
    We could not be worse off now in terms of lack of public 
confidence. This is precisely the moment to make everyone 
recognize what the truth is and not to give any regulator the 
authority to suppress the truth under the guise of systematic 
risk regulation.
    For that reason, I think SEC responsibilities for 
disclosure, transparency, and accounting should be specially 
spelled out and exempted from any power that the systematic 
risk regulator has to overrule other policies.
    Now, two last points. As a financial technology, asset-
based securitization, at least in the real estate field, has 
decisively failed. I think two steps should be done by 
legislation to mandate the one policies that I think will 
restore credibility to this field.
    First, to restore credibility, sponsors must abandon the 
originate-and-distribute business model and instead commit to 
retain at least a portion of the most subordinated tranche, the 
riskiest assets. Some of them have to be held by the promoter 
because that is the one signal of commitment that tells the 
marketplace that someone has investigated these assets because 
they are holding the weakest, most likely to fail. That would 
be step one.
    Step two, we need to reintroduce due diligence into the 
process, into the securitization process, both for public 
offerings and for Rule 144A offerings, which are private 
offerings. Right now Regulation AB deregulated; it does not 
really require adequately that the sponsor verify the loans, 
have the loan documentation in its possession, or to have 
examined the creditworthiness of the individual securities. I 
think the SEC can be instructed by Congress that there needs to 
be a reintroduction of stronger due diligence into both the 
public and the private placement process.
    Last point. Credit rating agencies are obviously the 
gatekeeper who failed most in this current crisis. The one 
thing they do not do that other gatekeepers do do is verify the 
information they are relying on. Their have their rating 
methodology, but they just assume what they are told; they do 
not verify it. I think they should be instructed that there has 
to be verification either by them or by responsible, 
independent professionals who certify their results to them.
    The only way to make that system work and to give it teeth 
is to reframe a special standard of liability for the credit 
rating agencies. I believe the Congress can do this, and I 
believe that Senator Reed and his staff are already examining 
closely the need for additional legislation for credit rating 
agencies, and I think they are very much on the right track, 
and I would encourage them.
    What I am saying, in closing, is that a very painful period 
of deleveraging is necessary. No one is going to like it. I 
think some responsibility should be given to the Federal 
Reserve as the overall systematic risk regulator, but they 
should not have authority to in any way overrule the SEC's 
policies on transparency.
    Thank you.
    Chairman Dodd. Thank you very much, Professor.
    Mr. Ryan, welcome.

    STATEMENT OF T. TIMOTHY RYAN, JR., PRESIDENT AND CHIEF 
           EXECUTIVE OFFICER, SECURITIES INDUSTRY AND
                 FINANCIAL MARKETS ASSOCIATION

    Mr. Ryan. Good morning. Thank you for inviting me. I 
appreciate being here.
    Our current financial crisis, which has affected nearly 
every American family, underscores the imperative to modernize 
our financial regulatory system. Our regulatory structure and 
the plethora of regulations applicable to financial 
institutions are based on historical distinctions between 
banks, securities firms, insurance companies, and other 
financial institutions--distinctions that no longer conform to 
the way business is conducted.
    The negative consequences to the investing public of this 
patchwork of regulatory oversight are real and pervasive. 
Investors do not have comparable protections across the same or 
similar financial products. Rather, the disclosures, standards 
of care, and other key investor protections vary based on the 
legal status of the intermediary or the product or service 
being offered.
    In light of these concerns, SIFMA advocates simplifying and 
reforming the financial regulatory structure to maximize and 
enhance investor protection and market integrity and 
efficiency.
    Systemic risk, as Professor Coffee noted, has been at the 
heart of the current financial crisis. As I have previously 
testified, we at SIFMA believe that a single, accountable 
financial markets stability regulator, a systemic regulator, 
will improve upon the current system. While our position on the 
mission of the financial markets stability regulator is still 
evolving, we currently believe that its mission should consist 
of mitigating systemic risk, maintaining financial stability, 
and addressing any financial crisis, all of which will benefit 
the investing public. It should have authority over all markets 
and market participants, regardless of charter, functional 
regulator, or unregulated status. It should have the authority 
to gather information from all financial institutions and 
markets, adopt uniform regulations related to systemic risk, 
and act as a lender of last resort. It should probably have a 
more direct role in supervising systemically important 
financial organizations, including the power to conduct 
examinations, take prompt corrective action, and appoint or act 
as the receiver or conservator of all or part of systemically 
important organizations.
    We also believe, as a second step, that we must work to 
rationalize the broader regulatory framework to eliminate 
regulatory gaps and imbalances that contribute to systemic risk 
by regulating similar activities and firms in a similar manner 
and by consolidating certain financial regulators.
    SIFMA has long advocated the modernization and 
harmonization of the disparate regulatory regimes for 
investment advisory, brokerage, and other financial services in 
order to promote investor protection. SIFMA recommends the 
adoption of a ``universal standard of care'' that avoids the 
use of labels that tend to confuse the investing public and 
expresses, in plain English, the fundamental principles of fair 
dealing that individual investors can expect from all of their 
financial services providers. Such a standard could provide a 
uniform code of conduct applicable to all financial 
professionals. It would make clear to all individual investors 
that their financial professionals are obligated to treat them 
fairly by employing the same core standards whether the firm is 
a financial planner, an investment adviser, a securities 
dealer, a bank, an insurance agency, or any other type of 
financial service provider.
    The U.S. is the only jurisdiction that splits the oversight 
of securities and futures activities between two separate 
regulatory bodies. We support the merger of the SEC and the 
CFTC.
    We believe that the development of a clearinghouse for 
credit derivatives is an effective way to reduce counterparty 
credit risk, facilitate regulatory oversight, and, thus, 
promote market stability. In particular, we strongly support 
our members' initiative to establish a clearinghouse of CDS, 
and we are pleased to note that ICE US Trust opened its doors 
for clearing CDS transactions yesterday.
    Finally, the current financial crisis reminds us that 
markets are global in nature, and so are the risks of 
contagion. To promote investor protection through effective 
regulation and the elimination of disparate regulatory 
treatment, we believe that common regulatory standards should 
be applied consistently across markets. Accordingly, we urge 
that steps be taken to foster greater cooperation and 
coordination among regulators in all major markets.
    Thank you.
    Chairman Dodd. Thank you very much for that.
    Paul, welcome. It is nice to see you and have you before 
the Committee.

STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT AND CHIEF EXECUTIVE 
                  OFFICER, INVESTMENT COMPANY
                           INSTITUTE

    Mr. Stevens. Thank you very much, Mr. Chairman. On behalf 
of the Institute and our member funds, I thank you, Chairman 
Dodd, Senator Shelby, and all the Members of the Committee for 
making it possible for me to appear today. We serve 93 million 
American investors, as you know, and we strongly commend the 
Committee for the attention you are devoting to improving our 
system of financial regulation.
    I believe the current financial crisis provides a very 
strong public mandate for Congress and for regulators to take 
bold steps to strengthen and modernize regulatory oversight. 
Like other stakeholders, and there are many, of course, we have 
been thinking hard about how to revamp the current system. Last 
week, we published a white paper detailing a variety of 
reforms, and in it we recommend changes to create a regulatory 
framework that provides strong consumer and investor protection 
while also enhancing regulatory efficiencies, limiting 
duplication, closing conspicuous regulatory gaps, and frankly, 
emphasizing the national character of our financial services 
markets. I would like briefly to summarize the proposals.
    First, we believe it is crucial to improve the government's 
capability to monitor and mitigate risks across the financial 
system, so ICI supports creation of a Systemic Risk Regulator. 
This could be a new or an existing agency or interagency body, 
and in our judgment should be responsible for monitoring the 
financial markets broadly, analyzing changing conditions here 
and overseas, evaluating and identifying risks that are so 
significant that they implicate the health of the financial 
system, and acting in coordination with other responsible 
regulators to mitigate these risks.
    In our paper, we stress the need to carefully define the 
responsibilities of a Systemic Risk Regulator as well as its 
relationships with other regulators, and I would say, Mr. 
Chairman, that is one of the points that Chairman Bernanke made 
in his speech today, to leverage the expertise and to work 
closely with other responsible regulators in accomplishing that 
mission.
    In our judgment, addressing systemic risk effectively, 
however, need not and should not mean stifling innovation, 
retarding competition, or compromising market efficiency. You 
can achieve all of these purposes, it seems to us, at the same 
time.
    Second, we urge the creation of a new Capital Markets 
Regulator that would combine the functions of the SEC and the 
CFTC. This Capital Markets Regulator's statutory mission should 
focus sharply on investor protection and law enforcement. It 
should also have a mandate, as the SEC does currently, to 
consider whether its proposed regulations promote efficiency, 
competition, and capital formation.
    We suggest several ways to maximize the effectiveness of 
the new Capital Markets Regulator. In particular, we would 
suggest a need for a very high-level focus on management of the 
agency, its resources, and its responsibilities, and also the 
establishment of mechanisms to allow it to stay much more 
effectively abreast of market and industry developments.
    Third, as we discuss more fully in our white paper, 
effective oversight of the financial system and mitigation of 
systemic risk will require effective coordination and 
information sharing among the Systemic Risk Regulator and 
regulators responsible for other financial sectors.
    Fourth, we have identified areas in which the Capital 
Markets Regulator needs more specific legislative authority to 
protect investors and the markets by closing regulatory gaps 
and responding to changes in the marketplace. In my written 
statement, I identify four such areas: hedge funds, 
derivatives, municipal securities, particularly to improve 
disclosure standards, and the inconsistent regulatory regimes 
that exist today for investment advisors and broker dealers.
    Now, as for mutual funds, they have not been immune from 
the effects of the financial crisis, nor, for that matter, have 
any other investors. But our regulatory structure, and this 
bears emphasizing, which grew out of the New Deal as a result 
of the last great financial crisis, has proven to be remarkably 
resilient, even through the current one.
    Under the Investment Company Act of 1940 and other 
securities laws, fund investors enjoy a range of vital 
protections: Daily pricing of fund shares with mark-to-market 
valuation every business day; separate custody of all fund 
assets; minimal or no use of leverage in our funds; 
restrictions on affiliated transactions and other forms of 
self-dealing; required diversification; and the most extensive 
disclosure requirements faced by any financial products.
    Funds have embraced this regulatory regime and they have 
prospered under it. Indeed, I think recent experience suggests 
that policymakers should consider extending some of these very 
same disciplines that have worked so well for us since 1940 to 
other marketplace participants in reaction to the crisis that 
we are experiencing today.
    Finally, let me comment, Mr. Chairman, briefly on money 
market funds. Last September, immediately following the 
bankruptcy of Lehman Brothers, a single money market fund was 
unable to sustain its $1 per share net asset value. Coming hard 
on the heels of a series of other extraordinary developments 
that roiled global financial markets, these events worsened an 
already severe credit squeeze. Investors wondered what other 
major financial institution might fail next and how other money 
market funds might be affected.
    Concern that the short-term fixed income market was all but 
frozen solid, the Federal Reserve and the Treasury Department 
took a variety of initiatives, including the establishment of a 
temporary guarantee program for money market funds. These steps 
have proved highly successful. Over time, investors have 
regained confidence. As of February, assets in money market 
funds were at an all-time high, almost $3.9 trillion.
    The Treasury Department's temporary guarantee program will 
end no later than September 18. Funds have paid more than $800 
million in premiums, yet no claims have been made and we do not 
expect any claims to be made. We do not envision any future 
role for Federal insurance of money market fund assets and we 
look forward to an orderly transition out of the temporary 
guarantee program.
    The events of last fall were unprecedented, but it is only 
responsible that we, the fund industry, look for lessons 
learned. So in November 2008, ICI formed a working group of 
senior fund industry leaders to study ways to minimize the risk 
to money market funds of even the most extreme market 
conditions. That group will issue a strong and comprehensive 
set of recommendations designed, among other things, to enhance 
the way money funds operate. We expect that report by the end 
of the month. We hope to place the executive summary in the 
record of this hearing, and Mr. Chairman, I would be delighted 
to return to the Committee, if it is of interest to you, to 
present those recommendations at a future date.
    Thank you very much.
    Chairman Dodd. Thank you very much for that. We will 
welcome that addition to the Committee record, as well.
    Professor Bullard, thank you very much for joining us.

STATEMENT OF MERCER E. BULLARD, ASSOCIATE PROFESSOR, UNIVERSITY 
 OF MISSISSIPPI SCHOOL OF LAW, AND PRESIDENT, FUND DEMOCRACY, 
                              INC.

    Mr. Bullard. Thank you, Chairman Dodd, Ranking Member 
Shelby, and Members of the Committee for the opportunity to 
appear here today. I congratulate the Committee for its 
thorough and deliberate investigation into the causes of the 
current financial crisis.
    Recent events have provided useful lessons on the 
management of systemic risk, prudential regulation, and 
investor protection in the investment management industry. The 
performance of stock and bond mutual funds, for example, has 
demonstrated the remarkable resiliency of the investment 
company structure in times of stress. As equity values have 
plummeted, most shareholders and stock funds have stood their 
ground, notwithstanding that they have the right to redeem 
their shares at short notice at their NAVs.
    There is no scientific explanation for the stability of 
mutual funds during this crisis, but I believe it is related to 
this redemption right, as Paul was describing a moment ago. 
Mutual fund investors are confident that they will receive the 
net asset value of their holdings upon redemption and they 
appear to believe that the net asset value of those shares--the 
net asset value will be fair and accurate. This confidence in 
the valuation and redeemability of mutual fund shares reduces 
the likelihood of the kind of panic selling that creates 
systemic risk and may provide a useful lesson for the 
regulation of other financial intermediaries.
    The current crisis has exposed certain investor protection 
issues, however. Many investors in target date and short-term 
bond funds have experienced investment returns that are not 
consistent with returns typical of that asset class. If a fund 
uses the name Target Date 2010, for example, its equity 
allocation should fall within the generally expected range for 
someone on the brink of retirement. Similarly, a 529 plan 
option that is touted as appropriate for a 16-year-old should 
not lose 40 percent of its value 2 years before the money will 
be needed for college.
    Investors should be free to choose more aggressive asset 
allocations than those normally considered most appropriate for 
this situation. But funds that use a name that most investors 
will assume reflects a particular strategy should be required 
to invest consistent with that strategy.
    In contrast with other types of mutual funds, the 
performance of money market funds has raised systemic and 
prudential regulation concerns. Money market funds constitute a 
major linchpin in our payment system and therefore a run on 
these funds poses significant systemic risk. The management of 
this risk has been inadequate, as demonstrated by the recent 
run on money market funds following the failure of the reserve 
primary fund.
    There are important lessons to be learned from this 
experience, but not the lessons that some commentators have 
found. The Group of 30, for example, has recommended that the 
money market franchise be eliminated. Former Fed Chairman 
Volcker explained that if money market funds are going to talk 
like a bank and squawk like a bank, they ought to be regulated 
like a bank. The problem with this argument is that money 
market funds don't fail like banks.
    Since 1980, more than 3,000 U.S. banks have failed, costing 
taxpayers hundreds of billions of dollars. During the same 
period, two money market funds have failed, costing taxpayers 
zero dollars. I agree that a regulatory rearrangement is in 
order, but it is banks that should be regulated more like money 
market funds. Banks routinely fail because they invest in 
risky, long-term assets while money market funds invest in 
safe, short-term assets. Insuring bank accounts may be 
necessary to protect against the systemic risk that a run on 
banks poses to the payment system, but there is no good reason 
why banks should be permitted to invest insured deposits in 
anything other than the safest assets. And there is no good 
reason why money market funds that pose the same systemic risk 
to our payment system should be left uninsured.
    I note, Chairman Dodd, you may have picked up this morning 
on Chairman Bernanke's comments that some kind of interim 
insurance program may be an appropriate response to the crisis, 
and I have to disagree with Paul that the program will 
necessarily end in September. I posted an article on SSRN that 
deals with one thesis of how to approach money market fund 
insurance and I hope the Committee and staff will take a look 
at that.
    The current crisis has also exposed significant weaknesses 
in hedge fund and investment advisor regulation. For example, 
hedge funds are permitted to sell investments to any person 
with a net worth of at least $1 million, a minimum that has not 
been adjusted since 1982. This means that a hedge fund is free 
to sell interest to a recently retired couple that owns a 
$250,000 house and has $750,000 in investments, notwithstanding 
that their retirement income is likely to be around $35,000 a 
year before Social Security.
    Finally, the Madoff scandal has again reminded us of the 
risks of the SEC's expansive interpretation of the broker 
exclusion from the definition of investment advisor. It appears 
that Madoff did not register as an investment advisor in 
reliance on the SEC's position that managing discretionary 
accounts could somehow be viewed as solely incidental to 
related brokerage services. This over-broad exclusion left 
Madoff subject only to broker regulation, which failed to 
uncover this fraud.
    The SEC has since rescinded its ill-advised position on 
discretionary accounts, but it continues to read the ``solely 
incidental'' exception so broadly as to leave thousands of 
brokers who provide individualized investment advice subject 
only to a broker's suitability obligation. These brokers should 
be subject to the same fiduciary duties that other investment 
advisors are subject to, including the duty to disclose revenue 
sharing payments and other compensation that create a potential 
conflict with their clients' interests.
    And finally, I would just add to the comments on the 
question of systemic or prudential regulator. I agree with 
Professor Coffee's comments that there is something simply 
fundamentally inconsistent with the SEC's investor protection 
role and the prudential role that it has not served 
particularly well in recent times and that those roles should 
be separated. I agree that there should be a Federal Prudential 
Regulator, which is what I would call it, that oversees all of 
those similar characteristics, such as net capital rules, money 
market fund rules, banking regulations that share those 
prudential or systemic risk concerns. It is not clear to me, 
however, that the particular types of liabilities that 
insurance companies hold would be suitable for one common 
prudential regulator, but that is something we don't 
necessarily need to consider unless the Federalizing of 
insurance regulation begins to make additional progress.
    And I would also add that we need to keep in mind that 
there is a significant difference between customer protection 
and investor protection. I think when Paul was talking about a 
Capital Markets Regulator, the way I would think of capital 
markets as being a way of talking about a regulator as investor 
protection regulator, which would serve fundamentally different 
functions, especially in that it embraces risk and looks to the 
full disclosure of that risk as its principal objective as 
opposed to what might be viewed as customer protection, which 
is really to ensure that promised services are what are 
delivered in a fully disclosed and honest way.
    These and other issues are addressed in greater detail in 
my written submission. Thank you very much.
    Chairman Dodd. Thank you very, very much.
    Mr. Pickel, we thank you for joining the Committee.

   STATEMENT OF ROBERT PICKEL, EXECUTIVE DIRECTOR AND CHIEF 
    EXECUTIVE OFFICER, INTERNATIONAL SWAPS AND DERIVATIVES 
                          ASSOCIATION

    Mr. Pickel. Thank you, Mr. Chairman and Ranking Member 
Shelby and Members of the Committee. Thank you for inviting 
ISDA to testify here today. We are grateful for the opportunity 
to discuss the privately negotiated derivatives business, and 
more specifically, the credit default swaps market.
    I have submitted written testimony, and as you noted, Mr. 
Chairman, it is a lengthy submission and so I would like to 
summarize some of the key remarks that I included in that 
testimony.
    I think first and foremost, we need to understand that the 
benefits of the OTC derivatives business are significant for 
the American economy and American companies. They manage a 
broad range of risk using these instruments that are not 
central to their businesses, allowing them to manage these 
financial risks typically so that they can focus on the 
business that they run. So a borrower borrowing on a floating 
basis can use an interest rate swap to manage its exposure to 
exchange fixed for floating obligations.
    Currency exposure--many companies have significant 
operations around the world and have significant currency 
exposure and use currency swaps, OTC currency swaps, to manage 
that risk. ISDA itself uses currency swaps to manage its 
overseas exposure.
    Commodity exposure--airlines have significant exposure to 
fuel costs and they typically look to utilize OTC derivatives 
to manage that exposure.
    And finally, credit exposure--using credit derivatives, 
credit default swaps, exposure to suppliers or to customers 
where credit is a significant concern, companies can use these 
products to help manage that risk.
    These products also create efficiencies in pricing and 
wider availability of credit, particularly credit default 
swaps. They facilitate lending at lower rates, and they are 
critical to have available, and have them widely available, as 
we come out of this recession. I think they will be an 
important part of the ability of firms to manage credit risk as 
they look at these important credit issues that we face in this 
financial crisis.
    As far as the role of the credit default swaps and OTC 
derivatives generally in the financial crisis, first of all, I 
think, and this Committee has certainly heard testimony, the 
fundamental source of the crisis is imprudent lending, 
particularly in the U.S. housing sector, but extending to other 
markets, as well, credit cards and commercial lending as an 
example. We must distinguish between the credit default swap 
business and the collateralized debt obligation business. There 
has been reference to the originate to distribute model. That 
certainly applies to the securitization process and to the CDO 
process.
    In the credit default swap business, a company, a bank that 
has lent money may use a credit default swap to hedge its 
exposure on that credit. In that process, it will be 
maintaining its lending relationship with the borrower and it 
will also be taking on credit risk and paying a fee to the 
company that is selling protection. So it is distinctly 
different from the originate to distribute model.
    We certainly have heard testimony, and this Committee heard 
testimony last week on the AIG situation. I think we need to 
spend some time and this organization needs to spend some time 
talking about that. AIG obviously was significantly involved in 
credit default swaps. It was the means by which it took risk. 
But we must understand the poor choices, the adverse policies, 
and the misunderstood risk that were involved there, and this 
Committee heard a lot about that in the testimony last week, 
particularly from Mr. Polakoff from the Office of Thrift 
Supervision.
    These were the source of their problems, these 
misunderstood risks and poor decisions. They were contrary to 
the best practices in the industry and to the experiences of 
swap market participants for the past 20 years. The fundamental 
decision that AIG made was to take on exposure to the housing 
market. They did that, yes, via credit default swaps. They also 
did that, as the Committee heard last week, in other means, as 
well, through their securities lending business, in which they 
actually continued to lend and take exposure to those markets 
into 2006 and 2007, when the worst of these securities were 
generated through the lending process.
    They also had a very myopic view of loss. They were only 
looking at the payout potential, the possibility they would 
actually have to pay out on these transactions. There was no 
consideration of the implications of the mark-to-market losses 
that they could face and to the effects on their capital and 
their liquidity. They seem to have completely ignored the 
possible effects of that.
    They relied on their AAA rating and refused to provide 
collateral from the start of their trading relationships. It 
takes away the discipline that collateral provides in that 
trading relationship. Collateral is extensively used in the OTC 
derivatives business to help manage risk and also introduce 
discipline to the trading relationship. They agreed, on the 
other hand, to provide collateral on the downgrade of their 
credit rating. That led to a falling off of a cliff, 
effectively, leading to substantial liquidity problems which 
eventually led to the decision to intervene.
    So yes, these decisions and policies are important to 
understand and we need to take steps to make sure that this 
does not happen again, but those relate to the decisions they 
made and not to the products themselves. The products, in fact, 
have performed as the parties intended. In fact, just 
yesterday, the Senior Supervisors Group, which is a group of 
senior supervisors from the G-7 countries, talked about how the 
CDS product had performed multiple times over the course of 
last fall and into this year in helping to settle transactions, 
credit default swaps that parties had engaged in, and they 
acknowledged that this process has been extremely effective.
    And then finally, this is a very important week in the 
credit default swap market. I believe Mr. Ryan referred earlier 
to the fact that one of the clearinghouses that has been talked 
about for many, many months has now actually begun to clear 
transactions, and that is a very significant development. And 
later this week, ISDA itself will introduce some changes to the 
standard contract that will facilitate the settlement of these 
trades in the future and will also facilitate moving more 
transactions onto a clearinghouse. So that is a very important 
development.
    There is much to be done by ISDA, by the industry, in close 
consultation with this Committee and other committees in 
Congress as well as the regulators here in the United States 
and globally and we are committed to be engaged in that 
process. We look forward to working with you as you analyze the 
causes of this financial crisis, and based on that analysis, 
consider changes to our regulatory structure with a goal to 
obtaining greater transparency, greater disclosure, and greater 
coordination among regulators.
    Thank you again for your time, and I look forward to your 
questions.
    Chairman Dodd. Thank you very, very much, Mr. Pickel.
    Damon Silvers. Damon, it is good to have you with us. Thank 
you.

 STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL COUNSEL, AFL-
                              CIO

    Mr. Silvers. Good morning, Chairman Dodd and Ranking Member 
Shelby. Thank you for inviting me here today. Before I begin, I 
would like to note that in addition to my role as Associate 
General Counsel of the AFL-CIO, I am the Deputy Chair of the 
Congressional Oversight Panel created by the Emergency Economic 
Stabilization Act of 2008 to oversee the TARP. While I will 
describe in my testimony aspects of the Congressional Oversight 
Panel's report on regulatory reform, my testimony reflects my 
views alone and the views of the AFL-CIO unless otherwise noted 
and is not on behalf of the panel, its staff, or its chair.
    The vast majority of American investors participate in the 
markets as a means to secure a comfortable retirement and to 
send their children to college, as you noted, Mr. Chairman, in 
your opening remarks. While the spectacular frauds like the 
Madoff Ponzi scheme have generated a great deal of publicity, 
the bigger question is what changes must be made to make our 
financial system a more reasonable place to invest the hard-
earned savings of America's working families.
    Today, I will address this larger question at three levels: 
Regulatory architecture, regulating the shadow markets and the 
challenge of jurisdiction, and certain specific steps Congress 
and regulators should take to address holes in the investor 
protection scheme.
    First, with respect to regulatory architecture, the 
Congressional Oversight Panel in its special report on 
regulatory reform observed that addressing issues of systemic 
risk cannot be a substitute for a robust, comprehensive system 
of routine financial regulation. Investor protection within 
this system should be the focus of a single agency within the 
broader regulatory framework. That agency needs to have the 
stature and independence to protect the principles of full 
disclosure by market participants and compliance with fiduciary 
duties among market intermediaries. This has been noted by 
several of the panelists prior to me.
    This mission is in natural tension with bank regulators' 
mission of safeguarding the safety and soundness of the banks 
they regulate, and that natural tension would apply to a 
Systemic Risk Regulator that was looking more broadly at safety 
and soundness issues. Because of these dynamics, effective 
investor protection requires that any solution to the problem 
of systemic risk prevention should involve the agency charged 
with investor protection and not supercede it.
    I have a more detailed document on issues associated with 
creating a Systemic Risk Regulator that I will provide the 
Committee following the hearing. I should just note that in 
relation to this, it is my belief that more of a group approach 
to systemic risk regulation rather than designating the Fed as 
the sole regulator would be preferable.
    Among the reasons for this are the issues of information 
sharing and coordination that other panelists raised, but most 
importantly, the fact that the Federal Reserve in its 
regulatory role fundamentally works through the regional Fed 
banks, which are fundamentally self-regulatory in nature. 
Several of the prior witnesses have mentioned some of the 
problems with self-regulation on critical issues. Furthermore, 
a Systemic Risk Regulator, as we have learned through the TARP 
experience, is likely to have to expend public dollars in 
extreme circumstances. It is completely inappropriate for that 
function to be vested in a body that is at all self-regulatory. 
While the Fed could be changed, its governance could be changed 
to make it fully a public agency, that would have implications, 
I believe, for the Fed's independence in its monetary policy 
role.
    Now, we have already in the Securities and Exchange 
Commission a regulator focused on investor protection. Although 
the Commission has suffered in recent years from diminished 
jurisdiction and leadership failure, the Commission remains an 
extraordinary government agency whose human capital and market 
expertise needs to be built upon as part of a comprehensive 
strategy for effective re-regulation of the capital markets. 
This point flows right into the issue of jurisdiction and the 
shadow markets.
    The financial crisis we are currently experiencing is 
directly connected to the degeneration of the New Deal system 
of comprehensive financial regulation into a Swiss cheese 
regulatory system where the holes, the shadow markets, grew to 
dominate the regulated markets. The Congressional Oversight 
Panel specifically observed that we need to regulate financial 
products and institutions, in the words of President Obama, 
``for what they do and not what they are.''
    The Congressional Oversight Panel's report further stated 
that shadow institutions should be regulated by the same 
regulators that currently have jurisdiction over their 
regulated counterparts. So, for example, the SEC should have 
jurisdiction over derivatives that are written using public 
debt or equity securities as their underlying asset. At a 
minimum, the panel stated, hedge funds should also be regulated 
by the SEC in their role as money managers.
    There is a larger point here, though. Financial re-
regulation will be utterly ineffective if it turns into a 
series of rifle shots at the particular mechanisms used to 
evade regulatory structures in earlier boom and bust cycles. 
What is needed is a return to the jurisdictional philosophy 
that was embodied in the founding statutes of Federal 
securities regulation: Very broad, flexible jurisdiction that 
allowed the Commission to follow changing financial market 
practices.
    If you follow this principle, the SEC should have 
jurisdiction over anyone over a certain size who manages public 
securities and over any contract written that references 
publicly traded securities. Applying this principle would 
require at least shifting the CFTC's jurisdiction over 
financial futures to the SEC, if not merging the two agencies 
under the SEC's leadership, as I gather some of my fellow 
panelists believe is necessary.
    Moving on to substantive reforms, beyond regulating the 
shadow markets, the Congress and the Securities and Exchange 
Commission need to act to shape a corporate governance and 
investor protection regime that is favorable to long-term 
investors and to the channeling of capital to productive 
purposes.
    First, strong boards of publicly traded companies that the 
public invests in--having strong boards requires meaningful 
accountability to long-term investors. The AFL-CIO urges 
Congress to work with the SEC to ensure that long-term 
investors can nominate and elect psychologically independent 
directors to company boards through access to the corporate 
proxy.
    Second, effective investor protection requires 
comprehensive executive pay reform involving both disclosure 
governance and tax policy around two concepts. Equity-linked 
pay should be held significantly beyond retirement. And two, 
pay packages as a whole should reflect a rough equality of 
exposure to downside risk as well as to upside gain. Part of 
this agenda must be a mechanism for long-term shareholders to 
advise companies on their executive pay packages in the form of 
an advisory vote.
    Finally, Congress needs to address the glaring hole in the 
fabric of investor protection created by the Central Bank of 
Denver and Stoneridge cases. These cases effectively granted 
immunity from civil liability to investors for parties such as 
investment banks and law firms that are actual co-conspirators 
in securities frauds.
    Now, to address very briefly the international context, the 
Bush administration fundamentally saw the internationalization 
of financial markets as a pretext for weakening U.S. investor 
protections. That needs to be replaced by a commitment on the 
part of the Obama administration, the Congress, and the 
regulators to building a strong global regulatory floor in 
coordination with the world's other major economies. However, 
Congress should not allow the need for global coordination to 
be an impediment or a prerequisite to vigorous action to re-
regulate U.S. financial markets and institutions.
    Obviously, this testimony simply sketches the outline of an 
approach and notes some key substantive steps for Congress and 
the administration to take. While I do not speak for the 
Oversight Panel, I think I am safe in saying that the Panel is 
honored to have been asked to assist Congress in this effort 
and is prepared to assist this Committee in any manner the 
Committee finds useful. I can certainly make that offer on 
behalf of the AFL-CIO. Thank you.
    Chairman Dodd. Thank you very much.
    Mr. Doe, we thank you for joining us, the Municipal Market 
Advisors.

  STATEMENT OF THOMAS DOE, CHIEF EXECUTIVE OFFICER, MUNICIPAL 
                        MARKET ADVISORS

    Mr. Doe. Chairman Dodd, Senator Shelby, and Committee 
Members, is a distinct pleasure that I come before you today to 
share my perspective on the municipal bond market. My firm, 
Municipal Market Advisors, has served for the past 15 years as 
the leading independent research and data provider to the 
industry. In addition, from 2003 to 2005, I served as a public 
member of the Municipal Securities Rulemaking Board, the self-
regulatory organization of the industry established by Congress 
in 1975.
    There are nearly 65,000 borrowers in the municipal market 
that are predominantly States and local governments. Recent 
figures identify an estimated $2.7 trillion in outstanding 
municipal debt. This is debt that aids our communities in 
meeting budgets and financing society's essential needs, 
whether it is building a hospital, constructing a school, 
ensuring clean drinking water, or sustaining the safety of 
America's infrastructure.
    A distinctive characteristic of the municipal market is 
that many of those who borrow funds--rural counties and small 
towns--are only infrequently engaged in the capital markets. As 
a result, there are many issuers of debt who are inexperienced 
when entering a transaction and are unable to monitor deals 
that may involve movement of interest rates of the value of 
derivative products.
    According to The Bond Buyer, the industry's trade 
newspaper, annual municipal bond issuance was $29 billion in 
1975; whereas, in 2007, issuance peaked at $430 billion. In the 
past 10 years, derivatives have proliferated as a standard 
liability management tool for many local governments. However, 
because derivatives are not regulated, it is exceptionally 
difficult, if not impossible, to identify the degree of 
systemic as well as specific risk to small towns and counties 
who have engaged in complex swaps and derivative transactions.
    Municipal issuers themselves sought to reduce borrowing 
costs in recent years by selling bonds with a floating rate of 
interest, such as auction rate securities. Because States and 
local governments do not themselves have revenues that vary 
greatly with interest rates, these issuers employed interest 
rate swaps to hedge their risk. Issuers use the instruments to 
transform their floating risk for a fixed-rate obligation.
    A key factor in the growth of the leverage and derivative 
structures was the prolific use of bond insurance. Municipal 
issuers are rated along a conservative rating scale, resulting 
in much lower ratings for school districts and States than for 
private sector financial and insurance companies. So although 
most States and local governments represent very little default 
risk to the investor, the penal ratings scale encouraged the 
use of insurance for both cash and derivatives in order to 
distribute products to investors and facilitate issuer 
borrowing.
    So instead of requiring more accurate ratings, the 
municipal industry chose to use bond insurance to enhance the 
issuer's lower credit rating to that of the higher insurance 
company's rating.
    The last 18 months have exposed the risks of this choice 
when insurance company downgrades, and auction rate security 
failures, forced numerous leveraged investors to unwind massive 
amounts of debt into an illiquid secondary market. The 
consequence was that issuers of new debt were forced to pay 
extremely high interest rates and investors were confused by 
volatile evaluations of their investments.
    The 34-year era of the municipal industry's self-regulation 
must come to an end. Today, the market would be in a much 
better place if:
    First, the regulator were independent of the financial 
institutions that create the products and facilitate issuers' 
borrowing. Municipal departments represent a relatively small 
contribution to a firm's revenue, and this inhibits MSRB board 
members from seeking regulatory innovation.
    Second, if the regulator were integrated into the national 
regime of regulation. Since the crisis began, we have 
discovered a limited market knowledge here in D.C., in the 
Federal Reserve, Treasury, Congress, and the SEC. I might add 
that when the crisis began to emerge in August 2007, we were 
immediately contacted by the New York Federal Reserve and the 
Federal Reserve itself, and are quite impressed in the last 18 
months with their vigilance and interest in this sector. So 
integration, we believe, would speed market recovery by the 
shared information.
    Third, the regulator's reach and authority needs to be 
extended to all financial tools and participants of the 
municipal transaction. This meant ratings agencies, insurers, 
evaluators, and investment and legal advisors for both the cash 
and swaps transactions. This need has become more apparent as 
we uncover the damaged issuers, and States such as Alabama, 
Tennessee, and Pennsylvania are suffering relative to interest 
rate swaps.
    Fourth, if the regulator were charged with more 
aggressively monitoring market data with consumers' interests 
in mind. When I think of consumers, I think of both investors 
and the issuers. In 2008, there were specific instances of 
meaningful transactions and price irregularities that should 
have prompted regulatory investigation to protect consumers.
    The good news is that this new era of regulatory oversight 
can be funded by the MSRB's annual revenue in 2008 of $20-plus 
million, collected from the bond transactions themselves, and 
can be staffed by the current MSRB policy and administrative 
infrastructure.
    I should be clear. The innovations of derivatives and swaps 
have a useful application and have been beneficial for those 
for which they are appropriate. However, it is also important 
that these instruments become transparent and regulated with 
the same care as the corresponding municipal cash market.
    It is critical to get this right. There is simply too much 
at stake.
    Thank you for having me here today, and I look forward to 
participating in the questions of the session.
    Chairman Dodd. Thank you very much, Mr. Doe.
    Lynn Turner is the former Chief Accountant at the 
Securities and Exchange Commission. Mr. Turner, we thank you.

     STATEMENT OF LYNN E. TURNER, FORMER CHIEF ACCOUNTANT, 
               SECURITIES AND EXCHANGE COMMISSION

    Mr. Turner. Thank you, Chairman Dodd and Ranking Member 
Shelby. It is always good to be here in this particular case, 
so I must commend both of you for holding this hearing on an 
issue that has not only impacted millions of investors but just 
literally everyone that has been devastated from this economy.
    I would ask that my written testimony be included in the 
record.
    Chairman Dodd. Yes, let me make that clear. There is a lot 
of additional documentation, and some of you may want to add as 
well, and so all of that will be included as part of the 
record. We thank you for that.
    Mr. Turner. It is only 17 pages, so it is a little bit 
quicker read than Professor Coffee's.
    Senator Dodd, I think you are right. There are really three 
root causes of this problem: people made bad loans, gatekeepers 
sold out, and a lack of regulation or regulators missing in 
action, quite frankly. And it is not the first time. As an 
auditor in the Southwest, in Denver, I lived through this with 
the S&Ls, had to do restructurings, workouts at that point in 
time. And those issues were all existent then, and we are back 
to a repeat.
    So, as Mr. Doe and Mr. Silvers indicated, I think it is 
especially important that this go-round the Committee get it 
right. I know that there is some push to try to get something 
done by an August recess. I would say it is more important to 
hit this target. We have seen the markets are serviced, a 
trustee of two large institutional investors. We have seen 
legislation come out that has not instilled that confidence to 
date. And we need to get it right this time so we instill that 
confidence and do not see a market of 5,000, quite frankly. So 
I would ask you to take your time, whatever is necessary, 
sooner better than late, but I am not sure this is one that can 
be both fast and right.
    Senator Shelby, you asked someone to comment on the mark-
to-market accounting. Being the one accountant, the one green 
eyeshade on this, let me say I could not agree more with you. 
The mark-to-market accounting that we are debating now is the 
same issue we debated two decades ago during the S&L crisis, 
and as the 1991 GAO report stated, the failure of the banks and 
the S&Ls during that travesty, to turn around, take marks down 
in a timely manner resulted in lax regulator action, people not 
getting on top of managing the assets and problems quick 
enough, and contributed to a significant increase in the cost 
to the taxpayers of that bailout. And so I would again urge you 
to push for transparency here, not step on those accounting 
standards, and let us get the real numbers.
    When you look at banks like Citigroup, who are trading at a 
stock price for less than what you can buy a Happy Meal these 
days at McDonald's, we know that the market clearly is not 
viewing those financials as credible, and we need to get that 
credibility back into the system.
    Certainly, as my fellow panelists mentioned, there are also 
gaps in regulation. Without a doubt, the credit derivatives 
market--we all know about that. You certainly have all heard 
about that as recently as this last week. But it was not so 
much the failure of a regulatory system, although things need 
to be fixed, as it was a failure of regulators to act. The 
Office of the Comptroller of the Currency, the SEC, both had 
risk management offices. The Federal Reserve had examiners day 
in, day out at Citigroup, and this was not the first time 
Citigroup became, for all practical purposes, insolvent and in 
need of a bailout. When I was at the Commission two decades 
ago, the exact same thing happened. And you ask, How can the 
Fed turn around and allow that to happen?
    I remember being in a meeting with banking regulators and 
the Chairman of the Fed some time ago, and I was asked, along 
with the Chairman of the SEC at the time, What is wrong if the 
banks are allowed to fudge the numbers a little bit? Now I 
think we know. If you turn around and ask me is that who you 
are going to make our systemic regulator, I would turn around 
and say, ``I would hope not.'' Rather, I think the notion that 
Professor Goldsmith, the former SEC Commissioner, has advocated 
as the council or commission--I think Damon talked on it as 
well--is a much better approach. You have got to give us this 
in investors, someone regulating that we can trust in. The 
notion of prudential supervision needs to be a notion that 
dies. What we want is actual regulators doing their job. That 
is what we are turning around and paying them for.
    Now, while certainly the SEC has fallen off the track here 
recently, I must say that over the years it has been very 
successful in its mission to protect investors and gain their 
confidence. I think investors would be ill served and very 
concerned if some other regulator with a mission other than 
investor and consumer protection, first and foremost, was given 
that leading role to protect them.
    As the Committee crafts a solution, I simply believe a 
focus on a systemic regulator in and of itself and doing 
regulation around just a systemic regulator does not get the 
job done. I think a more comprehensive single bill is the right 
way to go after that. And in doing so, I think you should focus 
on a few key principles that you need to ensure are 
established: independence in the system, transparency, 
accountability, enforcement of law, and making sure those 
responsible for doing the job have adequate resources.
    Following these key principles, as more specifically 
spelled out in the written statement, I think there needs to be 
a closure of the regulatory gaps such as with credit 
derivatives; SEC oversight over the investment banks; certainly 
the mortgage brokers who brought this problem upon us; greater 
accountability established through governance and investor 
rights, including private right of actions, as Damon has 
mentioned, for credit rating agencies; assisting others in the 
commission of fraud. Regulators simply cannot do it all and 
will never have enough resources, so we have to give 
institutional investors a chance to get justice and recover 
money when there has been fraud involved.
    We need to enhance transparency and disclosure, not only by 
the issuers but also by the regulators. The testimony last week 
where the Fed would not give us the names and the details 
behind the credit derivatives and who are really getting bailed 
out at AIG was most concerning and disappointing. There needs 
to be improvements in self-regulation, and there obviously 
needs to be better enforcement of the laws and regulation.
    But in the end, no agency here, neither the CFTC, SEC, the 
banking regulators, can do it without adequate resources. For 
example, the Office of Compliance and Inspections at the SEC, 
you are asking them to inspect 16,000 mutual funds, 11,000-plus 
investment advisers with 440 people. It simply cannot be done. 
At a minimum, the SEC needs $100 million to get the type of 
technology that just brings them up to what we use on the 
street in the market. If they do not even have those tools, 
there is no way they can supervise and stay on top of it--$100 
million in technology, and then they need about another $85, 
$90 million, just to bring staffing up to the levels they were 
4 to 5 years ago. And they need it now. They do not need it on 
October 1 of 2010. That needs to go into the budget now, not a 
year and a half from now.
    So I would certainly urge--and I know this is not the 
Appropriations Committee, but I would certainly urge the Senate 
to find a way to get them the resources. Without that, you are 
asking them to go into a gunfight with an empty gun, and we all 
know what happens then.
    So, with that, I will close and be happy to answer any 
questions. Thank you.
    Chairman Dodd. Well, thank you very much, Mr. Turner, and 
what I will do in terms of time--and I will not rigidly hold 
people to it, obviously, but try and do 5 or 6 minutes, and it 
will give us a chance at least to get a round. If you go over 
that, don't worry about it so much. We will just try to move 
along, because, again, we want to get our witnesses involved.
    The temptation here is to focus on sort of one aspect of 
this. There are a lot of issues, obviously, across the spectrum 
from obviously credit default swaps, transparency, corporate 
governance issues, conflicts of interest, credit rating 
agencies--just a lot of matters to pick out, so I am going to 
try and ask a broader question and then ask each one of you to 
comment on a broader question. And I think I know the answer to 
this one, having listened to all of you and I looked at your 
testimony. But I would like to ask, beginning with you, Dr. 
Coffee--and I think you identified this. But if you could make 
one recommendation as we are looking at this--and obviously we 
have got our hands full here in the coming weeks.
    By the way, I take the point that was raised, either by Mr. 
Doe or Mr. Turner, of getting this right and, obviously, there 
is a sense of urgency, but I think the Committee would agree 
that we want to get it done, we want to work at this very hard, 
but we do want to get it right. And so striking that balance 
between moving with some haste but not to such a degree that 
that becomes the goal rather than producing a product here that 
has been well thought out.
    But if you could make one recommendation that you feel is 
the most important legislative or regulatory action that the 
Committee could take to improve investment protection or the 
quality of securities regulation in the light of the financial 
crisis we are experiencing, what would it be? What is your one 
recommendation for us? Just go down the line.
    Mr. Coffee. I would tell you that you should endorse----
    Chairman Dodd. I need that microphone on.
    Mr. Coffee. I would tell you that is the twin peaks model 
for securities regulation, that is, having separate peaks--one, 
the systematic risk regulator, the prudential supervisor. I do 
not think the SEC is the best agency for that. By training or 
culture, it is a lawyer-dominated agency focused on enforcement 
and disclosure, which it does well. It is not able to deal with 
financial institutions, at least in terms of its first-line 
responsibilities. Someone else can do that better, presumably 
the Federal Reserve.
    But as was said by other people today, I think there is 
always the danger that the cultures of securities and banking 
regulation are so different, and if you put them all in one 
agency, the centralized regulator, much like the British model, 
the FSA, you are going to have tensions and tradeoffs between 
investor protection and the protection of bank solvency.
    Thus, I think you have to have a separate investor 
protection agency. You could merge the SEC and the CFTC, or you 
could transfer financial futures to the SEC. That is going to 
be costly in terms of the political process. I do not know 
whether it is feasible. But the first step, I would say, is to 
try to have a systematic risk regulator and to not give it the 
authority to override the disclosure regulators on questions of 
accounting or on investor protection. So that is the structural 
issue from 40,000 feet, and I would start there.
    Chairman Dodd. Gene Ludwig I have talked to, and he has 
talked about a similar twin peaks structure that you have just 
described. Are you familiar with his thoughts on this?
    Mr. Coffee. Well, this term ``twin peaks'' has been used by 
a number of people. Around the world we see two models: the 
centralized regulator, which is what the U.K. has, and it has 
not worked that well there, either; and we have the twin peaks 
models which Australia, the Netherlands, and other countries 
have.
    We in the U.S. have a unique fragmented system that is 
virtually Balkanized, with a different regulator for every 
class of institution. We have got to move one of those two, and 
I am telling you that the twin peaks model, I think, is vastly 
superior.
    Chairman Dodd. OK. I agree with you.
    Tim Ryan.
    Mr. Ryan. This is unique. We basically agree with the 
professor. I mean, we have not worked out most of the details 
on both aspects of the twin peak, but we know that the No. 1 
recommendation we have today--and actually, the country needs 
it. We need confidence in the system. There is no confidence 
today. We need a systemic risk regulator for the major 
institutions, and we would urge you to do that in a timely 
fashion. And we would define ``timely'' by the end of this 
year, and to do it right.
    Thank you.
    Chairman Dodd. Mr. Stevens.
    Mr. Stevens. We, as you know, endorse with some cautions 
the idea of a systemic risk regulator, but if you push me to 
say what one thing, Mr. Chairman, I would say that we need a 
capital markets regulator that is really at the top of its 
game. This problem would not have grown unless the securities 
markets made available, through packaging and reselling and all 
the rest of it, a vast opportunity to take these mortgages and 
distribute them to financial institutions globally.
    I in 30 years have been a close observer of the SEC, and I 
think it is a remarkable agency. But it has seen challenges in 
keeping up with the growth and the complexity and the linkages, 
the internationalization of our capital markets. What we need 
to do is give it the right tools, give it the right range of 
authority, and make sure there is a very strong management 
focus there that keeps it on its mission. And I agree with you, 
investor protection is mission one, but it also has a very 
important regulatory role, and so it needs to understand and be 
able to keep pace with these market changes in the way that 
has, I think, proven to be very, very difficult.
    So that would be my recommendation.
    Chairman Dodd. OK. Professor Bullard.
    Mr. Bullard. Mine would be to--probably to expand on what 
Professor Coffee was saying, I think that from an investor 
protection point of view, what is important to understand is 
that investor protection actually assumes that we want 
investors to take risk. And, therefore, investor protection is 
about making sure that the risks that they take are consistent 
with their expectations.
    That is fundamentally inconsistent with a prudential 
oversight role. Prudential oversight is what you want when 
somebody buys life insurance and expects the money to be there 
if their spouse dies. They invest in a banking account, and 
they expect those assets to be there. They buy a money market 
fund, and they expect that to be a safe investment.
    That is antithetical to investor protection risk because 
there sometimes the disclosure of the truth undermines the 
confidence that you need that those people rely on to keep 
their investments in banks--to keep their assets in banks and 
money market funds. So I would say those have to be separated, 
and investor protection needs to be, again, as I mentioned 
earlier, kept distinct from customer protection, which again is 
not something that needs to be regulated with an eye to 
promoting risk taking--that is, risk taking based on high 
expected value investments.
    And then, finally, I would say that I am a little concerned 
about mixing the systemic issue and the prudential issue. The 
way I have always thought about prudential oversight is that 
you are making sure that the promises made with respect to 
generally liabilities on one side are matched by the kind of 
assets that are created to support those liabilities.
    Systemic oversight is where you assume that prudential 
regulation, being necessarily imperfect, will sometimes lead to 
a breakdown, and the question is: What is the role of the 
Government going to be to prevent that breakdown under a 
prudential system, which will happen sometimes, and what will 
it do when it steps in? I think that that is a fundamentally 
separate function from prudential regulation, and that is why--
and I am not sure what a systemic regulator is as apart from a 
prudential regulator. But that is something, I think, that it 
would help to have more clarity on.
    Chairman Dodd. Yes, Mr. Pickel.
    Mr. Pickel. I think the requirement for greater 
coordination among the regulators is very important. I think 
that one of the things we are looking at here in the financial 
crisis is the ability to connect the dots across different 
products and across different markets, both nationally and 
globally. I think that is the root of some of the suggestions 
for the systemic risk regulator. But I think it could also be 
achieved, as I think Mr. Silvers and Mr. Turner suggested, 
through greater coordination or some collection of supervisor 
who would look at these issues and connect those dots.
    Chairman Dodd. Mr. Silvers.
    Mr. Silvers. I find myself in the unusual position of 
having really nothing to disagree with in what I have heard so 
far at the table. I would say, though, that the single item 
that I would put to you, I would put differently than my co-
panelists have done so far.
    I think that conceptually the thing you want to be most 
focused on is ensuring that we no longer have a Swiss cheese 
system, that we no longer have a system where you can do 
something like insure a bond, either in a completely regulated 
fashion, in which there are capital requirements and disclosure 
requirements and pre-clearance, or in a completely unregulated 
fashion through essentially a derivative and where you have 
none of these things; that the content of what a financial 
market actor does should determine the extent and type of that 
regulation.
    Closing regulatory loopholes, ending the notion that we 
have shadow markets, I think is the most important conceptual 
item for Congress to take up, because, otherwise, if it 
continues to be possible to essentially undertake the same 
types of activity with the same types of risk but to do so in 
an unregulated fashion, we will replay these events with a fair 
degree of certainty. And I believe that much of what the 
discussion about structure here has been is all about how we do 
that ending of shadow markets and regulatory gaps.
    I think in certain respects, some of the how is less 
important than actually getting it done. I would say, though, 
that I really strongly endorse what Mercer said about the 
different functions of regulation, that there is investor 
protection, disclosure and fiduciary duty oriented; there is 
consumer protection, although I think, Mercer, you had a 
different phrase for it, but protection around the public 
buying financial services which does not want to take risk; and 
then there is safety and soundness regulation. Those things are 
different, and it is dangerous to blend them.
    Chairman Dodd. Yes. Mr. Doe.
    Mr. Doe. As I have listened to my fellow panelists, I am 
reminded of a book called ``Why Most Things Fail'' by a U.K. 
economist named Paul Oremerod, where he draws comparisons 
between species extinction models and those of corporate and 
market failures. And in it, he cites two conditions where we 
have failure of a species. And one is when it gets soft and is 
not challenged. The second is when there is not incremental 
learning that is constantly being done.
    And I think what I have gathered in the last 18 months--
and, again, in our small niche in the municipal bond industry, 
which is smaller than others that have been addressed here 
today. But it is that the idea of a regulator that has an 
inspired inquisitiveness and a sense of purpose so that they 
are eager to pursue an understanding of the markets that they 
regulate. If there has been one--and this is where I hope that 
if we have a consolidated or a sharing of information across 
the different asset classes or the different products, whether 
they be cash, whether they be swaps, whether they are equity, 
whether they are fixed income, that this provides an 
opportunity of being able to identify the first hints of 
failure that might occur in a system, and that way we might be 
faster to act.
    I think what is very interesting about, again, the industry 
that I have been involved with in the municipal bond sector is 
that when innovation of products finally makes its way into the 
public sector, it is almost the last place, again, because the 
revenue relatively is small compared to the other asset classes 
in the taxable markets. But I think it becomes magnified 
because you are starting to deal now with the public trust in 
the most intimate form.
    And I think so that when we start looking at regulation, it 
is, again, how do you inspire that trust, but how do you 
inspire that inquisitiveness of the regulator, and maybe it is 
the pride that is associated with doing the job that they feel 
that they are really able to accomplish something and make a 
difference. And I think that is what we are all trying to do 
here.
    Thank you.
    Chairman Dodd. Yes. Last, Mr. Turner.
    Mr. Turner. I actually think if I could just pick up a 
magic wand and do one single thing here, it would make sure 
that inside the agencies, the regulators, we had competent 
people who were in the right mind-set to go do their jobs. Bad 
loans, the Fed had the law that you all passed in 1994 giving 
them clear-cut authority to go eliminate those. They did not do 
it. Enforcement agencies have not done enforcement.
    The bottom line here is much of this could have been 
prevented without a single additional piece of legislation 
being done if people had just done their jobs back here. And I 
would urge you, go back, let us make sure we get the right 
people in, and then let us make sure, quite frankly, there is 
more active, proactive oversight by the appropriate committees 
of those responsible.
    Aside from that, I would turn around and say the No. 1 
thing in the system has to be independence. These agencies have 
to clearly understand they are independent and free to go do 
what they need to do to protect investors and consumers. There 
should have been independence in the credit rating agencies. 
They clearly sold out. The e-mails and all show it. That was 
not there.
    There needs to be independence in the compliance officers 
in these businesses, in these banks. Clearly, that was not 
there.
    So aside from making sure you got people doing the job, we 
can have one peak, we can have two peaks. We can have 52--the 
14,000 peaks that we have got in Colorado. But if you have got 
bad people sitting on the top of each of those peaks, it is not 
going to matter what you legislate here.
    Chairman Dodd. With that encouraging note, let me turn to 
Senator Shelby.
    [Laughter.]
    Senator Shelby. Mr. Turner, we are glad you are here. Thank 
you. Thank you very much.
    Professor Coffee, I would like to direct this to you, if I 
could. Thank you, and welcome to the Committee again. You spend 
a lot of time here, and we welcome you, and you have added a 
lot to us.
    You recommend giving the Federal Reserve Board authority to 
regulate capital adequacy, safety and soundness, and risk 
management of all financial institutions that are ``too big to 
fail.'' Is this suggestion based on a careful examination of 
the Federal Reserve's track record as a prudential supervisor 
up to this point, which I think is lacking? Did you take into 
consideration the fact that the Fed already has responsibility 
for monetary policy, bank supervision, and lender-of-last-
resort functions? And are you concerned about the implications 
of the fact that, as you noted, the Fed is not politically 
accountable in the way other agencies are?
    I know that is a lot of question, but you are a 
distinguished professor and you can handle it.
    [Laughter.]
    Mr. Coffee. Those are all good points.
    Senator Shelby. Can you bring your microphone up a little 
bit? It is not on yet.
    Mr. Coffee. The problem is that the Fed is not perfect. It 
is far from perfect. I think it is better positioned than 
agencies like the SEC. The SEC is focused on transparency and 
enforcement, not on prudential supervision, and the second-tier 
functions of an agency are the functions that are most likely 
to be captured by the industry.
    Also, frankly, there no longer are any investment banks. 
They have all moved someplace else. There is nothing left for 
the SEC to exercise prudential supervision over. Therefore, I 
have got to think we have to start, warts and all, with the 
Federal Reserve as the only body that has this capacity and has 
the orientation and has the competence. It may not always have 
performed well.
    Your point about political accountability is very 
important, and that is why I keep insisting that investor 
protection should not be subordinated and should be given to a 
very independent agency, the SEC or the SEC/CFTC, because I do 
not think you can count on the Fed with its orientation to ever 
be a champion of the investor's rights. The culture is one of 
secrecy, and you saw this all in the AIG. I think AIG is 
representative of the problems you will have if you depend upon 
the Fed for transparency. But I do not think the SEC is going 
to do much better than it did in the Consolidated Supervised 
Entity Program.
    Senator Shelby. Professor Coffee, are you concerned that 
when you identify institutions as too big to fail, that will 
dull the market discipline of those firms which the market will 
view as having a Federal guaranty? Is that a concern always in 
the marketplace?
    Mr. Coffee. I am not testifying that every organization 
should be bailed out. I think the ones that most merit this are 
the ones that are so entangled that you get the true problem of 
systemic risk. Systemic risk is the danger of interconnected 
failures, the chain of falling dominoes. I am not telling you 
whether or not AIG should get more money. I am telling you only 
that where we have companies that are too entangled to fail, 
that is where we most need prudential supervision and a 
Systemic Risk Regulator.
    Senator Shelby. Mark-to-market accounting, Mr. Turner wrote 
this up and I think he is right. Do you believe the current 
attacks on mark-to-market accounting, Mr. Turner, are motivated 
by a similar understandable desire to avoid taking painful 
write-downs?
    Mr. Turner. I think, without a doubt, Senator Shelby, they 
are a problem here. You know, if you make a loan at $100 and 
you are only going to get $70 back, that is OK once or twice, 
but we did it millions and millions of times. The bottom line 
is they just aren't worth what they were, and to report to the 
public, to investors, regulators that you have got a balance 
sheet that is substantially different than what it is really 
worth is just flat out misleading, if not straightforward 
fraudulent.
    Senator Shelby. Mr. Ryan, your testimony recommends a 
Financial Market Stability Regulator that, among other things, 
would have a direct role in supervising, quote, your words, 
``systemically important financial organizations.'' What are 
the criteria, Mr. Ryan, that you would recommend for 
identifying systemically important entities, and do you believe 
that there would be any competitive implications for firms that 
are not so designated?
    Mr. Ryan. Thank you for your question. We have given a lot 
of thought to a number of issues, and on some of these issues 
we do not have final decisions. I am talking now within the 
industry. For instance, we spent a lot of time talking about 
should we recommend the Fed immediately as the systemic 
regulator, and we have not come to that conclusion yet. If we 
had to do it right away, they are probably the best qualified 
to do it, but we think that the industry and the Congress, the 
American people, deserve a really comprehensive view.
    The same is true of who is systemically important. It is 
pretty easy to identify the early entrants because they meet 
the test that Professor Coffee has enunciated. They are too 
interconnected. They are very large. They are providing 
consolidated services to the citizens of this country and we 
need a better understanding of their interconnected aggregated 
risks.
    So the first group will be easy. The second group will be 
more difficult because they may not be so interconnected. They 
may not even be that large. But they may be engaged in 
practices which could have a very dramatic impact on our 
health.
    So our hope would be that we anoint a systemic regulator, 
maybe it is a new entity, maybe it is within Treasury, maybe it 
is the Fed, that we orient them in legislation toward 
preselection of the people who are very obvious, and that we 
give them the flexibility to include and actually to have 
people move out of systemically important status going forward. 
So once you are in it doesn't necessarily mean that you will 
stay in it.
    I think it is pretty clear, though, we all know the basic 
early entrants and they are our larger financial institutions. 
We, by the way, would not limit this by charter at all, so 
there will be banks, there will be insurance companies, there 
will be hedge funds, there could be private equity players. It 
is people who could have a dramatic effect on our lives.
    Senator Shelby. Professor Coffee, why should we continue to 
prop up banks that are basically insolvent, some of our large 
banks that are walking dead, so to speak, give them a 
transfusion, and there is no end in sight? Why should we do 
that rather than take over some of their--guarantee some of 
their assets and whatever we have to do and wind them down?
    Mr. Coffee. Again, it is a perfectly fair question and I am 
not telling you that every bank should be bailed out, not even 
every large bank. But if we are going to get the financial 
system working again, we have to move credit through banks.
    Senator Shelby. Sure.
    Mr. Coffee. You can nationalize them. There still has to be 
a management.
    Senator Shelby. I have never advocated that.
    Mr. Coffee. The government can't run a bank. It might be 
that if you want to name institutions that may not deserve 
further bail-outs, AIG is an example. It is not a bank and 
basically the government is spending $160 billion there to pay 
off the counterparties, most of whom are foreign banks.
    Senator Shelby. Obviously poorly regulated.
    Mr. Coffee. I am saying that the key bank institutions are 
the only way we can get a corporate capital system moving 
again. The money has to flow through the system, and if they 
are part of the basic transmission belt, then there is a strong 
argument for ensuring their survival.
    Senator Shelby. Mr. Ryan, you and your organization, the 
Securities Industry and Financial Markets Association, have 
advocated a merger of the SEC and the CFTC. You are not by 
yourself there. If a merger, should it go forward, should it 
occur simultaneously with whatever broader regulatory 
restructuring we undertake in this Committee? Should it be part 
of the overall comprehensive structure, restructure?
    Mr. Ryan. I would sort your--because I think the biggest 
issue Congress has right now, you obviously have many, many 
issues on your plate and sorting them by priority is an 
essential component of your work right now, I am sure. So our 
recommendation is that you sort them with the systemic 
regulator being first and immediately come behind that with 
cleaning up the many regulatory agencies that have overlapping 
authority. If I was the new regulator, I may actually ask you 
to do those simultaneously so I would know my job.
    May I also----
    Senator Shelby. It would send certainty to the market, 
would it not?
    Mr. Ryan. Yes, sir. I think that is possible. May I also 
just provide one comment based on your last question to the 
professor to my right?
    Senator Shelby. Go ahead.
    Mr. Ryan. Because I am probably--because I spent an awful 
lot of time in this Committee when I was the OTS regulator----
    Senator Shelby. You did.
    Mr. Ryan. ----dealing with the RTC, and what I learned 
through those 3 years brings me to a very firm view on 
opposition totally to nationalization of financial 
institutions. We have a process in this country through the 
FDIC where we, in a sense, nationalize. We call them bridge 
banks. We know that if you put very large institutions into 
bridge banks and they stay there for a very long period of 
time, the cost escalates enormously. You can look back to the 
RTC experiences. If we ask the government to take control of a 
large financial institution and run them, the cost of 
resolution is going to dramatically increase. The way we are 
doing it right now is much better. Thank you.
    Senator Shelby. One last question, Mr. Chairman, if I can, 
to Mr. Silvers. Mr. Silvers, you advocate a greater role for 
long-term investors in the election, I will use your term, of 
psychologically independent directors on corporate boards. What 
measures would you take to ensure, sir, that these directors 
whose responsibilities would flow to all shareholders of the 
corporation are independent not only of management, which is 
important, but also the shareholder group responsible for their 
election?
    Mr. Silvers. Senator Shelby, I think that there are several 
specific ways of doing that. The first is that those 
mechanisms, as my testimony indicated, need to be tied to a 
certain amount of tenure as a shareholder. I think that is a 
way of ensuring that it is not captive to individuals who are 
looking for liquidity.
    Senator Shelby. What do you mean by tenure of a 
shareholder?
    Mr. Silvers. Holding, a holding period, that anyone who 
could use such a mechanism would have to be a fairly long-term 
holder so that you ensure that it is not used by people who are 
seeking a liquidity event as opposed to people who are seeking 
the long-term health of the corporation.
    Second, I think obviously that there needs to be, depending 
on exactly what mechanism one uses, that all discussions in 
this area have required that anyone who used such a mechanism 
would be either by themselves or as part of a group a 
significant set of holders. Certainly in large corporations, 
more than 1 percent of the shares, and in very large public 
corporations, it is a very large collection of money, or at 
least it used to be until recently market events.
    And then third, the most important protection here is a 
very simple one, which is that we are talking about a 
nomination mechanism, not an election mechanism. The majority 
of stockholders would have to vote for such a person, and the 
corporation, the management, at least under Delaware law, has 
the right to use pretty much limitless resources to campaign 
against them. I think that is the fundamental barrier.
    Senator Shelby, if you would allow me, I want to say a word 
or two to you about the Federal Reserve in response to your 
questions to Professor Coffee.
    Senator Shelby. Yes, sir.
    Mr. Silvers. I believe that the concerns you raise are 
profound and important ones and that they are profound in 
relation to the question of whether we want--the task we are 
asking a Systemic Risk Regulator to take on a fundamentally 
public task. The Oversight Panel that I serve on its regulatory 
reform recommendations specifically stated, if we are going to 
ask the Fed to take those obligations on, the Fed must be 
governed differently.
    I would be comfortable, personally, with that arrangement, 
with a greater degree of accountability and doing away with the 
self-regulatory aspects of some of what the Fed does. But I am 
convinced that that is probably not the best way to do this, 
and the reason why I am convinced about that is because, A, I 
am think that the Fed--there are tradeoffs with the Fed and the 
other things we ask the Fed to do. And the second reason is 
because, while I agree with Professor Coffee that the SEC is 
not suited to be the Systemic Risk Regulator, that that job is 
going to--as long as we have a twin peaks-type model where 
information about our markets is flowing from different 
directions within the regulatory system, that that coordination 
of information and openness to information is critical. If we 
ask one body to take it on, that is going to have an impact on 
the flows from the other bodies.
    The best answer, I think, in light of that is an agency 
with staff that is governed by the heads of our twin peaks or 
our three peaks. I hope we don't get to 14. How many hundred 
peaks are we talking about, Lynn?
    [Laughter.]
    Mr. Silvers. But an agency that is governed by the 
independent regulators but has its own staff and mission in 
this area. And I think the Fed would play a very large role 
there because they are----
    Senator Shelby. And they can't be overridden by the Fed?
    Mr. Silvers. Yes. That is----
    Senator Shelby. That is important.
    Mr. Silvers. I don't think we can give the power to 
override fully public bodies charged with issues like investor 
protection to the Fed. Thank you, Senator. I appreciate your 
indulgence.
    Senator Shelby. Thank you.
    Chairman Dodd. Thank you, Senator, very much, and that is a 
question that many of us have raised, given the already full 
plate that the Fed has, in addition to roles they are taking 
on. The obvious problem is that if you move away from the Fed 
as the model, creating a whole new entity raises another whole 
set of issues and that is the quandary I find myself in. I 
don't disagree with Richard Shelby's point. We have all talked 
about it here at various other times. And then I quickly say to 
myself, so what is your alternative? And when I come to my 
alternative, I find myself almost in as much of a quandary.
    And so we find ourselves in this position of trying to make 
a choice between an existing structure in which I can see how 
this could fit--I think your point, as well--although you would 
have to make some changes in this thing, or trying to create 
something altogether new, which has also got its difficulties. 
But it is a very critical point, obviously, and one that we are 
talking about, obviously, at this point.
    Anyway, with that point, Senator Bennet, I thank you for 
your patience.
    Senator Bennet. Thank you, Mr. Chairman.
    I want to start broadly and then ask a couple of narrow 
questions. Professor Coffee talked about the difference between 
the culture of the banking regulator and the culture of the 
securities regulator, which has been a theme that we have heard 
about in this Committee, and in thinking about the new 
structure, we want to make sure that that culture shifts, I 
think, so that we get the kind of oversight that all of us will 
feel comfortable with.
    In addition to that, there is the issue of no matter what 
structure you have, the constant innovation that goes on in the 
market and having some assurance that the regulator is keeping 
up with that innovation, as well. We want the innovation but we 
also want to make sure we understand it.
    And then Mr. Turner's observation that what is really 
critical, as it is with all human institutions, is that you get 
the right people in the job, and unfortunately, neither he nor 
we have the magic wand that he called for.
    But I guess the question I have is, are there thoughts from 
you, Professor Coffee or others on the panel, about what we 
could do in this legislation to assure that we have the kind of 
attention to the changes in the market knowledge about approach 
and the right people so that we can really get the job done?
    Mr. Coffee. First of all, you and Senator Shelby are 
definitely focused on the proper issue. The Federal Reserve may 
have to change. You may have to give it a very different staff, 
a very different accountability structure. You are certainly 
going to want it to monitor, but I don't think you can ever 
make the Fed into a strong enforcement agency. I don't think 
you could ever make the SEC into a strong prudential 
supervisor.
    What I think you have to recognize is in terms of new 
market developments, the Fed has a more universal view. The 
SEC, at least as it stands today, doesn't have jurisdiction 
over swaps, over-the-counter derivatives, or futures. It is not 
going to know inherently what is going on in those areas. Yes, 
you could merge the SEC and the CFTC, but that compounds the 
political difficulties of achieving our solution by, I think, 
several orders of magnitude.
    And I would agree with the prioritization model that Mr. 
Ryan just discussed. First create the optimal kind of Systemic 
Risk Regulator, which may require changing the Fed, changing 
its accountability structure, giving it a permanent staff that 
would do the kind of monitoring we have in mind. But I think 
that is the smaller change than designing something totally 
from scratch.
    Mr. Stevens. Senator, could I comment on that? I know that 
many have not had a chance to absorb it, but I am very struck 
by what Chairman Bernanke had said today, because everyone is 
talking about his agency, of course, and he says, and I am 
quoting now, ``Any new systemic risk authority should rely on 
the information assessments and supervisor and regulatory 
programs of existing financial supervisors and regulators 
whenever possible.''
    What that means to me is they don't want to take all these 
functions aboard themselves. They want a very strong Capital 
Markets Regulator. They want a very strong bank regulator. They 
probably want a very strong Federal insurance regulator that 
they can work with. The notion that they can pull all of that 
inside the Fed and at the same time accomplish their 
traditional missions is something I think, as I read the 
speech, and this is more subtext than text, is unsettling to 
the Chairman of the Fed, and with good reason, I believe.
    I would say also in commenting on Chairman Dodd's quandary, 
and I don't know if this is useful or not, but I spent a 
considerable period of time as Chief of Staff of the National 
Security Council and I have reflected a lot on that innovation 
in our government. It came online after World War II and our 
experience as a nation of the inability to coordinate and 
integrate the efforts of our Diplomatic Service, our Armed 
Forces, and the like at a time when we had burgeoning global 
responsibilities as the superpower in the aftermath of World 
War II. It is a Cabinet-level Council that is chaired by the 
President. It has a staff whose professionalism and abilities 
have been built up over time. And its function is there to 
collect information, to monitor developments, to integrate and 
coordinate the efforts of government.
    I think it is not out of the question that you could create 
a similar coordinating mechanism, and I think this is part of 
what Damon is pointing toward, at a very high level with the 
regulatory agencies that would pull all their expertise 
together, give the chairmanship of it to someone, and maybe 
that is the Chairman of the Fed, give it a permanent staff, and 
allow it to be monitoring and collecting data and doing the 
analysis, but in conjunction with those who are the front-line 
regulators and whose expertise has got to be leveraged. At 
least that is, I think, a reasonable concept on which to 
reflect.
    Senator Bennet. A completely unrelated question. I didn't 
come here to ask it, but the Ranking Member asked about mark-
to-market and your answer is very clear. This is a place where 
I have gone back and forth. If our markets were lubricated and 
were doing what they were supposed to be doing, we wouldn't be 
sitting here talking about investing taxpayers' money the way 
we are talking about investing it to create stability in the 
market.
    And I wonder whether there are others here that have a 
different point of view on mark-to-market in this sense. It 
seems to me that there is a legitimate distinction between 
assets that are held by these banks that have no collateral 
behind them or very little collateral and assets that are held 
by our banks that have collateral but simply have no market 
right now and therefore aren't trading at all. I know there is 
a pure view that says that should tell you that the assets 
don't have value, but the thing I keep stumbling over is that 
some have collateral and some don't have collateral and 
shouldn't we be taking notice of that?
    Mr. Silvers. I do not, in general, share Lynn's complete 
enthusiasm for mark-to-market accounting. I think that there 
are a wide range of areas in financial accounting where 
historical cost accounting is actually more indicative of the 
life of the business than mark-to-market. However, the 
financial institutions, particularly those with demand deposits 
where in theory the funds can walk out the door, are ones that 
seem uniquely kind of attuned to mark-to-market principles.
    In the course of the work of the Congressional Oversight 
Panel, we have done two oversight--two hearings, two field 
hearings in relation to our mortgage crisis, which I believe 
and I think most economists believe is at the heart of what has 
gone wrong here in our economy, that underlies the financial 
crisis, and it is clear from those field hearings, in P.G. 
County not ten miles from here and in Nevada, that even at this 
late date, we do not seem to be able to get rational outcomes 
out of private ordering in terms of non-performing mortgages. 
We can't get the mortgage providers and the servicers to 
negotiate rational outcomes with homeowners.
    Now, I believe that this is related to the remnants of non-
mark-to-market accounting in banking, that effectively loans 
that are never going to be worth--the banks are carrying loans 
that are never going to be worth full value, even though they 
are capped at high values maybe not at par, but at close to 
par. And the one thing that would force them to mark them down 
would be a rational settlement with the homeowner, because then 
you would have to admit what you actually had.
    Now, you asked about collateral. You walk through the 
subdivisions and not all of them are new. In P.G. County, you 
have got a lot of people who have been effectively exploited 
and stripped of their homes. That is Prince George's County, 
for those who are not Washingtonians, here in Maryland. You 
look at those properties. There may be collateral, but it will 
never support par value, never. It may return--it may recover 
value. It may, 10 years from now, if the last very serious real 
estate collapse is indicative, and I am afraid this is clearly 
worse, in many areas, it took 10 years to recover from the bust 
of the late 1980s and early 1990s. But returning to par in 10 
years means you are never really worth par present value basis, 
you are not going to be there.
    And so I am in favor of sort of--I am kind of in the middle 
of the road on these issues, but I think we need to recognize 
that there could be very, very serious broad economic 
consequences of indulging the fantasy that subprime loans 
backed up by collapsed residential property are ever going to 
be worth par. They are just not. And the consequences of that 
pretense is actually throwing people out of their homes.
    Senator Bennet. Mr. Chairman, could I ask one more quick 
question----
    Chairman Dodd. Certainly.
    Senator Bennet. ----for Mr. Doe. I was very interested in 
your testimony. This is a line of conversation that Senator 
Warner and I have been having. I assume that your view is that 
there is Federal authority now to be able to intercede, either 
through the Treasury or the Fed, with the VRDO market in some 
way that may give hospitals, public hospitals, schools, and 
other municipal credit some relief from the lack of market that 
exists for variable rate debt----
    Mr. Doe. Well, I think one of the key issues associated 
with that is that many of the issuers that have--that are 
confronted now with challenges of restructuring their debt in 
the variable rate market, as I pointed out in my testimony, 
these variable securities have links to interest rate swaps 
which have created all sorts of issues. And one of the things 
that these--the cost of termination of the swap transaction has 
become overly penal, and in some of these small towns and 
counties where it is arguably there was a mismatch in terms of 
appropriateness. And again, remember that the regulatory body 
of the municipal industry doesn't have purview--has limited 
purview, only on dealers and only on cash securities. So here 
you have these cash transactions linked to swaps. It makes it a 
little bit of a conundrum.
    But one of the things we think where the Treasury could 
step in and make a big impact is to provide subsidized loans to 
municipal issuers that would help them terminate those swap 
transactions, and then over time, the cost of those loans could 
be recouped in future transactions and discriminate fee, and I 
think that would be a really important step. So I think those 
are the people and the institutions that have been most 
adversely impacted.
    Senator Bennet. I would like to thank the witnesses for 
their testimony.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Reed.
    Senator Reed. Well, thank you very much, Mr. Chairman, and 
thank you, gentlemen, for excellent testimony.
    Just as two preliminary points, first, I want to thank 
Professor Coffee for his kind words about our credit rating 
legislation. Thank you very much and thanks for your help.
    And then to Mr. Turner's point about the need for resources 
regardless of what we do, this omnibus we are debating contains 
an additional $38 million for the Securities and Exchange 
Commission and the proposed budget of the President is around a 
13 percent increase over the 2008 marks going forward, so I 
completely concur. We can make all the structural and 
legislative changes in the world, but if they don't have the 
resources and the will to do the job, it won't get done.
    One of the impressions I had listening to your comments is 
that I think we were in this sort of false logic where 
regulators of all ilk were looking at the capital of 
institutions, saying we don't have to be too sensitive to their 
risk evaluation assessments because they have got capital. Of 
course, the capital was risk-based, so you are in this circle 
around where if you don't do a good job evaluating capital 
based on risk, then you don't have the capital, et cetera.
    Part of this goes to Basel, the efficacy or the 
effectiveness of Basel. I think that has to be looked at.
    And the other issue I think has to be looked at, too, is 
just the managerial capacity to run these organizations. I 
think one of the issues of size is do you really have the 
wherewithal, the computer systems, the structural managerial 
skills to run them?
    This is a long sort of preface to be saying that it appears 
that this, in my view, twin peaks model we will probably adopt 
in some form, that by default, perhaps the Federal Reserve will 
become the regulator, and unless we make some significant 
changes in the culture and the operating standards of the 
Federal Reserve, we might be exactly where we were before, that 
this sort of just looking at risks--not looking at risks, not 
looking really well at management.
    So I don't know if you have comments, Professor Coffee and 
gentlemen?
    Mr. Coffee. I think that is the danger. I think you are 
correct and I think it does justify what I think Senator Shelby 
was going for, some modification of the charter and the 
requirements and responsibilities of the Federal Reserve. I 
think the best way to protect transparency is to make sure that 
the SEC's authority to require full disclosure is not 
circumscribed. But I do think that we are now in the world 
where the price of all bank stocks has fallen so low, with 
Citicorp trading at $1.50, this is the time to pursue mark-to-
market because the market doesn't believe these banks have any 
value. You might as well bring the accounting in accord with 
the reality as the market reflects it.
    I think your concern is that changes in the Federal Reserve 
is a sound concern, and I can't tell you, because I am not a 
Federal Reserve expert, of what the five things I would do 
first to the Federal Reserve are.
    Senator Reed. Does anyone else want to comment? Mr. Ryan?
    Mr. Ryan. We have been talking about resources, and many of 
the panelists have talked about whatever changes we make here, 
let us make sure that we have the right people doing the job, 
that they have adequate resources.
    One specific topic I think deserves the Committee's 
attention and Congress's attention is whoever is going to do 
this job has to have the technology resources to get the job 
done, because when we ask someone to be the systemic regulator 
for our most important financial institutions, we are also, I 
think, asking them to do a job that regulators have not really 
done well at all, which is to look over the horizon. They are 
pretty good at looking back and looking at what went wrong and 
let us see if we can fix it. But we are going to ask this new 
entity or the Fed to do a job that we have not really done 
before and they need to have the tools to do it.
    They really need to think about the technology demands, 
because right now, we do not have a full understanding of the 
aggregated or collective risks of all of these interconnected 
entities. We have the capacity to do it from a technology, 
hardware, software standpoint, but we don't really have that 
done. It is going to be very expensive and it is very important 
that you spend some time on that.
    Senator Reed. One of the points I would note is that when 
Chairman Donaldson became Chairman of the SEC, he tried to 
establish a risk assessment operation. That initiative was 
undone by his successor. But I think we should consider along 
those lines, Mr. Ryan, requiring the systemic regulator to have 
a rather independent risk assessment group that on a periodic 
basis will publish to the Congress and to the people what they 
consider to be the most significant pending risk and the 
likelihood. That might force discussion and maybe even 
sometimes action.
    Professor Bullard, and then Mr. Silvers and then Mr. 
Turner, and then I have one last point.
    Mr. Bullard. I just wanted to add that, again, to me, the 
systemic risk question is one of someone who has oversight over 
a range of prudential regulatory regimes. The Fed already is 
our systemic regulator. It may not have that aggregated 
information as Paul was talking about, but it has the discount 
window, it has the open market transactions, it has the ability 
essentially to create money, although the Treasury has shown 
remarkable ingenuity in creating money recently, as well.
    So it already serves in that role. I think it is a separate 
question as to as it sits back and decides where it needs to 
take action to affect credit markets, it sees some hot spots 
over here with respect to the support for some area, that it 
also should not necessarily be expected to be the prudential 
regulator that is in charge of monitoring what stands behind 
that particular area of our financial services, because those 
really are separate functions.
    The systemic regulator is one who can go in and fix it with 
ultimately taxpayer dollars and then tries to find situations 
where it can mitigate that risk and reduce it. The prudential 
regulator is the one who writes the rules that says, to back 
these kinds of liabilities, these are the kinds of assets we 
expect you to have, and I am not sure that those are 
necessarily ones that should be or have to be housed in the 
same agency.
    Senator Reed. Mr. Silvers, then Mr. Turner, then I have one 
final unrelated question.
    Mr. Silvers. Senator Reed, first, I share your concerns 
about Basel II. I think that is clearly part of the causal 
fabric here for our crisis. There are three points about the 
sort of managerial and task challenges associated with systemic 
risk regulation.
    First, the Congressional Oversight Panel in its regulatory 
reform report suggested that the notion of intelligence, of 
looking over the horizon in relation to financial market 
systemic risk, should perhaps be delegated not to a regulatory 
body but to a panel of outside experts--some of my fellow 
panelists here might make good members of such a panel--whose 
sole job was to look ahead and that were not intertwined in the 
politics of the regulatory landscape.
    Second--and this is a concern that Senator Shelby raised--
our view was it would be a very bad idea to name who is 
systemically significant. In fact, it is not only a bad idea in 
terms of moral hazard, but it is actually impossible to do; 
that in a crisis people will--institutions will turn out to be 
systemically significant that you had no idea were. And Exhibit 
1 for that is Bear Stearns.
    And there are other times, calm times, when very large 
institutions may be allowed to fail, and probably should be; 
and that rather than naming institutions, we ought to have the 
capacity--and this comes to your point--the capacity for the 
systemic risk regulator to work with other regulators to set 
ratchets around capital requirements and around insurance costs 
to discourage people getting essentially too big to fail and to 
set up the financial basis to rescue them if they do.
    Finally, there is, I think, some--I am not a Fed expert, 
but I think there is some confusion about where the money comes 
from for bailouts and rescues and so forth. The Fed does not 
have the authority, as far as I know--although you all maybe 
can educate me. The Fed does not have the authority to simply 
expend taxpayer dollars. The Fed lends money. It is the lender 
of last resort.
    In a true systemic crisis, as we have just learned, we get 
beyond the ability of liquidity to solve the problem, and in 
that circumstance we start expending taxpayer dollars.
    It is hard not to look at the TARP experience and what 
preceded it and not conclude that the ad hoc quality of those 
experiences did not build public confidence or political 
support for what had to be done.
    Given all of that, I think we need to understand that when 
we ask a body to take on the role of systemic risk regulator, 
that also means we are asking them to take on the role of 
rescuer, and potentially to expend taxpayer dollars. And that I 
think requires a set of governance mechanisms and capacities, 
to your question, Senator, that we have yet really to build. 
And it also requires, I think, a careful balance between 
genuine public accountability and transparency, on the one 
hand, and genuine independence from the all too eager desire of 
everyone around to bail out their friends.
    Senator Reed. Mr. Turner, do you have comments?
    Mr. Turner. Just like Damon, I would say Basel II needs to 
be re-examined. I expressed concern almost 8 years ago to the 
Fed that it would not work, and I think if it stays the way it 
is, it will contribute to further problems. I think Sheila Bair 
has been very insightful on that in that regard.
    As far as managing the risk, I have actually had to run a 
large international semiconductor company, and in the 
technology area, we had a lot of risk, and it changed very 
dramatically, much faster than what it even does in the banking 
industry. And what we found was, if we are going to be 
successful in managing the risk, we could not do it with the 
same people that we had necessarily running the operational, 
the manufacturing side of the company. You needed a group of 
people that were much more focused on the future and where 
things were going. They needed to be looking not just ahead, 
but much further ahead, and have a pulse not only what was 
going on but where that turned around and took you.
    After Donaldson formed the Risk Management Office, I went 
and visited with him for a while. Certainly that type of 
mentality plus the tools were not in that group at that point 
in time. I have not seen that at the Fed in my dealings with 
the Fed over the last couple decades either.
    I am not sure you can get that without a major wholesale 
change, and so I come back to--having gone through this and 
having to manage risk myself, I come back to probably what 
Damon has said, and probably the best way to put this together 
across the broad spectrum would be to create the separate 
organization, chaired with the board of the major chairmen of 
the major agencies, but with real staff and real resources and 
focused on that aspect of the business. I just do not think we 
are going to get it if you put it inside one of these agencies.
    And, in fact, think about it. We have had risk management--
a Risk Management Office in the Fed, in the OCC, in the SEC, 
and it has not worked. And why would we turn around, given what 
this devastation and travesty has cost us all, why would we go 
back and say let us try it again? You know, this is not one 
where I give people another swing at the bat.
    Senator Reed. Mr. Chairman, you have been very kind. I have 
one question, if I may.
    Chairman Dodd. Sure.
    Senator Reed. I will address it to Professor Coffee, 
because it might be way off the beaten track. In fact, it 
sounds like an extra credit question in a law exam.
    [Laughter.]
    Senator Reed. So here it goes. Whatever happened to Rule 
10b-5? I mean, I have been listening to discussions of 
potential fraud in the marketplace, securities that had no 
underlying underwriting. And I grew up thinking that material 
omissions as well as material commissions gives the SEC in 
every capacity, as long as it is a security, to go in 
vigorously to investigate, a private right of action, and yet I 
have been before the Committee now for 2 and 3 years, and I do 
not think anyone has brought up, you know, Rule 10b-5 actions. 
Can you just sort of----
    Mr. Coffee. I am glad you asked that question because it is 
a good question, but there are two major limitations on Rule 
10b-5. As you have heard from others on this panel, it does not 
apply to aiders and abetters, even those who are conscious co-
conspirators in a fraud. That is one limitation that Congress 
can address. And, two, when you try to apply Rule 10b-5 to the 
gatekeepers, whether it is the accountants or the credit rating 
agencies, you run up against the need to prove scienter. It is 
possible to have been stupid and dumb rather than stupid and 
fraudulent, and that is basically the defense of accountants 
and credit rating agencies.
    I think you need to look to a standard of scienter that 
will at least create some threat of liability when you write an 
incredibly dumb AAA credit report on securities that you have 
not even investigated, because you do not do investigations as 
a credit rating agency. You just assume with the facts that you 
are given by management.
    So I do think there is some need for updating the anti-
fraud rules for the reasons I just specified.
    Senator Reed. Thank you.
    Chairman Dodd. Senator Warner.
    Senator Warner. Thank you, Mr. Chairman. A fascinating 
panel. First of all, I commend you for asking that ``What is 
the one take-away?'' question from each of these gentlemen. And 
while I think there was a consensus that we need to get rid of 
this shadow market, we need to make sure we get rid of this 
Swiss cheese approach to regulation, I think we will be 
challenged, taking some of these broad overviews and taking 
them into specific legislation.
    Chairman Dodd. I agree.
    Senator Warner. And I appreciate your asking that question.
    I want to follow up, before I get to my quick question, on 
Senator Shelby's comments along the notion of the institutions 
that have posed this systemic risk, the ``too big to fail'' 
excuse, and Damon's comments about perhaps not publishing those 
that are systemic risks, but this problem we are in the middle 
of the crisis now of too big to fail. And I would be curious 
perhaps in a written question to the Members--I know Senator 
Shelby has, I think, provocatively raised a number of times the 
issue of, well, how much more on Citi and should we go ahead 
and let it go through some kind of process? And the quick 
response normally being, well, no, that is too big to fail.
    Well, I would love to hear from the panel, perhaps in 
written testimony, if you were to see the transition, dramatic 
transition--and I know we are sometimes afraid of the 
terminology, whether it is ``receivership'' or 
``nationalization,'' some other way to get it out of the 
current ditch that it is in--you know, how you would take one 
of these institutions that fall into this ``too big to fail'' 
category that appears to have real solvency issues and get it 
through a transition? And I perhaps would work with the Senator 
on submitting that type of written question.
    So we have seen, you know, the big take-aways on how we 
regulate and where we put this prudential or systemic risk 
oversight. We have seen the question of how we deal with the 
current challenging institution. I want to come with my 
question, and I know our time is about up, but I will start 
with Mr. Pickel, but would love to hear others' comments on 
this, and that is, maybe come at this from the other end.
    Even if we get the risk right, with the great people that 
Mr. Turner has advocated, where and how should we look at the 
products? I would argue that intellectually I understand the 
value of derivatives and the better pricing of risk. I candidly 
would love somebody to say, How much societal value have we 
gained from this additional pricing of this risk when we have 
seen all of the downside that the whole system is now absorbing 
because, to use your terms, you know, actions by AIG and others 
of misunderstanding of the products and not taking appropriate 
hedging?
    I guess I have got a series of questions. How do we prevent 
the current products or future products from being abused? 
Should we have standards whereby if an AIG, a future AIG, 
either misunderstood or went beyond protocols, that that would 
set off more than an alarm bell and would require some kind of 
warning? Is it simply enough to say we are going to move toward 
some level of a clearinghouse? Is clearing alone enough 
security? As some of the European regulators have talked about 
for those products and contracts that do not go through a 
clearinghouse, should there be needs of additional capital 
requirements?
    You know, I am all for innovation, but in some cases I 
think under the guise of financial innovation and financial 
engineering, we have ended up with a lot of customers, 
including customers that Mr. Doe represents in terms of some of 
the muni market, getting in way over their head. And I just 
fear on a going-forward basis that regulation and transparency 
alone may not solve the problem.
    So rather than coming at it at the macro level on 
regulation or on the specific issues that I think Senator 
Shelby has wonderfully raised about how do we unwind one of the 
``too big to fail'' institutions, I would like to look at it 
from the bottom up on the products line, starting with Mr. 
Pickel and then anybody else can comment.
    Mr. Pickel. Yes, I think as far as the products themselves, 
if you look, for instance, at the credit default swap market, 
there is information that has been published by the Depository 
Trust and Clearing Corporation through their trade information 
warehouse, which encompasses 80 to 90 percent of credit default 
swaps engaged in around the world. And the information there is 
that virtually all the trades in that warehouse, essentially 
all, 100 percent, are done involving at least one dealer party 
who is, in fact, a regulated institution, and actually 86 
percent of them are between two dealer institutions. So you 
have got that structure of the institutional regulation there, 
of the oversight of those individual firms looking at the 
activities of those firms. And I think the Committee, again, 
heard testimony from the OTS last week admitting some 
shortcomings in their enforcement and in their execution of 
their authority, but perhaps we should look at making sure that 
they have got the ability to understand and get more detail on 
the products that those individual entities are----
    Senator Warner. Just a quick question, Mr. Pickel. But 
those 86 percent of institutions that are involved in using 
these products, are you saying the market knows all the terms 
and conditions and that we have got a transparent market there?
    Mr. Pickel. The parties who engage in those transactions 
have access to information and have the transparency to engage 
in those transactions. I think you also have regulators who 
have the authority--whether they have exercised it and what 
they have done with that, we should discuss further. But they 
have the authority to understand what those institutions are 
doing.
    I think the other thing is--and we have got a very good 
example of this in the credit default swap market, an effort 
that goes back to September 2005, started by now----
    Treasury Secretary Geithner, to pull in the regulators in a 
global initiative, regulators from around the world, as well at 
that time 18 major credit default swap players, dealers, and 
also buy-side entities as well, to talk about issues that were 
serious and needed to be addressed in the credit default swap 
market at that time. And significant progress was made very 
quickly, with the implicit threat--or, actually, explicit 
threat, I think, from the regulators, that if you do not get 
your act in order on these backlogs and assignment issues, that 
they will actually stop people from trading. So the regulators 
indicated that they would take that action, and the industry 
responded.
    The experience that we have gone through in settling credit 
default swaps over the past 6 to 8 months has been 
significantly facilitated by the foresight of Secretary 
Geithner at that time to anticipate these problems. So that was 
an important step at that time.
    So I think looking at those kind of public-private 
interactions where regulators and the industry work together to 
identify these issues is very important going forward as well.
    Senator Warner. Mr. Stevens, I would love to hear from you, 
Mr. Ryan, and Mr. Silvers.
    Mr. Stevens. Thank you, Senator. I think it is a really 
excellent question, and I have asked myself this, and it is not 
intended as a competitive observation.
    If Franklin Roosevelt were to come back today and he would 
find we had these enormous pooled funds that were outside, 
virtually outside of any form of regulation, I think he would 
say, ``I thought we solved that problem in 1940.''
    We need to make sure that the evident developments--and 
these are not secrets--the evident developments, major 
developments in our capital markets are addressed as they 
arise. Hedge fund investing is no doubt a tremendous innovation 
that can be of great value. But there were trillions of dollars 
in hedge funds that had no form of regulation. I think that is 
something that Congress was aware of, certainly the SEC was 
aware of.
    You could say the same about the major pooled funds in the 
money markets that will be part of the subject of our report 
when it is issued. Money market mutual funds are about a $4 
trillion intermediary, but we're only about a third of the 
money market, which has many other pooled funds.
    So I think it is a problem--and this is how I envision it--
of making sure that the capital markets regulator is staying 
even with market developments, and that is going to require not 
only nimbleness at a regulatory level, but, frankly, Mr. 
Chairman, it requires--it puts a burden on Committees like 
yours, because in many instances it is going to require the 
tough work of closing regulatory gaps, providing new authority, 
and even providing new resources.
    I do not think, however, that the answer, Senator is 
creating a new agency that only looks at products, because 
those products arise and exist in the context of a larger 
marketplace, and they need to be understood in that context.
    Senator Warner. Mr. Ryan.
    Mr. Ryan. Bob Pickel and I have basically overlapping 
membership. He is very domain oriented, very specific to 
derivatives, and we are basically almost all of the other 
products and oversight.
    We have spent a lot of time, I would say, over the last 6 
months trying to figure out what should we be recommending for 
a new regulatory structure. And I would say it is a uniform 
view among the core members of our group and of his group that 
we feel comfortable recommending a systemic risk regulator that 
would have no real limits on their authority. So they would 
have all markets, they would have all market participants who 
are significant. It would not make any difference of their 
charter, so it could be a bank, it could be an insurance 
company, it could be a hedge fund. And included therein would 
be their authority to deal with, for instance, derivative 
products.
    So we can see that there is a lack of confidence in the 
system. There is a lack of confidence among Members of this 
Committee, Members of Congress, members of other statutory 
developing entities around the globe, and we need to address 
that.
    So our first attempt at this is to say let us do it through 
the systemic regulator. Through the systemic regulator, we will 
also expand the activity, expand the breadth and depth of what 
is done from a regulatory standpoint to cover areas that have 
been discussing during this panel, some of the stuff that Paul 
has raised. That is the best way to do it.
    We are also going to, in a very early phase, be able to 
address most of the key issues and do it in a thoughtful 
manner.
    Senator Warner. Mr. Silvers and Mr. Doe.
    Mr. Silvers. Senator, these are very acute observations you 
have made about this set of questions.
    First, I am pleased to see that a moment of disagreement 
has emerged. My colleagues on the panel who wish to put the 
burden of regulating unregulated markets, like hedge funds and 
derivatives, on the systemic risk regulator are, in my opinion, 
making a grave mistake. What we need is routine regulation in 
those areas. That is what closing the Swiss cheese system is 
about, is routine regulation, not emergency regulation, not, 
you know, looking at will they kick off a systemic crisis. Just 
an observation about that.
    I think that the Fed's refusal to regulate mortgages was 
rooted somehow in the sense that consumer protection was a kind 
of--something that was not really a serious subject for serious 
people. It turned out to be, of course, the thread that 
unraveled the system. I think that we should learn something 
from that.
    When we talk about routine regulation in these areas, I 
think to your question, we have got to understand that it is 
more than one thing. For example, a credit default swap 
contract is effectively a kind of insurance. And if someone is 
writing that insurance, they should probably have some capital 
behind the promise they are making. That is what we learned not 
just in the New Deal but long before it about insurance itself, 
which was once an exotic innovation. But we learned we had to 
have capital behind it.
    But that is not the extent of what we need to do. If, for 
example, there are transparency issues, there are disclosure 
issues associated with these kinds of contracts, for contracts 
in which public securities are the underlying asset, it is 
clear that we need to have those kinds of disclosures, because 
if we do not, then we have essentially taken away the 
transparency from our securities markets.
    Now--two final points. One, derivatives and hedge funds 
have something profound in common. They do not have any 
substantive content as terms. They are legal vehicles for 
undertaking anything imaginable. You can write a derivative 
contract against anything. You can write it against the 
weather, against credit risk, against currency risk, against 
securities, against equity, against debt. It is just a legal 
vehicle for doing things in an unregulated fashion.
    A hedge fund is the same thing. The hedge fund is not an 
investment strategy. It is just a legal vehicle, and it is a 
legal vehicle for managing money any way you can imagine, in a 
way that essentially evades the limits that have historically 
been placed on bank trusts and mutual funds and so on and so 
forth.
    What is smart regulation here is not specific to those 
terms. It is specific to those activities. It is specific to 
money management. It is specific to insurance. It is specific 
to securities. And that is why it is so important that when we 
talk about filling these regulatory gaps, we do so in a manner 
that is routine, not extraordinary.
    Thank you.
    Mr. Doe. Senator Warner, if I could just offer an example, 
I like Mr. Silvers' comment about the subject of regulation 
being routine, because I think that brings vigilance. Let me 
give you just a quick example of why when I hear you ask the 
question about products, why I think that is so important.
    After the Lehman bankruptcy in September, on the Wednesday 
following there was a liquidation, an unannounced liquidation 
by a money market fund of substantial holdings of cash-
equivalent securities which had been created in the municipal 
market through leverage programs and which were used--
essentially synthetics securities, so derivatives.
    The liquidation, unannounced--again, a trying time in the 
market in mid-September--resulted in the following day of there 
being no liquidity in the municipal secondary market, where one 
transaction that occurred in a distressed situation resulted in 
the repricing of the entire holdings of investors that were in 
mutual funds that were in individual holdings.
    We estimated that, in a back-of-the-envelope kind of way, 
about $5.5 billion were lost on that September 18th, solely 
because an illiquid market, because of liquidation of a cash 
security that was synthetic in order to fulfill the needs of 
having short-term investments for these money market funds, is 
that created a crisis in confidence that--and a confusion among 
investors as to what was the security of the credits of the 
States, of the towns that were, you know, issuing municipal 
debt. And that type of concern--and that lasted through 
September and October, and municipal issuers who were trying to 
come to market and raise important funds for capital projects 
and for operations were really inhibited by extraordinarily 
penal rates.
    So here we had this, you know, single event and this 
cascaded, touching upon cash securities, derivative securities, 
and then also tied to the supposedly the most secure cash 
equivalents in these money market funds.
    The other thing I think is really important and not to be 
lost here, as we are talking about cash securities, we are 
talking about derivatives, and a lot has been talked about 
credit default swaps, the municipal market, predominantly it is 
interest rate swaps. Here, again, there is not transparency. 
And yet these are linked intimately with cash transactions. And 
when we talk about, gee, the taxpayer is coming in and helping 
to bail out the various transgressions that have occurred in 
the banking system or in the financial system is that here we 
have taxpayers--and I think, Senator Shelby, you had some 
instances with some derivatives in your State that are getting 
a lot of headlines. And taxpayers are on the hook most directly 
right there. And I would argue and suggest to you the notion of 
really examining this opportunity that we have in our U.S. 
municipal bond market, where all these products have come to 
roost, and the credit default swap market is emerging. It is in 
its nascent stage in the municipal bond market. Yet it is 
there, and it is creating perhaps a thinness or an illiquid 
market that those derivative products is maybe creating 
misconceptions about the soundness of our States and our towns 
and our counties.
    And so I think that when we start looking at how do we gain 
transparency on these securities that are now part of the risk 
management of our municipalities and how do we help so we can 
understand them, so we can see them, so investors that are 
putting their--are facilitating the borrowing by buying these 
securities, they can see what is going on, and we can also help 
to protect these issuers who, as Mr. Turner was saying--well, 
as we were talking about broadly in this financial regulation 
of the separation of risk management and operation, is that 
here we have these--our States and our towns and counties that 
are serving--wearing both hats and using complex securities 
that they may not have fully understood.
    So I guess when I hear you talk about products, I applaud 
that, because I think that it just cannot be the people 
involved. We have to look at what is being used, but also 
being--the word has been used--``nimble'' so that we can adapt 
regulation and be flexible so that as new innovations come in 
that can be very positive but also can be seen and understood.
    Senator Warner. And I think our time has expired, and my 
only last comment would just be that I think we will get to 
some stance where we will have some level of regulatory 
oversight. My hope is that we will adhere to Mr. Turner's 
suggestion that it is a nimble and well-funded regulator.
    But I would say from the industry, we are going to need 
your help on setting standards not just retrospectively but 
prospectively. With the complexity and financial engineering 
that goes on, I just do not want to be here 5 years later 
looking at what the next round of new products would be and 
say, ``Why didn't we see that ahead of time?'' and helping us 
see what those standards--so that you do not end up with having 
to pre-clear every new product at some regulator. You know, you 
are going to have to really step up on this one and give us 
some assistance.
    Thank you, Mr. Chairman.
    Chairman Dodd. Well, thank you as well, Senator Warner. 
Very good questions.
    Before I turn to Senator Shelby for any closing comments or 
questions he has, I am struck by a couple of things. It is 
exactly the point that Senator Warner was concluding with. 
There is this debate about whether or not we have a principle-
based system or a rule-based system in the country. And I have 
always felt I was sort of in a small, tiny minority that is 
attracted to the principle-based system for the simple reason 
that it seems to me almost in a way a bit more intimidating 
than a rule-based system for the very reason that Senator 
Warner suggested, that you end up setting standards or rules, 
and within a matter of literally hours, in some cases, very 
creative, imaginative people can come up and figure out some 
way just to get around that rule, legally and ethically and 
every other reason. And so you are back at it again because 
someone has come up--now, I think the idea of a clearinghouse 
makes a lot of sense, by the way, new product lines, and I know 
Senator Shelby feels as strongly as I do about that.
    But that in itself sort of is an indication of a problem 
you have with a rule-based system, and I wonder if just quickly 
any of you have any quick comments on a rule-based versus a 
principle-based system that you would care to share at this 
point. Professor Coffee.
    Mr. Coffee. Well, I have written a long article on this 
that is currently posted on SSRN. I do not think any workable 
system can exist without being a combination of both. You need 
the principles to backstop the rules, but you can really only 
enforce rules, and particularly in our litigation-oriented 
system, we want rules that let you know you are within the safe 
harbor and you have done what you are supposed to do.
    So I think there has to be a combination of both with 
principles backstopping the rules.
    Chairman Dodd. Yes. Anyone else want to comment on that?
    Mr. Turner. Senator Dodd, I would agree with Jack on this 
one. First of all, you know, if you look at the Ten 
Commandments, half the people tell you they are principles, 
half them tell you they are rules.
    [Laughter.]
    Mr. Turner. So I am not sure anyone knows really what a 
principle or rule is. I think it does take a combination. 
Principles get so broad that you just never get enforcement. 
Rules get so detailed that people just skirt around them. So it 
takes some common sense and a combination.
    Chairman Dodd. Mr. Silvers, do you have a comment you want 
to make?
    Mr. Silvers. Only that one of the reasons why this 
discussion has become sort of hard to follow or hard to 
understand is because the concept of a principles-based system 
became code, became a code word for a weak regulatory system.
    Chairman Dodd. Yes.
    Mr. Silvers. And, in reality, a true principles-based 
system would be the strongest possible regulatory system, but 
it would be one no one could live in for the reasons that my 
two colleagues on the panel have outlined.
    Chairman Dodd. Yes.
    Mr. Pickel. I would agree in general that we prefer a 
principles-based approach. There may be certain circumstances 
such as with retail investors where having clearer rules for 
those who engage in those markets would be appropriate. But for 
the markets that I think people are engaged in derivatives, in 
OTC derivatives, I think the principles approach is the best 
one.
    Chairman Dodd. Yes.
    Mr. Bullard. I would just add, putting on a private 
practice hat for a moment, that principles-based regulation is 
intimidating, as you described, because what it means is that 
regulators have enormous enforcement discretion, and what you 
typically have, at least at the SEC, it means that they play 
``gotcha'' and bring cases that are based on specific rules 
that are made up under those principles as opposed to opposed 
to having known ahead of time exactly how the SEC might 
interpret certain positions.
    Chairman Dodd. Senator Shelby.
    Senator Shelby. I will be brief. Mr. Chairman, thank you 
for assembling this panel. We could be here all day and 
probably learn a heck of a lot.
    Principles matter, but rules matter, too. I like the idea 
of what Professor Coffee is saying. We might need a hybrid in 
some way. If you just have principles and no rules, you know, 
gosh, who is going to define them to a certain extent? But just 
rules, people say, ``Well, we have got a rule. How can we get 
around it? How can we evade it in some way?''
    So maybe it is a combination. Who knows? But thank you for 
your input, and, you know, we have an awesome task ahead of us 
here. We have got to do this right. We cannot rush to it. We 
have both met with the President on this and many meetings. It 
has got to be comprehensive. It cannot cover every contingency. 
But I think we can do better than we have been doing.
    I wish my friend Senator Warner was still here, because we 
agree on a lot of things, but some of the product approvals, 
some of these products have got to be approved before they do 
irreparable damage to, I think, the marketplace myself.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator Shelby, and again, you 
have been a terrific panel and offered some wonderful advice. 
We will probably submit some additional questions for you over 
the coming days, and we look forward to your continuing 
involvement with us. We have a formal setting here, but my 
intention is to also have some informal settings with 
interested members here and other members who are not on the 
Committee, necessarily, who would like to be a part of the 
discussion as we move forward on this, because there is a 
growing interest, obviously, not just on the part of this 
Committee but others who care about this issue and are 
interested in how we proceed.
    So I am very, very grateful to all of you for your 
knowledge, your background, your experience, and the 
thoughtfulness with which you have prepared your testimony 
today and contributing to this very, very difficult task.
    Let me just say as well how much I appreciate Senator 
Shelby and the other Members of the Committee. Always from time 
to time we have our differences, but Senator Shelby has made 
the point and I make it as well: This is one where the barriers 
that we traditionally see along political lines have to really 
evaporate and disappear. I personally have said I am agnostic 
on the question of--I do not bring any ideological framework 
whatsoever to this. I want to do something that works, that 
closes gaps, that does not have that Swiss cheese look to it 
where people can forum shop, in a sense, in order to avoid the 
regulatory process, to make sure we have good people who are 
being adequately compensated for the jobs that they are doing, 
and then doing what has to be done, is engaging on a consistent 
basis. These things are never done forever. There are always 
new products, new ideas, new--which is the genius of this in 
many ways. That is not a liability. That is an asset, in a 
sense. I have often said our goal here is to, one, make sure 
that we have a solid, sound system that reflects the times we 
are in, but not so rigid that it in any way strangles the kind 
of creativity and imagination that has drawn the world and 
others to come here to make their investments, because we are 
creative and imaginative. But at the same time, we do not want 
to be at such creativity and imagination that we lose the kind 
of protections.
    Striking that balance is never perfect. It is never 
perfect. It is always tilting one way or the other. And our job 
is to constantly try and keep that balance, if we can, as we go 
forward. And that is the challenge we have in front of us, and 
so we welcome your involvement and thank you immensely for your 
participation.
    The Committee will stand adjourned.
    [Whereupon, at 1:16 p.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follow:]
               PREPARED STATEMENT OF JOHN C. COFFEE, JR.
                    Adolf A. Berle Professor of Law,
                     Columbia University Law School
                             March 10, 2009

 Enhancing Investor Protection and the Regulation of Securities Markets

    ``When the music stops, in terms of liquidity, things will get 
complicated. But as long as the music is playing, you've got to get up 
and dance. We're still dancing.''
                       ----Charles Prince, CEO of Citigroup
                                         Financial Times, July 2007

    Chairman Dodd, Ranking Member Shelby, and Fellow Senators, I am 
pleased and honored to be invited to testify here today.
    We are rapidly approaching the first anniversary of the March 17, 
2008, insolvency of Bear Stearns, the first of a series of epic 
financial collapses that have ushered in, at the least, a major 
recession. Let me take you back just one year ago when, on this date in 
2008, the U.S. had five major investment banks that were independent of 
commercial banks and were thus primarily subject to the regulation of 
the Securities and Exchange Commission: Goldman Sachs, Merrill Lynch, 
Morgan Stanley, Lehman Brothers, and Bear Stearns. Today, one (Lehman) 
is insolvent; two (Merrill Lynch and Bear Stearns) were acquired on the 
brink of insolvency by commercial banks, with the Federal Reserve 
pushing the acquiring banks into hastily arranged ``shotgun'' 
marriages; and the remaining two (Goldman and Morgan Stanley) have 
converted into bank holding companies that are primarily regulated by 
the Federal Reserve. The only surviving investment banks not owned by 
larger commercial banks are relatively small boutiques (e.g., Lazard 
Freres). Given the total collapse of an entire class of institutions 
that were once envied globally for their entrepreneurial skill and 
creativity, the questions virtually ask themselves: Who failed? What 
went wrong?
    Although there are a host of candidates--the investment banks, 
themselves, mortgage loan originators, credit-rating agencies, the 
technology of asset-backed securitizations, unregulated trading in 
exotic new instruments (such as credit default swaps), etc.--this 
question is most pertinently asked of the SEC. Where did it err? In 
overview, 2008 witnessed two closely connected debacles: (1) the 
failure of a new financial technology (asset-backed securitizations), 
which grew exponentially until, after 2002, annual asset-backed 
securitizations exceeded the annual total volume of corporate bonds 
issued in the United States, \1\ and (2) the collapse of the major 
investment banks. In overview, it is clear that the collapse of the 
investment banks was precipitated by laxity in the asset-backed 
securitization market (for which the SEC arguably may bear some 
responsibility), but that this laxity began with the reckless behavior 
of many investment banks. Collectively, they raced like lemmings over 
the cliff by abandoning the usual principles of sound risk management 
both by (i) increasing their leverage dramatically after 2004, and (ii) 
abandoning diversification in pursuit of obsessive focus on high-profit 
securitizations. Although these firms were driven by intense 
competition and short-term oriented systems of executive compensation, 
their ability to race over the cliff depended on their ability to 
obtain regulatory exemptions from the SEC. Thus, as will be discussed, 
the SEC raced to deregulate. In 2005, it adopted Regulation AB (an 
acronym for ``Asset-Backed''), which simplified the registration of 
asset-backed securitizations without requiring significant due 
diligence or responsible verification of the essential facts. Even more 
importantly, in 2004, it introduced its Consolidated Supervised Entity 
Program (``CSE''), which allowed the major investment banks to 
determine their own capital adequacy and permissible leverage by 
designing their own credit risk models (to which the SEC deferred). 
Effectively, the SEC abandoned its long-standing ``net capital rule'' 
\2\ and deferred to a system of self-regulation for these firms, which 
largely permitted them to develop their own standards for capital 
adequacy.
---------------------------------------------------------------------------
     \1\ See John C. Coffee, Jr., Joel Seligman & Hillary Sale, 
SECURITIES REGULATION: Cases and Materials (10th ed. 2007) at 10.
     \2\ See Rule 15c3-1 (``Net Capital Requirements for Brokers and 
Dealers''), 17 CFR 240.15c3-1.
---------------------------------------------------------------------------
    For the future, it is less important to allocate culpability and 
blame than to determine what responsibilities the SEC can perform 
adequately. The recent evidence suggests that the SEC cannot easily or 
effectively handle the role of systemic risk regulator or even the more 
modest role of a prudential financial supervisor, and it may be more 
subject to capture on these issues than other agencies. This leads me 
to conclude (along with others) that the U.S. needs one systemic risk 
regulator who, among other tasks, would have responsibility for the 
capital adequacy and safety and soundness of all institutions that are 
too ``big to fail.'' \3\ The key advantage of a unified systemic risk 
regulator with jurisdiction over all large financial institutions is 
that it solves the critical problem of regulatory arbitrage. AIG, which 
has already cost U.S. taxpayers over $150 billion, presents the 
paradigm of this problem because it managed to issue billions in credit 
default swaps without becoming subject to regulation by any regulator 
at either the federal or state level.
---------------------------------------------------------------------------
     \3\ I have made this argument in greater detail in an article with 
Professor Hillary Sale, which will appear in the 75th Anniversary of 
the SEC volume of the Virginia Law Review. See Coffee and Sale, 
``Redesigning the SEC: Does the Treasury Have a Better Idea?'' 
(available on the Social Science Research Network at http://ssrn.com/
abstract=1309776).
---------------------------------------------------------------------------
    But one cannot stop with this simple prescription. The next 
question becomes what should be the relationship between such a 
systemic risk regulator and the SEC? Should the SEC simply be merged 
into it or subordinated to it? I will argue that it should not. Rather, 
the U.S. should instead follow a ``twin peaks'' structure (as the 
Treasury Department actually proposed in early 2008 before the current 
crisis crested) that assigns prudential supervision to one agency and 
consumer protection and transparency regulation to another. Around the 
globe, countries are today electing between a unified financial 
regulator (as typified by the Financial Services Authority (``FSA'') in 
the U.K.) and a ``twin peaks'' model (which both Australia and The 
Netherlands have followed). I will argue that the latter model is 
preferable because it deals better with serious conflict of interest 
problems and the differing cultures of securities and banking 
regulators. By culture, training, and professional orientation, banking 
regulators are focused on protecting bank solvency, and they 
historically have often regarded increased transparency as inimical to 
their interests, because full disclosure of a bank's problems might 
induce investors to withdraw deposits and credit. The result can 
sometimes be a conspiracy of silence between the regulator and the 
regulated to hide problems. In contrast, this is one area where the 
SEC's record is unblemished; it has always defended the principle that 
``sunlight is the best disinfectant.'' Over the long-run, that is the 
sounder rule.
    If I am correct that a ``twin peaks'' model is superior, then 
Congress has to make clear the responsibilities of both agencies in any 
reform legislation in order to avoid predictable jurisdictional 
conflicts and to identify a procedure by which to mediate those 
disputes that are unavoidable.
What Went Wrong?
    This section will begin with the problems in the mortgage loan 
market, then turn to the failure of credit-rating agencies, and finally 
examine the SEC's responsibility for the collapse of the major 
investment banks.
The Great American Real Estate Bubble
    The earliest origins of the 2008 financial meltdown probably lie in 
deregulatory measures, taken by the U.S. Congress at the end of the 
1990s, that placed some categories of derivatives and the parent 
companies of investment banks beyond effective regulation. \4\ Still, 
most accounts of the crisis start by describing the rapid inflation of 
a bubble in the U.S. housing market. Here, one must be careful. The 
term ``bubble'' can be a substitute for closer analysis and may carry a 
misleading connotation of inevitability. In truth, bubbles fall into 
two basic categories: those that are demand-driven and those that are 
supply-driven. The majority of bubbles fall into the former category, 
\5\ but the 2008 financial market meltdown was clearly a supply-driven 
bubble, \6\ fueled by the fact that mortgage loan originators came to 
realize that underwriters were willing to buy portfolios of mortgage 
loans for asset-backed securitizations without any serious 
investigation of the underlying collateral. With that recognition, loan 
originators' incentive to screen borrowers for creditworthiness 
dissipated, and a full blown ``moral hazard'' crisis was underway. \7\
---------------------------------------------------------------------------
     \4\ Interestingly, this same diagnosis was recently given by SEC 
Chairman Christopher Cox to this Committee. See Testimony of SEC 
Chairman Christopher Cox before the Committee on Banking, Housing and 
Urban Affairs, United States Senate, September 23, 2008. Perhaps 
defensively, Chairman Cox located the origins of the crisis in the 
failure of Congress to give the SEC jurisdiction over investment bank 
holding companies or over-the-counter derivatives (including credit 
default swaps), thereby creating a regulatory void.
     \5\ For example, the high-tech Internet bubble that burst in early 
2000 was a demand-driven bubble. Investors simply overestimated the 
value of the Internet, and for a time initial public offerings of 
``dot.com'' companies would trade at ridiculous and unsustainable 
multiples. But full disclosure was provided to investors and the SEC 
cannot be faulted in this bubble--unless one assigns it the very 
paternalistic responsibility of protecting investors from themselves.
     \6\ This is best evidenced by the work of two University of 
Chicago Business School professors discussed below. See Atif Mian and 
Amir Sufi, ``The Consequences of Mortgage Credit Expansion: Evidence 
from the 2007 Mortgage Default Crisis'', (http://ssrn.com/
abstract=1072304) (May 2008).
     \7\ Interestingly, ``moral hazard'' problems also appear to have 
underlain the ``savings and loan'' crisis in the United States in the 
1980s, which was the last great crisis involving financial institutions 
in the United States. For a survey of recent banking crises making this 
point, see Note, Anticipatory Regulation for the Management of Banking 
Crises, 38 Colum. J. L. & Soc. Probs. 251 (2005).
---------------------------------------------------------------------------
    The evidence is clear that, between 2001 and 2006, an extraordinary 
increase occurred in the supply of mortgage funds, with much of this 
increased supply being channeled into poorer communities in which 
previously there had been a high denial rate on mortgage loan 
applications. \8\ With an increased supply of mortgage credit, housing 
prices rose rapidly, as new buyers entered the market. But at the same 
time, a corresponding increase in mortgage debt relative to income 
levels in these same communities made these loans precarious. A study 
by University of Chicago Business School professors has found that two 
years after this period of increased mortgage availability began, a 
corresponding increase started in mortgage defaults--in exactly the 
same zip code areas where there had been a high previous rate of 
mortgage loan denials. \9\ This study determined that a one standard 
deviation in the supply of mortgages from 2001 to 2004 produced a one 
standard deviation increase thereafter in mortgage default rates. \10\
---------------------------------------------------------------------------
     \8\ See Mian and Sufi, supra note 6, at 11 to 13.
     \9\ Id. at 18-19.
     \10\ Id. at 19.
---------------------------------------------------------------------------
    Even more striking, however, was its finding that the rate of 
mortgage defaults was highest in those neighborhoods that had the 
highest rates of securitization. \11\ Not only did securitization 
correlate with a higher rate of default, but that rate of default was 
highest when the mortgages were sold by the loan originator to 
financial firms unaffiliated with the loan originator. \12\ Other 
researchers have reached a similar conclusion: conditional on its being 
actually securitized, a loan portfolio that was more likely to be 
securitized was found to default at a 20 percent higher rate than a 
similar risk profile loan portfolio that was less likely to be 
securitized. \13\ Why? The most plausible interpretation is that 
securitization adversely affected the incentives of lenders to screen 
their borrowers.
---------------------------------------------------------------------------
     \11\ Id. at 20-21.
     \12\ Id.
     \13\ See Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and 
Vikrant Vig, ``Did Securitization Lead to Lax Screening? Evidence from 
Subprime Loans,'' (http://ssrn.com/abstract=1093137) (April, 2008). 
These authors conclude that securitization did result in ``lax 
screening.''
---------------------------------------------------------------------------
    Such a conclusion should not surprise. It simply reflects the 
classic ``moral hazard'' problem that arises once loan originators did 
not bear the cost of default by their borrowers. As early as March, 
2008, The President's Working Group on Financial Markets issued a 
``Policy Statement on Financial Market Developments'' that explained 
the financial crisis as the product of five ``principal underlying 
causes of the turmoil in financial markets'':

    a breakdown in underwriting standards for subprime 
        mortgages;

    a significant erosion of market discipline by those 
        involved in the securitization process, including originators, 
        underwriters, credit rating agencies, and global investors, 
        related in part to failures to provide or obtain adequate risk 
        disclosures;

    flaws in credit rating agencies' assessment of subprime 
        residential mortgages . . . and other complex structured credit 
        products, . . .

    risk management weaknesses at some large U.S. and European 
        financial institutions; and

    regulatory policies, including capital and disclosure 
        requirements, that failed to mitigate risk management 
        weaknesses. \14\
---------------------------------------------------------------------------
     \14\ The President's Working Group on Financial Markets, ``Policy 
Statement on Financial Market Developments,'' at 1 (March 2008).

    Correct as the President's Working Group was in noting the 
connection between the decline of discipline in the mortgage loan 
origination market and a similar laxity among underwriters in the 
capital markets, it did not focus on the direction of the causality. 
Did mortgage loan originators fool or defraud investment bankers? Or 
did investment bankers signal to loan originators that they would buy 
whatever the loan originators had to sell? The available evidence tends 
to support the latter hypothesis: namely, that irresponsible lending in 
the mortgage market was a direct response to the capital markets' 
increasingly insatiable demand for financial assets to securitize. If 
underwriters were willing to rush deeply flawed asset-backed 
securitizations to the market, mortgage loan originators had no 
rational reason to resist them.
    The rapid deterioration in underwriting standards for subprime 
mortgage loans is revealed at a glance in the following table: \15\
---------------------------------------------------------------------------
     \15\ See Allen Ferrell, Jennifer Bethel and Gang Hu, Legal and 
Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis 
(Harvard Law & Economics Discussion Paper No. 612, Harvard Law School 
Program in Risk Regulation Research Paper No. 08-5) at Table 4.

                        Underwriting Standards in Subprime Home-Purchase Loans, 2001-2006
----------------------------------------------------------------------------------------------------------------
                                                              Debt
                   Year                      Low/No-Doc     Payments/    Loan/Value     ARM Share     Interest-
                                                Share        Income                                  Only Share
----------------------------------------------------------------------------------------------------------------
2001......................................        28.5%         39.7%         84.0%         73.8%          0.0%
2002......................................        38.6%         40.1%         84.4%         80.0%          2.3%
2003......................................        42.8%         40.5%         86.1%         80.1%          8.6%
2004......................................        45.2%         41.2%         84.9%         89.4%         27.3%
2005......................................        50.7%         41.8%         83.2%         93.3%         37.8%
2006......................................        50.8%         42.4%         83.4%         91.3%         22.8%
----------------------------------------------------------------------------------------------------------------
Source: Freddie Mac, obtained from the International Monetary Fund.


    The investment banks could not have missed that low document loans 
(also called ``liar loans'') rose from 28.5 percent to 50.8 percent 
over the 5 year interval between 2001 and 2006 or that ``interest 
only'' loans (on which there was no amortization of principal) 
similarly grew from 6 percent to 22.8 percent over this same interval.
    Thus, the real mystery is not why loan originators made unsound 
loans, but why underwriters bought them. Here, it seems clear that both 
investment and commercial banks saw high profits in securitizations and 
believed they could quickly sell on a global basis any securitized 
portfolio of loans that carried an investment grade rating. In 
addition, investment banks may have had a special reason to focus on 
securitizations: structured finance offered a level playing field where 
they could compete with commercial banks, whereas, as discussed later, 
commercial banks had inherent advantages at underwriting corporate debt 
and were gradually squeezing the independent investment banks out of 
this field. \16\ Consistent with this interpretation, anecdotal 
evidence suggests that due diligence efforts within the underwriting 
community slackened in asset-backed securitizations after 2000. \17\ 
Others have suggested that the SEC contributed to this decline by 
softening its disclosure and due diligence standards for asset-backed 
securitizations, \18\ in particular by adopting in 2005 Regulation AB, 
which covers the issuance of asset backed securities. \19\ From this 
perspective, relaxed discipline in both the private and public sectors 
overlapped to produce a disaster.
---------------------------------------------------------------------------
     \16\ See text and notes infra at notes 56 to 61.
     \17\ Investment banks formerly had relied on ``due diligence'' 
firms that they employed to determine whether the loans within a loan 
portfolio were within standard parameters. These firms would 
investigate and inform the underwriter as to the percentage of the 
loans that were ``exception'' loans (i.e., loans outside the investment 
bank's normal guidelines). Subsequent to 2000, the percentage of 
``exception loans'' in portfolios securitized by these banks often rose 
from the former level of 25 percent to as high as 80 percent. Also, the 
underwriters scaled back the intensity of the investigations that they 
would authorize the ``due diligence'' firm to conduct, reducing from 30 
percent to as few as 5 percent the number of loans in a portfolio that 
it was to check. See Vikas Bajaj & Jenny Anderson, ``Inquiry Focuses on 
Withholding of Data on Loans,'' N.Y. Times, January 12, 2008, at p. A-
1.
     \18\ See Richard Mendales, ``Collateralized Explosive Devices: Why 
Securities Regulation Failed to Prevent the CDO Meltdown And How To Fix 
It'' (Working Paper 2008) at 36 (forthcoming in 2009, U. Ill. L. Rev.).
     \19\ See Securities Act Release No. 8518 (``Asset-Backed 
Securities'') (January 7, 2005, 79 FR 1506). Regulation AB codified a 
series of ``no action'' letters and established disclosures standards 
for all asset-backed securitizations. See 17 C.F.R.  229.1100-1123 
(2005). Although it did not represent a sharp deregulatory break with 
the past, Regulation AB did reduce the due diligence obligation of 
underwriters by eliminating any need to assure that assets included in 
a securitized pool were adequately documented. See Mendales, supra note 
18.
---------------------------------------------------------------------------
Credit Rating Agencies as Gatekeepers
    It has escaped almost no one's attention that the credit rating 
agencies bear much responsibility for the 2008 financial crisis, with 
the consensus view being that they inflated their ratings in the case 
of structured finance offerings. Many reasons have been given for their 
poor performance: (1) rating agencies faced no competition (because 
there are really only three major rating agencies); (2) they were not 
disciplined by the threat of liability (because credit rating agencies 
in the U.S. appear never to have been held liable and almost never to 
have settled a case with any financial payment); (3) they were granted 
a ``regulatory license'' by the SEC, which has made an investment grade 
rating from a rating agency that was recognized by the SEC a virtual 
precondition to the purchase of debt securities by many institutional 
investors; (4) they are not required to verify information (as auditors 
and securities analysts are), but rather simply express views as to the 
creditworthiness of the debt securities based on the assumed facts 
provided to them by the issuer. \20\ These factors all imply that 
credit rating agencies had less incentive than other gatekeepers to 
protect their reputational capital from injury. After all, if they face 
little risk that new entrants could enter their market to compete with 
them or that they could be successfully sued, they had less need to 
invest in developing their reputational capital or taking other 
precautions. All that was necessary was that they avoid the type of 
major scandal, such as that which destroyed Arthur Andersen & Co., the 
accounting firm, that had made it impossible for a reputable company to 
associate with them.
---------------------------------------------------------------------------
     \20\ For these and other explanations, see Coffee, GATEKEEPERS: 
The Professions and Corporate Governance (Oxford University Press, 
2006), and Frank Partnoy, ``How and Why Credit Rating Agencies Are Not 
Like Other Gatekeepers'' (http://ssrn.com/abstract=900257) (May 2006).
---------------------------------------------------------------------------
    Much commentary has suggested that the credit rating agencies were 
compromised by their own business model, which was an ``issuer pays'' 
model under which nearly 90 percent of their revenues came from the 
companies they rated. \21\ Obviously, an ``issuer pays'' model creates 
a conflict of interest and considerable pressure to satisfy the issuer 
who paid them. Still, neither such a conflicted business model nor the 
other factors listed above can explain the dramatic deterioration in 
the performance of the rating agencies over the last decade. Both 
Moody's and Standard & Poor were in business before World War I and 
performed at least acceptably until the later 1990s. To account for 
their more recent decline in performance, one must point to more recent 
developments and not factors that long were present. Two such factors, 
each recent and complementary with the other, do provide a persuasive 
explanation for this deterioration: (1) the rise of structured finance 
and the change in relationships that it produced between the rating 
agencies and their clients; and (2) the appearance of serious 
competition within the ratings industry that challenged the long stable 
duopoly of Moody's and Standard & Poor's and that appears to have 
resulted in ratings inflation.
---------------------------------------------------------------------------
     \21\ See Partnoy, supra note 20.
---------------------------------------------------------------------------
    First, the last decade witnessed a meteoric growth in the volume 
and scale of structured finance offerings. One impact of this growth 
was that it turned the rating agencies from marginal, basically break-
even enterprises into immensely profitable enterprises that rode the 
crest of the breaking wave of a new financial technology. 
Securitizations simply could not be sold without ``investment grade'' 
credit ratings from one or more of the Big Three rating agencies. 
Structured finance became the rating agencies' leading source of 
revenue. Indeed by 2006, structured finance accounted for 54.2 percent 
of Moody's revenues from its ratings business and 43.5 percent of its 
overall revenues. \22\ In addition, rating structured finance products 
generated much higher fees than rating similar amounts of corporate 
bonds. \23\ For example, rating a $350 million mortgage pool could 
justify a fee of $200,000 to $250,000, while rating a municipal bond of 
similar size justified only a fee of $50,000. \24\
---------------------------------------------------------------------------
     \22\ See In re Moody's Corporation Securities Litigation, 2009 
U.S. Dist. LEXIS 13894 (S.D.N.Y. February 23, 2009) at *6 (also noting 
that Moody's grossed $1.635 billion from its ratings business in 2006).
     \23\ See Gretchen Morgenson, ``Debt Watchdogs: Tamed or Caught 
Napping?'' New York Times, December 7, 2008, at p. 1, 40.
     \24\ Id.
---------------------------------------------------------------------------
    Beyond simply the higher profitability of rating securitized 
transactions, there was one additional difference about structured 
finance that particularly compromised the rating agencies as 
gatekeepers. In the case of corporate bonds, the rating agencies rated 
thousands of companies, no one of which controlled any significant 
volume of business. No corporate issuer, however large, accounted for 
any significant share of Moody's or S&P's revenues. But with the rise 
of structured finance, the market became more concentrated. As a 
result, the major investment banks acquired considerable power over the 
rating agencies, because each of them had ``clout,'' bringing highly 
lucrative deals to the agencies on a virtually monthly basis. As the 
following chart shows, the top six underwriters controlled over 50 
percent of the mortgage-backed securities underwriting market in 2007, 
and the top eleven underwriters each had more than 5 percent of the 
market and in total controlled roughly 80 percent of this very 
lucrative market on whom the rating agencies relied for a majority of 
their ratings revenue: \25\
---------------------------------------------------------------------------
     \25\ See Ferrell, Bethel, and Hu, supra note 15, at Table 2. For 
anecdotal evidence that ratings were changed at the demand of the 
investment banks, see Morgenson, supra note 23.

                                                                MBS Underwriters in 2007
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                  Proceed Amount +
                          Rank                                        Book Runner               Number  of      Market      Overallotment Sold in  U.S.
                                                                                                 Offerings       Share                ($mill)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1.......................................................                     Lehman Brothers           120        10.80%                       $100,109
2.......................................................                     Bear Stearns & Co., Inc.  128         9.90%                         91,696
3.......................................................                      Morgan Stanley            92         8.20%                         75,627
4.......................................................                            JPMorgan            95         7.90%                         73,214
5.......................................................                                    Credit Suis109         7.50%                         69,503
6.......................................................       Bank of America Securities LLC          101         6.80%                         62,776
7.......................................................                    Deutsche Bank AG            85         6.20%                         57,337
8.......................................................        Royal Bank of Scotland Group            74         5.80%                         53,352
9.......................................................                       Merrill Lynch            81         5.20%                         48,407
10......................................................                    Goldman Sachs & Co.         60         5.10%                         47,696
11......................................................                                    Citigroup   95         5.00%                         46,754
12......................................................                                 UBS            74         4.30%                         39,832
--------------------------------------------------------------------------------------------------------------------------------------------------------


    If the rise of structured finance was the first factor that 
compromised the credit rating agencies, the second factor was at least 
as important and had an even clearer empirical impact. Until the late 
1990s, Moody's and Standard & Poor's shared a duopoly over the rating 
of U.S. corporate debt. But, over the last decade, a third agency, 
Fitch Ratings, grew as the result of a series of mergers and increased 
its U.S. market share from 10 percent to approximately a third of the 
market. \26\ The rise of Fitch challenged the established duopoly. What 
was the result? A Harvard Business School study has found three 
significant impacts: (1) the ratings issued by the two dominant rating 
agencies shifted significantly in the direction of higher ratings; (2) 
the correlation between bond yields and ratings fell, suggesting that 
under competitive pressure ratings less reflected the market's own 
judgment; and (3) the negative stock market reaction to bond rating 
downgrades increased, suggesting that a downgrade now conveyed worse 
news because the rated offering was falling to an even lower quality 
threshold than before. \27\ Their conclusions are vividly illustrated 
by one graph they provide that shows the correlation between grade 
inflation and higher competition:
---------------------------------------------------------------------------
     \26\ Bo Becker and Todd Milburn, ``Reputation and Competition: 
Evidence from the Credit Rating Industry,'' Harvard Business School, 
Working Paper No. 09-051 (2008) (http://ssrn.com/abstract =1278150) at 
p. 4.
     \27\ Id. at 17.
    
    
    Under high competition, lower ratings declined and investment grade 
rations soared. The authors conclude that increased competition may 
impair ``the reputational mechanism that underlies the provision of 
good quality ratings.'' \28\
---------------------------------------------------------------------------
     \28\ Id. at 21.
---------------------------------------------------------------------------
    The anecdotal evidence supports a similar conclusion: the major 
rating agencies responded to the competitive threat from Fitch by 
making their firms ``more client-friendly and focused on market 
share.'' \29\ Put simply, the evidence implies that the rapid change 
toward a more competitive environment made the competitors not more 
faithful to investors, but more dependent on their immediate clients, 
the issuers. From the standpoint of investors, agency costs increased.
---------------------------------------------------------------------------
     \29\ See ``Ratings Game--As Housing Boomed, Moody's Opened Up,'' 
The Wall Street Journal, April 11, 2008, at p. A-1.
---------------------------------------------------------------------------
The Responsibility of the SEC
    Each of the major investment banks that failed, merged, or 
converted into bank holding companies in 2008 had survived prior 
recessions, market panics, and repeated turmoil and had long histories 
extending back as far as the pre-Civil War era. Yet, each either failed 
or was gravely imperiled within the same basically 6 month period 
following the collapse of Bear Stearns in March 2008. \30\
---------------------------------------------------------------------------
     \30\ For a concise overview of these developments, see Jon 
Hilsenrath, Damian Palette, and Aaron Lucchetti, ``Goldman, Morgan 
Scrap Wall Street Model, Become Banks in Bid To Ride Out Crisis,'' The 
Wall Street Journal, September 22, 2008, at p. A-1 (concluding that 
independent investment banks could not survive under current market 
conditions and needed closer regulatory supervision to establish 
credibility).
---------------------------------------------------------------------------
    If their uniform collapse is not alone enough to suggest the 
likelihood of regulatory failure, one additional common fact unites 
them: each of these five firms voluntarily entered into the SEC's 
Consolidated Supervised Entity (``CSE'') Program, which was established 
by the SEC in 2004 for only the largest investment banks. \31\ Indeed, 
these five investment banks were the only investment banks permitted by 
the SEC to enter the CSE program. A key attraction of the CSE Program 
was that it permitted its members to escape the SEC's traditional net 
capital rule, which placed a maximum ceiling on their debt to equity 
ratios, and instead elect into a more relaxed ``alternative net capital 
rule'' that contained no similar limitation. \32\ The result was 
predictable: all five of these major investment banks increased their 
debt-to-equity leverage ratios significantly over the brief two year 
period following their entry into the CSE Program, as shown by Figure 1 
below: \33\
---------------------------------------------------------------------------
     \31\ See Securities Exchange Act Release No. 34-49830 (June 21, 
2004), 69 FR 34428 (``Alternative Net Capital Requirements for Broker-
Dealers That Are Part of Consolidated Supervised Entities'').
     \32\ The SEC's ``net capital rule,'' which dates back to 1975, 
governs the capital adequacy and aggregate indebtedness permitted for 
most broker-dealers. See Rule 15c3-1 (``Net Capital Requirements for 
Brokers and Dealers''). 17 C.F.R.  240.15c3-1. Under subparagraph 
(a)(1)(i) of this rule, aggregate indebtedness is limited to fifteen 
times the broker-dealer's net capital; a broker-dealer may elect to be 
governed instead by subparagraph (a)(1)(ii) of this rule, which 
requires it maintain its net capital at not less than the greater of 
$250,000 or two percent of ``aggregate debit items'' as computed under 
a special formula that gives ``haircuts'' (i.e., reduces the valuation) 
to illiquid securities. Both variants place fixed limits on leverage.
     \33\ This chart comes from U.S. Securities and Exchange 
Commission, Office of the Inspector General, ``SEC's Oversight of Bear 
Stearns and Related Entities: The Consolidated Entity Program'' 
(`Report No. 446-A, September 25, 2008) (hereinafter ``SEC Inspector 
General Report'') at Appendix IX at p. 120.


    For example, at the time of its insolvency, Bear Stearns' gross 
leverage ratio had hit 33 to 1. \34\
---------------------------------------------------------------------------
     \34\ See SEC Inspector General Report at 19.
---------------------------------------------------------------------------
    The above chart likely understates the true increase in leverage 
because gross leverage (i.e., assets divided by equity) does not show 
the increase in off-balance sheet liabilities, as the result of 
conduits and liquidity puts. Thus, another measure may better show the 
sudden increase in risk. One commonly used metric for banks is the 
bank's value at risk (VaR) estimate, which banks report to the SEC in 
their annual report on Form 10-K. This measure is intended to show the 
risk inherent in their financial portfolios. The chart below shows 
``Value at Risk'' for the major underwriters over the interval 2004 to 
2007: \35\
---------------------------------------------------------------------------
     \35\ See Ferrell, Bethel, and Hu, supra note 15, at Table 8. Value 
at risk estimates have proven to be inaccurate predictors of the actual 
writedowns experienced by banks. They are cited here not because they 
are accurate estimates of risk, but because the percentage increases at 
the investment banks was generally extreme. Even Goldman Sachs, which 
survived the crisis in better shape than its rivals, saw its VaR 
estimate more than double over this period.

                        Value at Risk, 2004-2007
------------------------------------------------------------------------
                                    2004      2005      2006      2007
              Firms                ($mil)    ($mil)    ($mil)    ($mil)
------------------------------------------------------------------------
Bank of America.................    $44.1     $41.8     $41.3         -
Bear Stearns....................     14.8      21.4      28.8     $69.3
Citigroup.......................    116.0      93.0     106.0         -
Credit Suisse...................     55.1      66.2      73.0         -
Deutsche Bank...................     89.8      82.7     101.5         -
Goldman Sachs...................     67.0      83.0     119.0     134.0
JPMorgan........................     78.0     108.0     104.0         -
Lehman Brothers.................     29.6      38.4      54.0     124.0
Merrill Lynch...................     34.0      38.0      52.0         -
Morgan Stanley..................     94.0      61.0      89.0      83.0
UBS.............................    103.4     124.7     132.8         -
Wachovia........................     21.0      18.0      30.0         -
------------------------------------------------------------------------
VaR statistics are reported in the 10K or 20F (in the case of foreign
  firms) of the respective firms. Note that the firms use different
  assumptions in computing their Value of Risk. Some annual reports are
  not yet avaialble for 2007.


    Between 2004 and 2007, both Bear Stearns and Lehman more than 
quadrupled their value at risk estimates, while Merrill Lynch's figure 
also increased significantly. Not altogether surprisingly, they were 
the banks that failed.
    These facts provide some corroboration for an obvious hypothesis: 
excessive deregulation by the SEC caused the liquidity crisis that 
swept the global markets in 2008. \36\ Still, the problem with this 
simple hypothesis is that it may be too simple. Deregulation did 
contribute to the 2008 financial crisis, but the SEC's adoption of the 
CSE Program in 2004 was not intended to be deregulatory. Rather, the 
program was intended to compensate for earlier deregulatory efforts by 
Congress that had left the SEC unable to monitor the overall financial 
position and risk management practices of the nation's largest 
investment banks. Still, even if the 2004 net capital rule changes were 
not intended to be deregulatory, they worked out that way in practice. 
The ironic bottom line is that the SEC unintentionally deregulated by 
introducing an alternative net capital rule that it could not 
effectively monitor.
---------------------------------------------------------------------------
     \36\ For the bluntest statement of this thesis, see Stephen 
Labaton, ``S.E.C. Concedes Oversight Plans Fueled Collapse,'' New York 
Times, September 27, 2008, at p. 1. Nonetheless, this analysis is 
oversimple. Although SEC Chairman Cox did indeed acknowledge that there 
were flaws in the ``Consolidated Supervised Entity'' Program, he did 
not concede that it ``fueled'' the collapse or that it represented 
deregulation. As discussed below, the SEC probably legitimately 
believed that it was gaining regulatory authority from the CSE Program 
(but it was wrong).
---------------------------------------------------------------------------
    The events leading up to the SEC's decision to relax its net 
capital rule for the largest investment banks began in 2002, when the 
European Union adopted its Financial Conglomerates Directive. \37\ The 
main thrust of the E.U.'s new directive was to require regulatory 
supervision at the parent company level of financial conglomerates that 
included a regulated financial institution (e.g., a broker-dealer, bank 
or insurance company). The E.U.'s entirely reasonable fear was that the 
parent company might take actions that could jeopardize the solvency of 
the regulated subsidiary. The E.U.'s directive potentially applied to 
the major U.S. investment and commercial banks because all did 
substantial business in London (and elsewhere in Europe). But the 
E.U.'s directive contained an exemption for foreign financial 
conglomerates that were regulated by their home countries in a way that 
was deemed ``equivalent'' to that envisioned by the directive. For the 
major U.S. commercial banks (several of which operated a major broker-
dealer as a subsidiary), this afforded them an easy means of avoiding 
group-wide supervision by regulators in Europe, because they were 
subject to group-level supervision by U.S. banking regulators.
---------------------------------------------------------------------------
     \37\ See Council Directive 2002/87, Financial Conglomerates 
Directive, 2002 O.J. (L 35) of the European Parliament and of the 
Council of 16 December 2002 on the supplementary supervision of credit 
institutions, insurance undertakings and investment firms in a 
financial conglomerate and amending Council Directives. For an overview 
of this directive and its rationale, see Jorge E. Vinuales, The 
International Regulation of Financial Conglomerates: A Case Study of 
Equivalence as an Approach to Financial Integration, 37 Cal. W. Int'l 
L.J. 1, at 2 (2006).
---------------------------------------------------------------------------
    U.S. investment banks had no similar escape hatch, as the SEC had 
no similar oversight over their parent companies. Thus, fearful of 
hostile regulation by some European regulators, \38\ U.S. investment 
banks lobbied the SEC for a system of ``equivalent'' regulation that 
would be sufficient to satisfy the terms of the directive and give them 
immunity from European oversight. \39\ For the SEC, this offered a 
serendipitous opportunity to oversee the operations of investment bank 
holding companies, which authority the SEC had sought for some time. 
Following the repeal of the Glass-Steagall Act, the SEC had asked 
Congress to empower it to monitor investment bank holding companies, 
but it had been rebuffed. Thus, the voluntary entry of the holding 
companies into the Consolidated Supervised Entity program must have 
struck the SEC as a welcome development, and Commission unanimously 
approved the program without any partisan disagreement. \40\
---------------------------------------------------------------------------
     \38\ Different European regulators appear to have been feared by 
different entities. Some commercial banks saw French regulation as 
potentially hostile, while U.S. broker-dealers, all largely based in 
London, did not want their holding companies to be overseen by the 
U.K.'s Financial Services Agency (FSA).
     \39\ See Stephen Labaton, ``Agency's '04 Rule Let Banks Pile Up 
Debt and Risk,'' New York Times, October 3, 2008, at A-1 (describing 
major investment banks as having made an ``urgent plea'' to the SEC in 
April, 2004).
     \40\ See Securities Exchange Act Release No. 34-49830, supra note 
31.
---------------------------------------------------------------------------
    But the CSE Program came with an added (and probably unnecessary) 
corollary: Firms that entered the CSE Program were permitted to adopt 
an alternative and more relaxed net capital rule governing their debt 
to net capital ratio. Under the traditional net capital rule, a broker-
dealer was subject to fixed ceilings on its permissible leverage. 
Specifically, it either had to (a) maintain aggregate indebtedness at a 
level that could not exceed fifteen times net capital, \41\ or (b) 
maintain minimum net capital equal to not less than two percent of 
``aggregate debit items.'' \42\ For most broker-dealers, this 15 to 1 
debt to net capital ratio was the operative limit within which they 
needed to remain by a comfortable margin.
---------------------------------------------------------------------------
     \41\ See Rule 15c3-1(a)(1)(i)(``Alternative Indebtedness 
Standard''), 17 C.F.R.  240.15c3-1(a)(1).
     \42\ See Rule 15c3-1(a)(1)(ii)(``Alternative Standard''), 17 
C.F.R.  240.15c3-1(a)(1)(ii). This alternative standard is framed in 
terms of the greater of $250,000 or 2 percent, but for any investment 
bank of any size, 2 percent will be the greater. Although this 
alternative standard may sound less restrictive, it was implemented by 
a system of ``haircuts'' that wrote down the value of investment assets 
to reflect their illiquidity.
---------------------------------------------------------------------------
    Why did the SEC allow the major investment banks to elect into an 
alternative regime that placed no outer limit on leverage? Most likely, 
the Commission was principally motivated by the belief that it was only 
emulating the more modern ``Basel II'' standards that the Federal 
Reserve Bank and European regulators were then negotiating. To be sure, 
the investment banks undoubtedly knew that adoption of Basel II 
standards would permit them to increase leverage (and they lobbied hard 
for such a change). But, from the SEC's perspective, the goal was to 
design the CSE Program to be broadly consistent with the Federal 
Reserve's oversight of bank holding companies, and the program even 
incorporated the same capital ratio that the Federal Reserve mandated 
for bank holding companies. \43\ Still, the Federal Reserve introduced 
its Basel II criteria more slowly and gradually, beginning more than a 
year later, while the SEC raced in 2004 to introduce a system under 
which each investment bank developed its own individualized credit risk 
model. Today, some believe that Basel II represents a flawed model even 
for commercial banks, while others believe that, whatever its overall 
merits, it was particularly ill-suited for investment banks. \44\
---------------------------------------------------------------------------
     \43\ See SEC Inspector General Report at 10-11. Under these 
standards, a ``well-capitalized'' bank was expected to maintain a 10 
percent capital ratio. Id. at 11. Nonetheless, others have argued that 
Basel II ``was not designed to be used by investment banks'' and that 
the SEC ``ought to have been more careful in moving banks on to the new 
rules.'' See ``Mewling and Puking: Bank Regulation,'' The Economist, 
October 25, 2008 (U.S. Edition).
     \44\ For the view that Basel II excessively deferred to commercial 
banks to design their own credit risk models and their increase 
leverage, see Daniel K. Tarullo, BANKING ON BASEL: The Future of 
International Financial Regulation (2008). Mr. Tarullo has recently 
been nominated by President Obama to the Board of Governors of the 
Federal Reserve Board. For the alternative view, that Basel II was 
uniquely unsuited for investment banks, see ``Mewling and Puking,'' 
supra note 43.
---------------------------------------------------------------------------
    Yet, what the evidence demonstrates most clearly is that the SEC 
simply could not implement this model in a fashion that placed any real 
restraint on its subject CSE firms. The SEC's Inspector General 
examined the failure of Bear Stearns and the SEC's responsibility 
therefor and reported that Bear Stearns had remained in compliance with 
the CSE Program's rules at all relevant times. \45\ Thus, if Bear 
Stearns had not cheated, this implied (as the Inspector General found) 
that the CSE Program, itself, had failed. The key question is then what 
caused the CSE Program to fail. Here, three largely complementary 
hypotheses are plausible. First, the Basel II Accords may be flawed, 
either because they rely too heavily on the banks' own self-interested 
models of risk or on the highly conflicted ratings of the major credit 
rating agencies. \46\ Second, even if Basel II made sense for 
commercial banks, it may have been ill-suited for investment banks. 
\47\ Third, whatever the merits of Basel II in theory, the SEC may have 
simply been incapable of implementing it.
---------------------------------------------------------------------------
     \45\ SEC Inspector General Report, 10.
     \46\ The most prominent proponent of this view is Professor Daniel 
Tarullo. See supra note 44.
     \47\ See ``Mewling and Puking,'' supra note 43.
---------------------------------------------------------------------------
    Clearly, however, the SEC moved faster and farther to defer to 
self-regulation by means of Basel II than did the Federal Reserve. \48\ 
Clearly also, the SEC's staff was unable to monitor the participating 
investment banks closely or to demand specific actions by them. Basel 
II's approach to the regulation of capital adequacy at financial 
institutions contemplated close monitoring and supervision. Thus, the 
Federal Reserve assigns members of its staff to maintain an office 
within a regulated bank holding company in order to provide constant 
oversight. In the case of the SEC, a team of only three SEC staffers 
were assigned to each CSE firm \49\ (and a total of only thirteen 
individuals comprised the SEC's Office of Prudential Supervision and 
Risk Analysis that oversaw and conducted this monitoring effort). \50\ 
From the start, it was a mismatch: three SEC staffers to oversee an 
investment bank the size of Merrill Lynch, which could easily afford to 
hire scores of highly quantitative economists and financial analysts, 
implied that the SEC was simply outgunned. \51\
---------------------------------------------------------------------------
     \48\ The SEC adopted its CSE program in 2004. The Federal Reserve 
only agreed in principle to Basel II in late 2005. See Stavros Gadinis, 
The Politics of Competition in International Financial Regulation, 49 
Harv. Int'l L. J. 447, 507 n. 192 (2008).
     \49\ SEC Inspector General Report at 2.
     \50\ Id. Similarly, the Office of CSE Inspectors had only seven 
staff. Id.
     \51\ Moreover, the process effectively ceased to function well 
before the 2008 crisis hit. After SEC Chairman Cox re-organized the CSE 
review process in the Spring of 2007, the staff did not thereafter 
complete ``a single inspection.'' See Labaton, supra note 39.
---------------------------------------------------------------------------
    This mismatch was compounded by the inherently individualized 
criteria upon which Basel II relies. Instead of applying a uniform 
standard (such as a specific debt to equity ratio) to all financial 
institutions, Basel II contemplated that each regulated financial 
institution would develop a computer model that would generate risk 
estimates for the specific assets held by that institution and that 
these estimates would determine the level of capital necessary to 
protect that institution from insolvency. Thus, using the Basel II 
methodology, the investment bank generates a mathematical model that 
crunches historical data to evaluate how risky its portfolio assets 
were and how much capital it needed to maintain to protect them. 
Necessarily, each model was ad hoc, specifically fitted to that 
specific financial institution. But no team of three SEC staffers was 
in a position to contest these individualized models or the historical 
data used by them. Effectively, the impact of the Basel II methodology 
was to shift the balance of power in favor of the management of the 
investment bank and to diminish the negotiating position of the SEC's 
staff. Whether or not Basel II's criteria were inherently flawed, it 
was a sophisticated tool that was beyond the capacity of the SEC's 
largely legal staff to administer effectively.
    The SEC's Inspector General's Report bears out this critique by 
describing a variety of instances surrounding the collapse of Bear 
Stearns in which the SEC's staff did not respond to red flags that the 
Inspector General, exercising 20/20 hindsight, considered to be 
obvious. The Report finds that although the SEC's staff was aware that 
Bear Stearns had a heavy and increasing concentration in mortgage 
securities, it ``did not make any efforts to limit Bear Stearns 
mortgage securities concentration.'' \52\ In its recommendations, the 
Report proposed both that the staff become ``more skeptical of CSE 
firms' risk models'' and that it ``develop additional stress scenarios 
that have not already been contemplated as part of the prudential 
regulation process.'' \53\
---------------------------------------------------------------------------
     \52\ SEC Inspector General Report at ix.
     \53\ SEC Inspector General Report at ix.
---------------------------------------------------------------------------
    Unfortunately, the SEC Inspector General Report does not seem 
realistic on this score. The SEC's staff cannot really hope to regulate 
through gentle persuasion. Unlike a prophylactic rule (such as the 
SEC's traditional net capital rule that placed a uniform ceiling on 
leverage for all broker-dealers), the identification of ``additional 
stress scenarios'' by the SEC's staff does not necessarily lead to 
specific actions by the CSE firms; rather, such attempts at persuasion 
are more likely to produce an extended dialogue, with the SEC's staff 
being confronted with counter-models and interpretations by the 
financial institution's managers.
    The unfortunate truth is that in an area where financial 
institutions have intense interests (such as over the question of their 
maximum permissible leverage), a government agency in the U.S. is 
unlikely to be able to obtain voluntary compliance. This conclusion is 
confirmed by a similar assessment from the individual with perhaps the 
most recent experience in this area. Testifying in September, 2008 
testimony before the Senate Banking Committee, SEC Chairman Christopher 
Cox emphasized the infeasibility of voluntary compliance , expressing 
his frustration with attempts to negotiate issues such as leverage and 
risk management practices with the CSE firms. In a remarkable statement 
for a long-time proponent of deregulation, he testified:

        Beyond highlighting the inadequacy of the . . . CSE program's 
        capital and liquidity requirements, the last six months--during 
        which the SEC and the Federal Reserve worked collaboratively 
        with each of the CSE firms . . . --have made abundantly clear 
        that voluntary regulation doesn't work. \54\
---------------------------------------------------------------------------
     \54\ See Testimony of SEC Chairman Christopher Cox before the 
Committee on Banking, Housing, and Urban Affairs, United States Senate, 
September 23, 2008 (``Testimony Concerning Turmoil in U.S. Credit 
Markets: Recent Actions Regarding Government Sponsored Entities, 
Investment Banks and Other Financial Institutions''), at p. 4 
(available at www.sec.gov) (emphasis added). Chairman Cox has repeated 
this theme in a subsequent Op/Ed column in the Washington Post, in 
which he argued that ``Reform legislation should steer clear of 
voluntary regulation and grant explicit authority where it is needed.'' 
See Christopher Cox, ``Reinventing A Market Watchdog,'' the Washington 
Post, November 4, 2008, at A-17.

    His point was that the SEC had no inherent authority to order a CSE 
firm to reduce its debt to equity ratio or to keep it in the CSE 
Program. \55\ If it objected, a potentially endless regulatory 
negotiation might only begin.
---------------------------------------------------------------------------
     \55\ Chairman Cox added in the next sentence of his Senate 
testimony: ``There is simply no provision in the law authorizes the CSE 
Program, or requires investment bank holding companies to compute 
capital measures or to maintain liquidity on a consolidated basis, or 
to submit to SEC requirements regarding leverage.'' Id. This is true, 
but if a CSE firm left the CSE program, it would presumably become 
subject to European regulation; thus, the system was not entirely 
voluntary and the SEC might have used the threat to expel a non-
compliant CSE firm. The SEC's statements about the degree of control 
they had over participants in the CSE Program appear to have been 
inconsistent over time and possibly defensively self-serving. But 
clearly, the SEC did not achieve voluntary compliance.
---------------------------------------------------------------------------
    Ultimately, even if one absolves the SEC of ``selling out'' to the 
industry in adopting the CSE Program in 2004, it is still clear at a 
minimum that the SEC lacked both the power and the expertise to 
restrict leverage by the major investment banks, at least once the 
regulatory process began with each bank generating its own risk model. 
Motivated by stock market pressure and the incentives of a short-term 
oriented executive compensation system, senior management at these 
institutions affectively converted the process into self-regulation.
    One last factor also drove the rush to increased leverage and may 
best explain the apparent willingness of investment banks to relax 
their due diligence standards: competitive pressure and the need to 
establish a strong market share in a new and expanding market drove the 
investment banks to expand recklessly. For the major players in the 
asset-backed securitization market, the long-term risk was that they 
might be cut off from their source of supply, if loan originators were 
acquired by or entered into long-term relationships with their 
competitors, particularly the commercial banks. Needing an assured 
source of supply, some investment banks (most notably Lehman and 
Merrill, Lynch) invested heavily in acquiring loan originators and 
related real estate companies, thus in effect vertically integrating. 
\56\ In so doing, they assumed even greater risk by increasing their 
concentration in real estate and thus their undiversified exposure to a 
downturn in that market. This need to stay at least even with one's 
competitors best explains the now famous line uttered by Charles 
Prince, the then CEO of Citigroup in July, 2007, just as the debt 
market was beginning to collapse. Asked by the Financial Times if he 
saw a liquidity crisis looming, he answered:
---------------------------------------------------------------------------
     \56\ See Terry Pristin, ``Risky Real Estate Deals Helped Doom 
Lehman,'' N.Y. Times, September 17, 2008, at C-6 (discussing Lehman's 
expensive, multi-billion dollar acquisition of Archstone-Smith); 
Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' N.Y. 
Times, November 9, 2008, at B4-1 (analyzing Merrill Lynch's failure and 
emphasizing its acquisitions of loan originators).

        When the music stops, in terms of liquidity, things will get 
        complicated. But as long as the music is playing, you've got to 
        get up and dance. We're still dancing. \57\
---------------------------------------------------------------------------
     \57\ See Michiyo Nakamoto & David Wighton, ``Citigroup Chief Stays 
Bullish on Buy-Outs,'' Financial Times, July 9, 2007, available at 
http://www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html

    In short, competition among the major investment banks can 
periodically produce a mad momentum that sometimes leads to a lemmings-
like race over the cliff. \58\ This in essence had happened in the 
period just prior to the 2000 dot.com bubble, and again during the 
accounting scandals of 2001-2002, and this process repeated itself 
during the subprime mortgage debacle. Once the market becomes hot, the 
threat of civil liability--either to the SEC or to private plaintiffs 
in securities class actions--seems only weakly to constrain this 
momentum. Rationalizations are always available: ``real estate prices 
never fall;'' ``the credit rating agencies gave this deal a `Triple A' 
rating,'' etc. Explosive growth and a decline in professional standards 
often go hand in hand. Here, after 2000, due diligence standards appear 
to have been relaxed, even as the threat of civil liability in private 
securities litigation was growing. \59\
---------------------------------------------------------------------------
     \58\ Although a commercial bank, Citigroup was no exception this 
race, impelled by the high fee income it involved. From 2003 to 2005, 
``Citigroup more than tripled its issuing of C.D.O.s to more than $30 
billion from $6.28 billion.'' See Eric Dash and Julie Creswell, 
``Citigroup Pays for a Rush to Risk'' New York Times, November 22, 
2008, at 1, 34. In 2005 alone, the New York Times estimates that 
Citigroup received over $500 million in fee income from these C.D.O. 
transactions. From being the sixth largest issuer of C.D.O.s in 2003, 
it rose to being the largest C.D.O. issuer worldwide by 2007, issuing 
in that year some $49.3 billion out of a worldwide total of $442.3 
billion (or slightly over 11 percent of the world volume). Id. at 35.
    What motivated this extreme risk-taking? Certain of the managers 
running Citigroup's securitization business received compensation as 
high as $34 million per year (even though they were not among the most 
senior officers of the bank). Id. at 34. This is consistent with the 
earlier diagnosis that equity compensation inclines management to 
accept higher and arguably excessive risk. At the highest level of 
Citigroup's management, the New York Times reports that the primary 
concern was ``that Citigroup was falling behind rivals like Morgan 
Stanley and Goldman.'' Id. at 34 (discussing Robert Rubin and Charles 
Prince's concerns). Competitive pressure is, of course, enforced by the 
stock market and Wall Street's short-term system of bonus compensation. 
The irony then is that a rational strategy of deleveraging cannot be 
pursued by making boards and managements more sensitive to shareholder 
desires.
     \59\ From 1996 to 1999, the settlements in securities class 
actions totaled only $1.7 billion; thereafter, aggregate settlements 
rose exponentially, hitting a peak of $17.1 billion in 2006 alone. See 
Laura Simmons & Ellen Ryan, ``Securities Class Action Settlements: 
2006, Review and Analysis'' (Cornerstone Research 2006) at 1. This 
decline of due diligence practices as liability correspondingly 
increased seems paradoxical, but may suggest that at least private 
civil liability does not effectively deter issuers or underwriters.
---------------------------------------------------------------------------
    As an explanation for an erosion in professional standards, 
competitive pressure applies with particular force to those investment 
banks that saw asset-back securitizations as the core of their future 
business model. In 2002, a critical milestone was reached, as in that 
year the total amount of debt securities issued in asset-backed 
securitizations equaled (and then exceeded in subsequent years) the 
total amount of debt securities issued by public corporations. \60\ 
Debt securitizations were not only becoming the leading business of 
Wall Street, as a global market of debt purchasers was ready to rely on 
investment grade ratings from the major credit rating agencies, but 
they were particularly important for the independent investment banks 
in the CSE Program.
---------------------------------------------------------------------------
     \60\ For a chart showing the growth of asset-backed securities in 
relation to conventional corporate debt issuances over recent years, 
see J. Coffee, J. Seligman, and H. Sale, SECURITIES REGULATION: Case 
and Materials (10th ed. 2006) at p. 10.
---------------------------------------------------------------------------
    Although all underwriters anticipated high rates of return from 
securitizations, the independent underwriters had gradually been 
squeezed out of their traditional line of business--underwriting 
corporate securities--in the wake of the step-by-step repeal of the 
Glass-Steagall Act. Beginning well before the formal repeal of that Act 
in 1999, the major commercial banks had been permitted to underwrite 
corporate debt securities and had increasingly exploited their larger 
scale and synergistic ability to offer both bank loans and underwriting 
services to gain an increasing share of this underwriting market. 
Especially for the smaller investment banks (e.g., Bear Stearns and 
Lehman), the future lay in new lines of business, where, as nimble and 
adaptive competitors, they could steal a march on the larger and slower 
commercial banks. To a degree, both did, and Merrill eagerly sought to 
follow in their wake. \61\ To stake out a dominant position, the CEOs 
of these firms adopted a ``Damn-the-torpedoes-full-speed-ahead'' 
approach that led them to make extremely risky acquisitions. Their 
common goal was to assure themselves a continuing source of supply of 
subprime mortgages to securitize, but in pursuit of this goal, both 
Merrill Lynch and Lehman made risky acquisitions, in effect vertically 
integrating into the mortgage loan origination field. These decisions, 
plus their willingness to acquire mortgage portfolios well in advance 
of the expected securitization transaction, left them undiversified and 
exposed to large writedowns when the real estate market soured.
---------------------------------------------------------------------------
     \61\ For a detailed description of Merrill, Lynch's late entry 
into the asset-backed securitization field and its sometimes frenzied 
attempt to catch up with Lehman by acquiring originators of mortgage 
loans, see Gretchen Morgenson, ``How the Thundering Herd Faltered and 
Fell,'' New York Times, November 9, 2008, at BU-1. Merrill eventually 
acquired an inventory of $71 billion in risky mortgages, in part 
through acquisitions of loan originators. By mid-2008, an initial 
writedown of $7.9 billion forced the resignation of its CEO. As 
discussed in this New York Times article, loan originators dealing with 
Merrill believed it did not accurately understand the risks of their 
field. For Lehman's similar approach to acquisitions of loan 
originators, see text and note, supra, at note 56.
---------------------------------------------------------------------------
Regulatory Modernization: What Should Be Done?
An Overview of Recent Developments
    Financial regulation in the major capital markets today follows one 
of three basic organizational models:
    The Functional/Institutional Model: In 2008, before the financial 
crisis truly broke, the Treasury Department released a major study of 
financial regulation in the United States. \62\ This document (known as 
the ``Blueprint'') correctly characterized the United States as having 
a ``current system of functional regulation, which maintains separate 
regulatory agencies across segregated functional lines of financial 
services, such as banking, insurance, securities, and futures.'' \63\ 
Unfortunately, even this critical assessment may understate the 
dimensions of this problem of fragmented authority. In fact, the U.S. 
falls considerably short of even a ``functional'' regulatory model. By 
design, ``functional'' regulation seeks to subject similar activities 
to regulation by the same regulator. Its premise is that no one 
regulator can have, or easily develop, expertise in regulating all 
aspects of financial services. Thus, the securities regulator 
understands securities, while the insurance regulator has expertise 
with respect to the very different world of insurance. In the Gramm-
Leach-Bliley Act of 1999 (``GLBA''), which essentially repealed the 
Glass-Steagall Act, Congress endorsed such a system of functional 
regulation. \64\
---------------------------------------------------------------------------
     \62\ The Department of the Treasury, Blueprint for Modernized 
Financial Regulatory Structure (2008) (hereinafter, ``Blueprint'').
     \63\ Id. at 4 and 27.
     \64\ The Conference Report to the Gramm-Leach-Bliley Act clearly 
states this: Both the House and Senate bills generally adhere to the 
principle of functional regulation, which holds that similar activities 
should be regulated by the same regulator. Different regulators have 
expertise at supervising different activities. It is inefficient and 
impractical to expect a regulator to have or develop expertise in 
regulating all aspects of financial services. H.R. Rep. No. 106-434, at 
157 (1999), reprinted in 1999 U.S.C.C.A.N. 1252.
---------------------------------------------------------------------------
    Nonetheless, the reality is that the United States actually has a 
hybrid system of functional and institutional regulation. \65\ The 
latter approach looks not to functional activity, but to institutional 
type. Institutional regulation is seldom the product of deliberate 
design, but rather of historical contingency, piecemeal reform, and 
gradual evolution.
---------------------------------------------------------------------------
     \65\ For this same assessment, see Heidi Mandanis Schooner & 
Michael Taylor, United Kingdom and United States Responses to the 
Regulatory Challenges of Modern Financial Markets, 38 Tex. Int'l L. J. 
317, 328 (2003).
---------------------------------------------------------------------------
    To illustrate this difference between functional and institutional 
regulation, let us hypothesize that, under a truly functional system, 
the securities regulator would have jurisdiction over all sales of 
securities, regardless of the type of institution selling the security. 
Conversely, let us assume that under an institutional system, 
jurisdiction over sales would be allocated according to the type of 
institution doing the selling. Against that backdrop, what do we 
observe today about the allocation of jurisdiction? Revealingly, under 
a key compromise in GLBA, the SEC did not receive general authority to 
oversee or enforce the securities laws with respect to the sale of 
government securities by a bank. \66\ Instead, banking regulators 
retained that authority. Similarly, the drafters of the GLBA carefully 
crafted the definitions of ``broker'' and ``dealer'' in the Securities 
Exchange Act of 1934 to leave significant bank securities activities 
under the oversight of bank regulators and not the SEC. \67\ 
Predictably, even in the relatively brief time since the passage of 
GLBA in 1999, the SEC and bank regulators have engaged in a continuing 
turf war over the scope of the exemptions accorded to banks from the 
definition of ``broker'' and ``dealer.'' \68\
---------------------------------------------------------------------------
     \66\ See 15 U.S.C.  78o-5(a)(1)(B), 15 U.S.C.  78(c)(a)(34)(G), 
and 15 U.S.C.  78o-5(g)(2).
     \67\ See 15 U.S.C.  78(c)(a)(4),(5).
     \68\ See Kathleen Day, Regulators Battle Over Banks: 3 Agencies 
Say SEC Rules Overstep Securities-Trading Law, Wash. Post, July 3, 
2001, at E3. Eventually, the SEC backed down in this particular 
skirmish and modified its original position. See Securities Exch. Act 
Release No. 34-44570 (July 18, 2001) and Securities Exchange Age 
Release No. 34-44291, 66 Fed. Reg. 27760 (2001).
---------------------------------------------------------------------------
    None of this should be surprising. The status quo is hard to 
change, and regulatory bodies do not surrender jurisdiction easily. As 
a result, the regulatory body historically established to regulate 
banks will predictably succeed in retaining much of its authority over 
banks, even when banks are engaged in securities activities that from a 
functional perspective should belong to the securities regulator.
    ``True'' functional regulation would also assign similar activities 
to one regulator, rather than divide them between regulators based on 
only nominal differences in the description of the product or the legal 
status of the institution. Yet, in the case of banking regulation, 
three different federal regulators oversee banks: the Office of the 
Controller of the Currency (``OCC'') supervises national banks; the 
Federal Reserve Board (``FRB'') oversees state-chartered banks that are 
members of the Federal Reserve System and the Federal Deposit Insurance 
Corporation (``FDIC'') supervises state-chartered banks that are not 
members of the Federal Reserve System but are federally insured. \69\ 
Balkanization does not stop there. The line between ``banks,'' with 
their three different regulators at the federal level, and ``thrifts,'' 
which the Office of Thrift Supervision (``OTS'') regulates, is again 
more formalistic than functional and reflects a political compromise 
more than a difference in activities.
---------------------------------------------------------------------------
     \69\ This is all well described in the Blueprint. See Blueprint, 
supra note 62, at 31-41.
---------------------------------------------------------------------------
    Turning to securities regulation, one encounters an even stranger 
anomaly: the United States has one agency (the SEC) to regulate 
securities and another (the Commodities Future Trading Commission 
(CFTC)) to regulate futures. The world of derivatives is thereby 
divided between the two, with the SEC having jurisdiction over options, 
while the CFTC has jurisdiction over most other derivatives. No other 
nation assigns futures and securities regulation to different 
regulators. For a time, the SEC and CFTC both asserted jurisdiction 
over a third category of derivatives--swaps--but in 2000 Congress 
resolved this dispute by placing their regulation largely beyond the 
reach of both agencies. Finally, some major financial sectors (for 
example, insurance and hedge funds) simply have no federal regulator. 
By any standard, the United States thus falls well short of a true 
system of functional regulation, because deregulation has placed much 
financial activity beyond the reach of any federal regulator.
    Sensibly, the Blueprint proposes to rationalize this patchwork-
quilt structure of fragmented authority through the merger and 
consolidation of agencies. Specifically, it proposes both a merger of 
the SEC and CFTC and a merger of the OCC and the OTS. Alas, such 
mergers are rarely politically feasible, and to date, no commentator 
(to our knowledge) has predicted that these proposed mergers will 
actually occur.
    Thus, although the Blueprint proposes that we move beyond 
functional regulation, the reality is that we have not yet approached 
even a system of functional regulation, as our existing financial 
regulatory structure is organized at least as much by institutional 
category as by functional activity. Disdaining a merely ``functional'' 
reorganization under which banking, insurance, and securities would 
each be governed by their own federal regulator, the Blueprint instead 
envisions a far more comprehensive consolidation of all these 
specialized regulators. Why? In its view, the problems with functional 
regulation are considerable:
    A functional approach to regulation exhibits several inadequacies, 
the most significant being the fact that no single regulator possesses 
all the information and authority necessary to monitor systemic risk, 
or the potential that events associated with financial institutions may 
trigger broad dislocation or a series of defaults that affect the 
financial system so significantly that the real economy is adversely 
affected. \70\
---------------------------------------------------------------------------
     \70\ Blueprint, supra note 62, at 4.
---------------------------------------------------------------------------
    But beyond these concerns about systemic risk, the architects of 
the Blueprint were motivated by a deeper anxiety: regulatory reform is 
necessary to maintain the capital market competitiveness of the United 
States. \71\ In short, the Blueprint is designed around two objectives: 
(1) the need to better address systemic risk and the possibility of a 
cascading series of defaults, and (2) the need to enhance capital 
market competitiveness. As discussed later, the first concern is 
legitimate, but the second involves a more dubious logic.
---------------------------------------------------------------------------
     \71\ In particular, the Blueprint hypothesizes that the U.K. has 
enhanced its own competitiveness by regulatory reforms, adopted in 
2000, that are principles-based and rely on self regulation for their 
implementation. Id. at 3.
---------------------------------------------------------------------------
    The Consolidated Financial Services Regulator: A clear trend is 
today evident towards the unification of supervisory responsibilities 
for the regulation of banks, securities markets and insurance. \72\ 
Beginning in Scandinavia in the late 1980s, \73\ this trend has 
recently led the United Kingdom, Japan, Korea, Germany and much of 
Eastern Europe to move to a single regulator model. \74\ Although there 
are now a number of precedents, the U.K. experience stands out as the 
most influential. It was the first major international market center to 
move to a unified regulator model, \75\ and the Financial Services and 
Markets Act, adopted in 2000, went significantly beyond earlier 
precedents towards a ``nearly universal regulator.'' \76\ The Blueprint 
focuses on the U.K.'s experience because it believes that the U.K.'s 
adoption of a consolidated regulatory structure ``enhanced the 
competitiveness of the U.K. economy.'' \77\
---------------------------------------------------------------------------
     \72\ For recent overviews, see Ellis Ferran, Symposium: Do 
Financial Supermarkets Need Super-Regulators? Examining the United 
Kingdom's Experience in Adopting the Single Financial Regulator Model, 
28 Brook. J. Int'l L. 257, 257-59 (2003); Jerry W. Markham, A 
Comparative Analysis of Consolidated and Functional Regulation: Super 
Regulator: A Comparative Analysis of Securities and Derivative 
Regulation in the United States, the United Kingdom, and Japan, 28 
Brook. J. Int'l L. 319, 319-20 (2003); Giorgio Di Giorgio & Carmine D. 
Noia, Financial Market Regulation and Supervision: How Many Peaks for 
the Euro Area?, 28 Brook. J. Int'l L. 463, 469-78 (2003).
     \73\ Norway moved to an integrated regulatory agency in 1986, 
followed by Denmark in 1988, and Sweden in 1991. See D. Giorgio & D. 
Noia, supra note 72, at 469-478.
     \74\ See Bryan D. Stirewalt & Gary A. Gegenheimer, Consolidated 
Supervision of Banking Groups in the Former Soviet Republics: A 
Comparative Examination of the Emerging Trend in Emerging Markets, 23 
Ann. Rev. Banking & Fin. L. 533, 548-49 (2004). As discussed later, in 
some countries (most notably Japan), the change seems more one of form 
than of substance, with little in fact changing. See Markham, supra 
note 72, at 383-393, 396.
     \75\ See Ferran, supra note 72, at 258.
     \76\ See Schooner & Taylor, supra note 65, at 329. Schooner and 
Taylor also observe that the precursors to the U.K.'s centralized 
regulator, which were mainly in Scandinavia, had a ``predominantly 
prudential focus.'' Id. at 331. That is, the unified new regulator was 
more a guardian of ``safety and soundness'' and less oriented toward 
consumer protection.
     \77\ Blueprint, supra note 62 at 3.
---------------------------------------------------------------------------
    Yet it is unclear whether the U.K.'s recent reforms provide a 
legitimate prototype for the Blueprint's proposals. Here, the Blueprint 
may have doctored its history. By most accounts, the U.K.'s adoption of 
a single regulator model was ``driven by country-specific factors,'' 
\78\ including the dismal failure of a prior regulatory system that 
relied heavily on self-regulatory bodies but became a political 
liability because of its inability to cope with a succession of serious 
scandals. Ironically, the financial history of the U.K. in the 1990s 
parallels that of the United States over the last decade. On the 
banking side, the U.K. experienced two major banking failures--the Bank 
of Credit and Commerce International (``BCCI'') in 1991 and Barings in 
1995. Each prompted an official inquiry that found lax supervision was 
at least a partial cause. \79\
---------------------------------------------------------------------------
     \78\ Ferran, supra note 72, at 259.
     \79\ Id. at 261-262.
---------------------------------------------------------------------------
    Securities regulation in the U.K. came under even sharper criticism 
during the 1990s because of a series of financial scandals that were 
generally attributed to an ``excessively fragmented regulatory 
infrastructure.'' \80\ Under the then applicable law (the Financial 
Services Act of 1986), most regulatory powers were delegated to the 
Securities and Investments Board (SIB), which was a private body 
financed through a levy on market participants. However, the SIB did 
not itself directly regulate. Rather, it ``set the overall framework of 
regulation,'' but delegated actual authority to second tier regulators, 
which consisted primarily of self-regulatory organizations (SROs). \81\ 
Persistent criticism focused on the inability or unwillingness of these 
SROs to protect consumers from fraud and misconduct. \82\ Ultimately, 
the then chairman of the SIB, the most important of the SROs, 
acknowledged that self-regulation had failed in the U.K. and seemed 
unable to restore investor confidence. \83\ This acknowledgement set 
the stage for reform, and when a new Labour Government came into power 
at the end of the decade, one of its first major legislative acts (as 
it had promised in its election campaign) was to dismantle the former 
structure of SROs and replace it with a new and more powerful body, the 
Financial Services Authority (FSA).
---------------------------------------------------------------------------
     \80\ Id. at 265.
     \81\ Id. at 266. The most important of these were the Securities 
and Futures Authority (SFA), the Investment Managers' Regulatory 
Organization (IMRO), and the Personal Investment Authority (PIA).
     \82\ Two scandals in particular stood out: the Robert Maxwell 
affair in which a prominent financier effectively embezzled the pension 
funds of his companies and a ``pension mis-selling'' controversy in 
which highly risky financial products were inappropriately sold to 
pension funds without adequate supervision or disclosure. Id. at 267-
268.
     \83\ Id. at 268.
---------------------------------------------------------------------------
    Despite the Blueprint's enthusiasm for the U.K.'s model, the 
structure that the Blueprint proposes for the U.S. more closely 
resembles the former U.K. system than the current one. Under the 
Blueprint's proposals, the securities regulator would be restricted to 
adopting general ``principles-based'' policies, which would be 
implemented and enforced by SROs. \84\ Ironically, the Blueprint relies 
on the U.K. experience to endorse essentially the model that the U.K. 
concluded had failed.
---------------------------------------------------------------------------
     \84\ See infra notes--and accompanying text.
---------------------------------------------------------------------------
    The ``Twin Peaks'' Model: As the Blueprint recognizes, not all 
recent reforms have followed the U.K. model of a universal regulator. 
Some nations--most notably Australia and the Netherlands--instead have 
followed a ``twin peaks'' model that places responsibility for the 
``prudential regulation of relevant financial institutions'' in one 
agency and supervision of ``business conduct and consumer protection'' 
in another. \85\ The term ``twin peaks'' derives from the work of 
Michael Taylor, a British academic and former Bank of England official. 
In 1995, just before regulatory reform became a hot political issue in 
the U.K., he argued that financial regulation had two separate basic 
aims (or ``twin peaks''): (1) ``to ensure the soundness of the 
financial system,'' and (2) ``to protect consumers from unscrupulous 
operators.'' \86\ Taylor's work was original less in its proposal to 
separate ``prudential'' regulation from ``business conduct'' regulation 
than in its insistence upon the need to consolidate ``responsibility 
for the financial soundness of all major financial institutions in a 
single agency.'' \87\ Taylor apparently feared that if the Bank of 
England remained responsible for the prudential supervision of banks, 
its independence in setting interest rates might be compromised by its 
fear that raising interest rates would cause bank failures for which it 
would be blamed. In part for this reason, the eventual legislation 
shifted responsibility for bank supervision from the Bank of England to 
the FSA.
---------------------------------------------------------------------------
     \85\ Blueprint, supra note 62, at 3. For a recent discussion of 
the Australian reorganization, which began in 1996 (and thus preceded 
the U.K.), see Schooner & Taylor, supra note65, at 340-341. The 
Australian Securities and Investments Commission (ASIC) is the 
``consumer protection'' agency under this ``twin peaks'' approach, and 
the Australian Prudential Regulatory Authority (APRA) supervises bank 
``safety and soundness.'' Still, the ``twin peaks'' model was not fully 
accepted in Australia as ASIC, the securities regulator, does retain 
supervisory jurisdiction over the ``financial soundness'' of investment 
banks. Thus, some element of functional regulation remains.
     \86\ Michael Taylor, Twin Peaks: A Regulatory Structure for the 
New Century i (Centre for the Study of Financial Institutions 1995). 
For a brief review of Taylor's work, see Cynthia Crawford Lichtenstein, 
The Fed's New Model of Supervision for ``Large Complex Banking 
Organizations'': Coordinated Risk-Based Supervision of Financial 
Multinationals for International Financial Stability, 18 Transnat'l 
Law. 283, 295-296 (2005).
     \87\ Lichtenstein, supra note 86, at 295; Taylor, supra note 86, 
at 4.
---------------------------------------------------------------------------
    The Blueprint, itself, preferred a ``twin peaks'' model, and that 
model is far more compatible with the U.S.'s current institutional 
structure for financial regulation. But beyond these obvious points, 
the best argument for a ``twin peaks'' model involves conflict of 
interests and the differing culture of banks and securities regulators. 
It approaches the self-evident to note that a conflict exists between 
the consumer protection role of a universal regulator and its role as a 
``prudential'' regulator intent on protecting the safety and soundness 
of the financial institution. The goal of consumer protection is most 
obviously advanced through deterrence and financial sanctions, but 
these can deplete assets and ultimately threaten bank solvency. When 
only modest financial penalties are used, this conflict may sound more 
theoretical than real. But, the U.S. is distinctive in the severity of 
the penalties it imposes on financial institutions. In recent years, 
the SEC has imposed restitution and penalties exceeding $3 billion 
annually, and private plaintiffs received a record $17 billion in 
securities class action settlements in 2006. \88\ Over a recent ten 
year period, some 2,400 securities class actions were filed and 
resulted in settlements of over $27 billion, with much of this cost (as 
in the Enron and WorldCom cases) being borne by investment banks. \89\ 
If one agency were seeking both to protect consumers and guard the 
solvency of major financial institutions, it would face a difficult 
balancing act to achieve deterrence without threatening bank solvency, 
and it would risk a skeptical public concluding that it had been 
``captured'' by its regulated firms.
---------------------------------------------------------------------------
     \88\ See Coffee, Law and the Market: The Impact of Enforcement, 
156 U. of Pa. L. Rev. 299 (2007) (discussing average annual SEC 
penalties and class action settlements).
     \89\ See Richard Booth, The End of the Securities Fraud Class 
Action as We Know It, 4 Berkeley Bus. L. J. 1, at 3 (2007).
---------------------------------------------------------------------------
    Even in jurisdictions adopting the universal regulator model, the 
need to contemporaneously strengthen enforcement has been part of the 
reform package. Although the 2000 legislation in the U.K. did not adopt 
the ``twin peaks'' format, it did significantly strengthen the consumer 
protection role of its centralized regulator. The U.K.'s Financial 
Services and Markets Act, enacted in 2000, sets out four statutory 
objectives, with the final objective being the ``reduction of financial 
crime.'' \90\ According to Heidi Schooner and Michael Taylor, this 
represented ``a major extension of the FSA's powers compared to the 
agencies it replaced,'' \91\ and it reflected a political response to 
the experience of weak enforcement by self-regulatory bodies, which had 
led to the creation of the FSA. \92\ With probably unintended irony, 
Schooner and Taylor described this new statutory objective of reducing 
``financial crime'' as the ``one aspect of U.K. regulatory reform in 
which its proponents seem to have drawn direct inspiration from U.S. 
law and practice.'' \93\ Conspicuously, the Blueprint ignores that 
``modernizing'' financial regulation in other countries has generally 
meant strengthening enforcement.
---------------------------------------------------------------------------
     \90\ See Financial Services and Markets Act, 2000, c. 8, pt. 1, 6, 
http://www.opsi.gov.uk/ACTS/acts2000/pdf/ukpga_20000008_en.pdf
     \91\ See Schooner & Taylor, supra note 65, at 335.
     \92\ Id.
     \93\ Id. at 335-36.
---------------------------------------------------------------------------
    A Preliminary Evaluation: Three preliminary conclusions merit 
emphasis:
    First, whether the existing financial regulatory structure in the 
United States is considered ``institutional'' or ``functional'' in 
design, its leading deficiency seems evident: it invites regulatory 
arbitrage. Financial institutions position themselves to fall within 
the jurisdiction of the most accommodating regulator, and investment 
banks design new financial products so as to encounter the least 
regulatory oversight. Such arbitrage can be defended as desirable if 
one believes that regulators inherently overregulate, but not if one 
believes increased systemic risk is a valid concern (as the Blueprint 
appears to believe).
    Second, the Blueprint's history of recent regulatory reform 
involves an element of historical fiction. The 2000 legislation in the 
U.K., which created the FSA as a nearly universal regulator, was not an 
attempt to introduce self-regulation by SROs, as the Blueprint seems to 
assume, but a sharp reaction by a Labour Government to the failures of 
self-regulation. Similarly, Japan's slow, back-and-forth movement in 
the direction of a single regulator seems to have been motivated by an 
unending series of scandals and a desire to give its regulator at least 
the appearance of being less industry dominated. \94\
---------------------------------------------------------------------------
     \94\ Japan has a history and a regulatory culture of economic 
management of its financial institutions through regulatory bodies that 
is entirely distinct from that of Europe or the United States. Although 
it has recently created a Financial Services Agency, observers contend 
that it remains committed to its traditional system of bureaucratic 
regulation that supports its large banks and discourages foreign 
competition. See Markham, supra note 72, at 383-92, 396. Nonetheless, 
scandals have been the primary force driving institutional change there 
too, and Japan's FSA was created at least in part because Japan's 
Ministry of Finance (MOF) had become embarrassed by recurrent scandals.
---------------------------------------------------------------------------
    Third, the debate between the ``universal'' regulator and the 
``twin peaks'' alternative should not obscure the fact that both are 
``superregulators'' that have moved beyond ``functional'' regulation on 
the premise that, as the lines between banks, securities dealers, and 
insurers blur, so regulators should similarly converge. That idea will 
and should remain at the heart of the U.S. debate, even after many of 
the Blueprint's proposals are forgotten.
Defining the Roles of the ``Twin Peaks'' (Systemic Risk Regulator and 
        Consumer Protector)--Who Should Do What?
    The foregoing discussion has suggested why the SEC would not be an 
effective risk regulator. It has neither the specialized competence nor 
the organizational culture for the role. Its comparative advantage is 
enforcement, and thus its focus should be on transparency and consumer 
protection. Some also argue that ``single purpose'' agencies, such as 
the SEC, are more subject to regulatory capture than are broader or 
``general purpose'' agencies. \95\ To the extent that the Federal 
Reserve would have responsibility for all large financial institutions 
and would be expected to treat monitoring their capital adequacy and 
risk management practices as among its primary responsibilities, it 
does seem less subject to capture, because any failure would have high 
visibility and it would bear the blame. Still, this issue is largely 
academic because the SEC no longer has responsibility over any 
investment banks of substantial size.
---------------------------------------------------------------------------
     \95\ See Jonathan Macey, Organizational Design and Political 
Control of Administrative Agencies, 8 J. Law, Economics, and 
Organization 93 (1992). It can, of course, be argued which agency is 
more ``single purpose'' (the SEC or the Federal Reserve), but the 
latter does deal with a broader class of institutions in terms of their 
capital adequacy.
---------------------------------------------------------------------------
    The real issue then is defining the relationships between the two 
peaks so that neither overwhelms the other.
    The Systemic Risk Regulator (SRR): Systemic risk is most easily 
defined as the risk of an inter-connected financial breakdown in the 
financial system--much like the proverbial chain of falling dominoes. 
The closely linked insolvencies of Lehman, AIG, Fannie Mae and Freddie 
Mac in the Fall of 2008 present a paradigm case. Were they not bailed 
out, other financial institutions were likely to have also failed. The 
key idea here is not that one financial institution is too big to fail, 
but rather that some institutions are too interconnected to permit any 
of them to fail, because they will drag the others down.
    What should a system risk regulator be authorized to do? Among the 
obvious powers that it should have are the following:
    a. Authority To Limit the Leverage of Financial Institutions and 
Prescribe Mandatory Capital Adequacy Standards. This authority would 
empower the SRR to prescribe minimum levels of capital and ceilings on 
leverage for all categories of financial institutions, including banks, 
insurance companies, hedge funds, money market funds, pension plans, 
and quasi-financial institutions (such as, for example, G.E. Capital). 
The standards would not need to be identical for all institutions and 
should be risk adjusted. The SRS should be authorized to require 
reductions in debt to equity ratios below existing levels, to consider 
off-balance sheet liabilities (including those of partially owned 
subsidiaries and also contractual agreements to repurchase or 
guarantee) in computing these tests and ratios (even if generally 
accepted accounting principles would not require their inclusion).
    The SRR would focus its monitoring on the largest institutions in 
each financial class, leaving small institutions to be regulated and 
monitored by their primary regulator. For example, the SEC might 
require all hedge funds to register with it under the Investment 
Advisers Act of 1940, but hedge funds with a defined level of assets 
(say, $25 billion in assets) would be subject to the additional and 
overriding authority of the SSR.
    b. Authority To Approve, Restrict and Regulate Trading in New 
Financial Products. By now, it has escaped no one's attention that one 
particular class of over-the-counter derivative (the credit default 
swap) grew exponentially over the last decade and was outside the 
jurisdiction of any regulatory agency. This was not accidental, as the 
Commodities Futures Modernization Act of 2000 deliberately placed over-
the-counter derivatives beyond the general jurisdiction of both the SEC 
and the CFTC. The SRR would be responsible for monitoring the growth of 
new financial products and would be authorized to regulate such 
practices as the collateral or margin that counter-parties were 
required to post. Arguably, the SRR should be authorized to limit those 
eligible to trade such instruments and could bar or restrict the 
purchase of ``naked'' credit default swaps (although the possession of 
this authority would not mean that the SRR would have to exercise it, 
unless it saw an emergency developing).
    c. Authority To Mandate Clearing Houses. Securities and options 
exchanges uniformly employ clearing houses to eliminate or mitigate 
credit risk. In contrast, when an investor trades in an over-the-
counter derivative, it must accept both market risk (the risk that the 
investment will sour or price levels will change adversely) and credit 
risk (the risk that the counterparty will be unable to perform). Credit 
risk is the factor that necessitated the bailout of AIG, as its failure 
could have potentially led to a cascade of failures by other financial 
institutions if it defaulted on its swaps. Use of the clearing house 
should eliminate the need to bail out a future AIG because its 
responsibilities would fall on the clearing house to assume and the 
clearing house would monitor and limit the risk that its members 
assumed.
    At present, several clearinghouses are in the process of 
development in the United States and Europe. The SRR would be the 
obvious body to oversee such clearing houses (and indeed the Federal 
Reserve was already instrumental in their formation). Otherwise, some 
clearing houses are likely to be formed under the SEC's supervision and 
some under the CFTC's, thus again permitting regulatory arbitrage to 
develop.
    A final and complex question is whether competing clearing houses 
are desirable or whether they should be combined into a single 
centralized clearing house. This issue could also be given to the SRR.
    d. Authority To Mandate Writedowns for Risky Assets. A real estate 
bubble was the starting point for the 2008 crisis. When any class of 
assets appreciates meteorically, the danger arises that on the eventual 
collapse in that overvalued market, the equity of the financial 
institution will be wiped out (or at the least so eroded as to create a 
crisis in investor confidence that denies that institution necessary 
financing). This tendency was palpably evident in the failure of Bear 
Stearns, Lehman, Fannie Mae and Freddie Mac. If the SRR regulator 
relies only on debt/equity ratios to protect capital adequacy, they 
will do little good and possibly provide only illusory protections. Any 
financial institution that is forced to writedown its investment in 
overpriced mortgage and real estate assets by 50 percent will 
necessarily breach mandated debt to equity ratios. The best answer to 
this problem is to authorize the SRR to take a proactive and 
countercyclical stance by requiring writedowns in risky asset classes 
(at least for regulatory purposes) prior to the typically much later 
point at which accountants will require such a writedown.
    Candidly, it is an open question whether the SRS, the Federal 
Reserve, or any banking regulator would have the courage and political 
will to order such a writedown (or impose similar restraints on further 
acquisitions of such assets) while the bubble was still expanding. But 
Congress should at least arm its regulators with sufficient power and 
direct them to use it with vigor.
    e. Authority To Intervene To Prevent and Avert Liquidity Crises. 
Financial institutions often face a mismatch between their assets and 
liabilities. They may invest in illiquid assets or make long-term 
loans, but their liabilities consist of short-term debt (such as 
commercial paper). Thus, regulating leverage ratios is not alone 
adequate to avoid a financial crisis, because the institution may 
suddenly experience a ``run'' (as its depositors flee) or be unable to 
roll over its commercial paper or other short-term debt. This problem 
is not unique to banks and can be encountered by hedge funds and 
private equity funds (as the Long Term Capital Management crisis 
showed). The SRR thus needs the authority to monitor liquidity problems 
at large financial institutions and direct institutions in specific 
cases to address such imbalances (either by selling assets, raising 
capital, or not relying on short-term debt).
    From the foregoing description, it should be obvious that the only 
existing agency in a position to take on this assignment and act as an 
SRR is the Federal Reserve Board. But it is less politically 
accountable than most other federal agencies, and this could give rise 
to some problems discussed below.
    The Consumer Protection and Transparency Agency: The creation of an 
SSR would change little at the major Federal agencies having 
responsibilities for investor protection. Although it might be 
desirable to merge the SEC and the CFTC, this is not essential. Because 
no momentum has yet developed for such a merger, I will not discuss it 
further at this time.
    Currently, there are over 5,000 broker-dealers registered with the 
SEC. They would remain so registered, and the SRR would concern itself 
only with those few whose potential insolvency could destabilize the 
markets. The focus of the SEC's surveillance of broker-dealers is on 
consumer protection and market efficiency, and this would not be within 
the expertise of the Federal Reserve or any other potential SRR.
    The SEC is also an experienced enforcement agency, while the 
Federal Reserve has little, if any, experience in this area. Further, 
the SEC understands disclosure issues and is a champion of 
transparency, whereas banking regulators start from the unstated 
premise that disclosures of risks or problems at a financial 
institution is undesirable because it might provoke a ``run'' on the 
bank. The SEC and the Controller of the Currency have long disagreed 
about what banks should disclose in the Management Discussion and 
Analysis that banks file with the SEC. Necessarily, this tension will 
continue.
    Resolving the Conflicts: The SEC and the PCAOB have continued to 
favor ``mark to market'' accounting, while major banks have sought 
relief from the write-downs that it necessitates. Suppose then that in 
the future a SRR decided that ``mark to market'' accounting increased 
systemic risk. Could it determine that financial institutions should be 
spared from such an accounting regime on the ground that it was pro-
cyclical? This is an issue that Congress should address in any 
legislation authorizing a SRR or enhancing the powers of the Federal 
Reserve. I would recommend that Congress maintain authority in the SEC 
to determine appropriate accounting policies, because, put simply, 
transparency has been the core value underlying our system of 
securities regulation.
    But there are other areas where a SRR might well be entitled to 
overrule the SEC. Take, for example, the problem of short selling the 
stocks of financial institutions during a period of market stress. 
Although the SEC did ban short selling in financial stocks briefly in 
2008, one can still imagine an occasion on which the SRR and the SEC 
might disagree. Here, transparency would not be an issue. Short selling 
is pro-cyclical, and a SRR could determine that it had the potential to 
destabilize and increase systemic risk. If it did so, its judgment 
should control.
    These examples are given only by way of illustration, and the 
inevitability of conflicts between the two agencies is not assumed. The 
President's Working Group on Financial Markets has generally been able 
to work out disagreements through consultation and negotiation. Still, 
in any legislation, it would be desirable to identify those core 
policies (such as transparency and full disclosure) that the SRR could 
not override.
    The Failure of Quantitative Models: If one lesson should have been 
learned from the 2008 crisis, it is that quantitative models, based on 
historical data, eventually and inevitably fail. Rates of defaults on 
mortgages can change (and swiftly), and housing markets do not 
invariably rise. In the popular vernacular, ``black swans'' both can 
occur and even become predominant. This does not mean that quantitative 
models should not be used, but that they need to be subjected to 
qualitative and judgmental overrides.
    The weakness in quantitative models is particularly shown by the 
extraordinary disparity between the value at risk estimates (VaRs) 
reported by underwriters to the SEC and their eventual writedowns for 
mortgage-backed securities. Ferrell, Bethel and Hu report that for a 
selected group of major financial institutions the average ratio of 
asset writedowns as of August 20, 2008, to VaRs reported for 2006 was 
291 to 1. \96\ If financial institutions cannot accurately estimate 
their exposure for derivatives and risky assets, this undermines many 
of the critical assumptions underlying the Basel II Accords, and 
suggests that regulators cannot defer to the institutions' own risk 
models. Instead, they must reach their own judgments, and Congress 
should so instruct them.
---------------------------------------------------------------------------
     \96\ See Farrell, Bethel, and Hu, supra note 15, at 47.
---------------------------------------------------------------------------
The Lessons of Madoff: Implications for the SEC, FINRA, and SIPC
    No time need be wasted pointing out that the SEC missed red flags 
and overlooked credible evidence in the Madoff scandal. Unfortunately, 
most Ponzi schemes do not get detected until it is too late. This 
implies that an ounce of prevention may be worth several pounds of 
penalties. More must be done to discourage and deter such schemes ex 
ante, and the focus cannot be only on catching them ex post.
    From this perspective focused on prevention, rather than detection, 
the most obvious lesson is that the SEC's recent strong tilt towards 
deregulation contributed to, and enabled, the Madoff fraud in two 
important respects. First, Bernard L. Madoff Investment Securities LLC 
(BMIS) was audited by a fly-by-night auditing firm with only one active 
accountant who had neither registered with the Public Company 
Accounting Oversight Board (``PCAOB'') nor even participated in New 
York State's peer review program for auditors. Yet, the Sarbanes-Oxley 
Act required broker-dealers to use a PCAOB-registered auditor. \97\ 
Nonetheless, until the Madoff scandal exploded, the SEC repeatedly 
exempted privately held broker-dealers from the obligation to use such 
a PCAOB-registered auditor and permitted any accountant to suffice. 
\98\ Others also exploited this exemption. For example, in the Bayou 
Hedge Fund fraud, which was the last major Ponzi scheme before Madoff, 
the promoters simply invented a fictitious auditing firm and forged 
certifications in its name. Had auditors been required to have been 
registered with PCAOB, this would not have been feasible because 
careful investors would have been able to detect that the fictitious 
firm was not registered.
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     \97\ See Section 17(e)(1) of the Securities Exchange Act of 1934, 
15 U.S.C.  78(q)(e)(1).
     \98\ See, e.g., Securities Exch. Act Rel. No. 34-54920 (Dec. 12, 
2006).
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    Presumably, the SEC's rationale for this overbroad exemption was 
that privately held broker-dealers did not have public shareholders who 
needed protection. True, but they did have customers who have now been 
repeatedly victimized. At the end of 2008, the SEC quietly closed the 
barn door by failing to renew this exemption--but only after $50 
billion worth of horses had been stolen.
    A second and even more culpable SEC mistake continues to date. 
Under the Investment Advisers Act, investment advisers are required to 
maintain client funds or securities with a ``qualified custodian.'' 
\99\ In principle, this requirement should protect investors from Ponzi 
schemes, because an independent custodian would not permit the 
investment adviser to have access to the investors' funds. Indeed, for 
exactly this reason, mutual funds appear not to have experienced Ponzi-
style frauds, which have occurred only in the case of hedge funds and 
investment advisers. Under Section 17(f) of the Investment Company Act, 
mutual funds must use a separate custodian. But in the case of 
investment advisors, the SEC permits the investment adviser to use an 
affiliated broker-dealer or bank as its qualified custodian. Thus, 
Madoff could and did use BMIS, his broker dealer firm, to serve as 
custodian for his investment adviser activities. The net result is that 
only a very tame watchdog monitors the investment adviser. Had an 
independent and honest custodian held the investors' funds, Madoff 
could not have recycled new investors' contributions to earlier 
investors, and the custodian would have noticed that Madoff was not 
actually trading. Other recent Ponzi schemes seem to have similarly 
sidestepped the need for an independent custodian. At Senate Banking 
Committee hearings on the Madoff debacle this January, the director of 
the SEC's Office of Compliance, Inspection and Examinations estimated 
that, out of the 11,300 investment advisers currently registered with 
the SEC, some 1,000 to 1,500 might similarly use an affiliated broker-
dealer as their custodian. For investors, the SEC's tolerance for self-
custodians makes the ``qualified custodian'' rule an illusory 
protection.
---------------------------------------------------------------------------
     \99\ See Rule 206(4)-2 (``Custody of Funds or Securities of 
Clients By Investment Advisers''), 17 CFR  275.206(4)-2.
---------------------------------------------------------------------------
    At present, the Madoff scandal has so shaken investor confidence in 
investment advisors that even the industry trade group for investment 
advisers (the Investment Advisers Association) has urged the SEC to 
adopt a rule requiring investment advisers to use an independent 
custodian. Unfortunately, one cannot therefore assume that the SEC will 
quickly produce such a rule. The SEC's staff knows that smaller 
investment advisers will oppose any rule that requires them to incur 
additional costs. Even if a reform rule is proposed, the staff may 
still overwhelm such a rule with exceptions (such as by permitting an 
independent custodian to use sub-custodians who are affiliated with the 
investment adviser). Congress should therefore direct it to require an 
independent custodian, across the board for mutual funds, hedge funds, 
and investment advisers.
    The Madoff scandal exposes shortcomings not only at the SEC but 
elsewhere in related agencies. Over the last 5 years, the number of 
investment advisers has grown from roughly 7,500 to 11,300--more than 
one third. Given this growth, it is becoming increasingly anomalous 
that there is no self-regulatory body (SRO) for investment advisers. 
Although FINRA may have overstated in its claim that it had no 
authority to investigate Madoff's investment adviser operations 
(because it could and should have examined BMIS's performance as the 
``qualified custodian'' for Madoff's investment advisory activities), 
it still lacks authority to examine investment advisers. Some SRO 
(either FINRA or a new body) should have direct authority to oversee 
the investment adviser activities of an integrated broker-dealer firm.
    Similarly, the Securities Investor Protection Corporation (SIPC) 
continues to charge all broker-dealer firms the same nominal fee for 
insurance without any risk-adjustment. Were it to behave like a private 
insurer and charge more to riskier firms for insurance, these firms 
would have a greater incentive to adopt better internal controls 
against fraud. A broker-dealer that acted as a self-custodian for a 
related investment adviser would, for example, pay a higher insurance 
commission. Also, if higher fees were charged, more insurance (which is 
currently capped at $500,000 per account) could be provided to 
investors. When all broker-dealers are charged the same insurance 
premium, this subsidizes the riskier firms--i.e., the future Madoffs of 
the industry.
    Finally, one of the most perplexing problems in the Madoff story is 
why, when the SEC finally forced Madoff to register as an investment 
adviser in 2006, it did not conduct an early examination of BMIS's 
books and records. Red flags were flying, as Madoff (1) used an unknown 
accountant, (2) served as his own self-custodian, (3) had apparently 
billions of dollars in customer accounts, (4) had long resisted 
registration, and (5) was the subject of plausible allegations of fraud 
from credible whistle-blowers. Cost constrained as the SEC may have 
been, the only conclusion that can be reached here is that the SEC has 
poor criteria for evaluating the relative risk of investment advisers. 
At a minimum, Congress should require a report by the SEC as to the 
criteria used to determine the priority of examinations and how the SEC 
proposes to change those criteria in light of the Madoff scandal.
    Some have proposed eliminating the SEC's Office of Compliance, 
Inspection and Examinations and combining its activities with the 
Division of Investment Management. I do not see this as a panacea. 
Rather, it simply reshuffles the cards. The real problem is the 
criteria used to determine who should be examined. Credible allegations 
of fraud need to be directed to the compliance inspectors.
Asset-Backed Securitizations: What Failed?
    Asset-backed securitizations represent a financial technology that 
failed. As outlined earlier, this failure seems principally 
attributable to a ``moral hazard'' problem that arose under which both 
loan originators and underwriters relaxed their lending standards and 
packaged non-creditworthy loans into portfolios, because both found 
that they could sell these portfolios at a high profit and on a global 
basis--at least so long as the debt securities carried an investment 
grade credit rating from an NRSRO credit rating agency.
    Broad deregulatory rules contributed to this problem, and the two 
most important such SEC rules are Rules 3a-7 under the Investment 
Company Act \100\ and Regulation AB. \101\ Asset-backed securities 
(including CDOs) are typically issued by a special purpose vehicle 
(SPV) controlled by the promoter (which often may be an investment or 
commercial bank). This SPV would under ordinary circumstances be deemed 
an ``investment company'' and thus subjected to the demanding 
requirements of the Investment Company Act--but for Rule 3a-7. That 
rule exempts fixed-income securities issued by an SPV if, at the time 
of sale, the securities are rated in one of the four highest categories 
of investment quality by a ``nationally recognized statistical rating 
organization'' (NRSRO). In essence, the SEC has delegated to the NRSROs 
(essentially, at the time at least, Moody's, S&P and Fitch) the ability 
exempt SPVs from the Investment Company Act. Similarly, Regulation AB 
governs the disclosure requirements for ``asset-backed securities'' (as 
such term is defined in Section 1101(c) of Regulation AB) in public 
offerings. Some have criticized Regulation AB for being more permissive 
than the federal housing agencies with respect to the need to document 
and verify the loans in a portfolio. \102\ Because Regulation AB 
requires that the issuer not be an investment company (see Item 
101(c)(2)(i) of Regulation AB), its availability (and thus expedited 
registration) also depends on an NRSRO investment grade rating.
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     \100\ 17 CFR  270.3a-7 (``Issuers of Asset-Backed Securities''). 
This exemption dates back to 1992.
     \101\ 17 CFR  229.1100 et seq. (``Asset-Backed Securities''). 
Regulation AB was adopted in 2005, but reflects an earlier pattern of 
exemptions in no-action letters.
     \102\ See Mendales, supra note 18.
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    No suggestion is here intended that SPVs should be classified as 
``investment companies,'' but the need for the exemption given by Rule 
3a-7 shows that the SEC has considerable leverage and could condition 
this exemption on alternative or additional factors beyond an NRSRO 
investment grade rating. The key point is that exemptions like Rule 3a-
7 give the SEC a tool that they could use even without Congressional 
legislation--if the SEC was willing to take action.
    What actions should be taken to respond to the deficiencies in 
asset-backed securitizations? I would suggest two basic steps: (1) 
curtail the ``originate-and-distribute'' model of lending that gave 
rise to the moral hazard problem, and (2) re-introduce due diligence 
into the securities offering process (both for public and Rule 144A 
offerings).
    Restricting the ``Originate-and-Distribute'' Model of Lending. In a 
bubble, everyone expects that they can pass the assets on to the next 
buyer in the chain--``before the music stops.'' Thus, all tend to 
economize on due diligence and ignore signs that the assets are not 
creditworthy. This is because none expect to bear the costs of holding 
the financial assets to maturity.
    Things were not always this way. When asset-backed securitizations 
began, the promoter usually issued various tranches of debt to finance 
its purchase of the mortgage assets, and these tranches differed in 
terms of seniority and maturity. The promoter would sell the senior 
most tranche in public offerings to risk averse public investors and 
retain some or all of the subordinated tranche, itself, as a signal of 
its confidence in the creditworthiness of the underlying assets. Over 
time, this practice of retaining the subordinated tranche withered 
away. In part, this was because hedge funds would take the risk of 
buying this riskier debt; in part, it was because the subordinated 
tranche could be included in more complex CDOs (where 
overcollateralization was the investor's principal protection), and 
finally it was because in a bubbly market, investors no longer looked 
for commitments or signals from the promoter.
    Given this definition of the problem, the answer seems obvious: 
require the promoter to retain some portion of the subordinated 
tranche. This would incentivize it to buy only creditworthy financial 
assets and end the ``moral hazard'' problem.
    To make this proposal truly effective, however, more must be done. 
The promoter would have to be denied the ability to hedge the risk on 
the subordinated tranche that it retained. Otherwise it might hedge 
that risk by buying a credit default swap on its own offering through 
an intermediary. But this is feasible. Even in the absence of 
legislation, the SEC could revise Rule 3a-7 to require, as a price of 
its exemption, that the promoter (either through the SPV or an 
affiliate) retain a specified percentage of the bottom, subordinated 
tranche (or, if there were no subordinated tranche, of the offering as 
a whole). Still, the cleaner, simpler way would be a direct legislative 
requirement of a minimum retention.
    2. Mandating Due Diligence. One of the less noticed but more 
important developments associated with asset-backed securitization is 
the rapid decline in due diligence after 2000. Once investment banks 
did considerable due diligence on asset-backed securitizations, but 
they outsourced the work to specialized ``due diligence'' firms. These 
firms (of which Clayton Holdings, Inc. was the best known) would send 
squads of ten to fifteen loan reviewers to sample the loans in a 
securitized portfolio, checking credit scores and documentation. But 
the intensity of this due diligence review declined over recent years. 
The Los Angeles Times quotes the CEO of Clayton Holdings to the effect 
that:

        Early in the decade, a securities firm might have asked Clayton 
        to review 25 percent to 40 percent of the sub-prime loans in a 
        pool, compared with typically 10 percent in 2006 \103\

     \103\ See E. Scott Reckard, ``Sub-Prime mortgage watchdogs kept on 
leash; loan checkers say their warnings of risk were met with 
indifference,'' Los Angeles Times, March 17, 2008, at C-1.
---------------------------------------------------------------------------
    The President of a leading rival due diligence firm, the Bohan 
Group, made an even more revealing comparison:

        By contrast, loan buyers who kept the mortgages as an 
        investment instead of packaging them into securities would have 
        50 percent to 100 percent of the loans examined, Bohan 
        President Mark Hughes said. \104\
---------------------------------------------------------------------------
     \104\ Id.

    In short, lenders who retained the loans checked the borrowers 
carefully, but the investment banks decreased their investment in due 
diligence, making only a cursory effort by 2006. Again, this seems the 
natural consequence of an originate-and-distribute model.
    The actual loan reviewers employed by these firms also told the 
above-quoted Los Angeles Times reporter that supervisors in these firms 
would often change documentation in order to avoid ``red-flagging 
mortgages.'' These employees also report regularly encountering 
inflated documentation and ``liar's loans,'' but, even when they 
rejected loans, ``loan buyers often bought the rejected mortgages 
anyway.'' \105\
---------------------------------------------------------------------------
     \105\ Id.
---------------------------------------------------------------------------
    In short, even when the watchdog barked, no one at the investment 
banks truly listened. Over the last several years, due diligence 
practices long followed in the industry seemed to have been relaxed, 
ignored, or treated as a largely optional formality. That was also the 
conclusion of the President's Working Group on Financial Markets, which 
in early 2008 identified ``a significant erosion of market discipline 
by those involved in the securitization process, including originators, 
underwriters, credit rating agencies, and global investors.'' \106\
---------------------------------------------------------------------------
     \106\ See President's Working Group on Financial Markets, Policy 
Statement on Financial Market Developments at 1 (March, 2008). 
(emphasis added). This report expressly notes that underwriters had the 
incentive to perform due diligence, but did not do so adequately.
---------------------------------------------------------------------------
    Still, in the case of the investments bank, this erosion in due 
diligence may seem surprising. At least over the long-term, it seems 
contrary to their own self-interest. Four factors may explain their 
indifference: (1) an industry-wide decline in due diligence as the 
result of deregulatory reforms that have induced many underwriters to 
treat legal liability as simply a cost of doing business; (2) 
heightened conflicts of interest attributable to the underwriters' 
position as more a principal than an agent in structured finance 
offerings; (3) executive compensation formulas that reward short-term 
performance (coupled with increased lateral mobility in investment 
banking so that actors have less reason to consider the long-term); and 
(4) competitive pressure. Each is briefly examined below, and then I 
suggest some proposed reforms to address these problems.
    i. The Decline of Due Diligence: A Short History: The Securities 
Act of 1933 adopted a ``gatekeeper'' theory of protection, in the 
belief that by imposing high potential liability on underwriters (and 
others), this would activate them to search for fraud and thereby 
protect investors. As the SEC wrote in 1998:

        Congress recognized that underwriters occupied a unique 
        position that enabled them to discover and compel disclosure of 
        essential facts about the offering. Congress believed that 
        subjecting underwriters to the liability provisions would 
        provide the necessary incentive to ensure their careful 
        investigations of the offering.'' \107\
---------------------------------------------------------------------------
     \107\ See SEC Release No. 7606A (``The Regulation of Securities 
Offerings''), 63 Fed. Reg. 67174, 67230 (Dec. 4 1998).

    Specifically, Section 11 of the Securities Act of 1933 holds the 
underwriters (and certain other persons) liable for any material 
misrepresentation or omission in the registration statement, without 
requiring proof of scienter on the part of the underwriter or reliance 
by the plaintiff. This is a cause of action uniquely tilted in favor of 
the plaintiff, but then Section 11(b) creates a powerful incentive by 
establishing an affirmative defense under which any defendant (other 
---------------------------------------------------------------------------
than the issuer) will not be held liable if:

        he had, after a reasonable investigation, reasonable ground to 
        believe and did believe, at the time such registration 
        statement became effective, that the statements made therein 
        were true and that there was an omission to state a material 
        fact required to be stated therein or necessary to make the 
        statements therein not misleading. 15 U.S.C.  77k (b)(3)(A). 
        (emphasis added)

    Interpreting this provision, the case law has long held that an 
underwriter must ``exercise a high degree of care in investigation and 
independent verification of the company's representations.'' Feit v. 
Leasco Data Processing Equip. Corp., 332 F. Supp. 554, 582 (E.D.N.Y. 
1971). Overall, the Second Circuit has observed that ``no greater 
reliance in our self-regulatory system is placed on any single 
participant in the issuance of securities than upon the underwriter.'' 
Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F. 2d 341, 370 
(2d Cir. 1973).
    Each underwriter need not personally perform this investigation. It 
can be delegated to the managing underwriters and to counsel, and, more 
recently, the task has been outsourced to specialized experts, such as 
the ``due diligence firms.'' The use of these firms was in fact strong 
evidence of the powerful economic incentive that Section 11(b) of the 
Securities Act created to exercise ``due diligence.''
    But what then changed? Two different answers make sense and are 
complementary: First, many and probably most CDO debt offerings are 
sold pursuant to Rule 144A, and Section 11 does not apply to these 
exempt and unregistered offerings. Second, the SEC expedited the 
processing of registration statements to the point that due diligence 
has become infeasible. The latter development goes back nearly thirty 
years to the advent of ``shelf registration'' in the early 1980s. In 
order to expedite the ability of issuers to access the market and 
capitalize on advantageous market conditions, the SEC permitted issuers 
to register securities ``for the shelf''--i.e., to permit the 
securities to be sold from time to time in the future, originally over 
a two year period (but today extended to a three year period). \108\ 
Under this system, ``takedowns''--i.e., actual sales under a shelf 
registration statement--can occur at any time without any need to 
return to the SEC for any further regulatory permission. Effectively, 
this telescoped a period that was often three or four months in the 
case of the traditional equity underwriting (i.e., the period between 
the filing of the registration statement and its ``effectiveness,'' 
while the SEC reviewed the registration statement) to a period that 
might be a day or two, but could be only a matter of hours.
---------------------------------------------------------------------------
     \108\ See Rule 415 (17 C.F.R.  230.415)(2007).
---------------------------------------------------------------------------
    Today, because there is no longer any delay for SEC review in the 
case of an issuer eligible for shelf registration, an eligible issuer 
could determine to make an offering of debt or equity securities and in 
fact do so within a day's time. The original premise of this new 
approach was that eligible issuers would be ``reporting entities'' that 
filed continuous periodic disclosures (known as Form 10-Ks and Form 10-
Qs) under the Securities Exchange Act of 1934. Underwriters, the SEC 
hoped, could do ``continuing due diligence'' on these issuers at the 
time they filed their periodic quarterly reports in preparation for a 
later, eventual public offering. This hope was probably never fully 
realized, but, more importantly, this premise never truly applied to 
debt offerings by issuers of asset-backed securities.
    For bankruptcy and related reasons, the issuers of asset-backed 
issuers (such as CDOs backed by a pool of residential mortgages) are 
almost always ``special purpose vehicles'' (SPVs), created for the 
single offering; they thus have no prior operating history and are not 
``reporting companies'' under the Securities Exchange Act of 1934. To 
enable issuers of asset-backed securities to use shelf-registration and 
thus obtain immediate access to the capital markets, the SEC had to 
develop an alternative rationale. And it did! To use Form S-3 (which is 
a precondition for eligibility for shelf-regulation), an issuer of 
asset-backed securities must receive an ``investment grade'' rating 
from an ``NRSRO'' credit-rating agency. \109\ Unfortunately, this 
requirement intensified the pressure that underwriters brought to bear 
on credit-ratings agencies, because unless the offering received an 
investment grade rating from at least one rating agency, the offering 
could not qualify for Form S-3 (and so might be delayed for an 
indefinite period of several months while its registration statement 
received full-scale SEC review). An obvious alternative to the use of 
an NRSRO investment grade rating as a condition for Form S-3 
eligibility would be certification by ``gatekeepers'' to the SEC (i.e., 
attorneys and due diligence firms) of the work they performed. Form S-3 
could still require an ``investment grade'' rating, but that it come 
from an NRSRO rating agency should not be mandatory.
---------------------------------------------------------------------------
     \109\ See Form S-3, General Instructions, IB5 (``Transaction 
Requirements--Offerings of Investment Grade Asset-Backed Securities'').
---------------------------------------------------------------------------
    After 2000, developments in litigation largely convinced 
underwriters that it was infeasible to expect to establish their due 
diligence defense. The key event was the WorldCom decision in 2004. 
\110\ In WorldCom, the court effectively required the same degree of 
investigation for shelf-registered offerings as for traditional 
offerings, despite the compressed time frame and lack of underwriter 
involvement in the drafting of the registration statement. The Court 
asserted that its reading of the rule should not be onerous for 
underwriters because they could still perform due diligence prior to 
the offering by means of ``continuous due diligence'' (i.e., through 
participation by the underwriter in the drafting of the various Form 
10-Ks and Form 10-Qs that are incorporated by reference into the shelf-
registration).
---------------------------------------------------------------------------
     \110\ In re WorldCom Inc. Securities Litigation, 346 F. Supp. 2d 
628 (S.D.N.Y. 2004). The WorldCom decision denied the underwriters' 
motion for summary judgment based on their asserted due diligence 
defense, but never decided whether the defense could be successfully 
asserted at trial. The case settled before trial for approximately $6.2 
billion.
---------------------------------------------------------------------------
    For underwriters, the WorldCom decision was largely seen as a 
disaster. Their hopes--probably illusory in retrospect--were dashed 
that courts would soften Securities Act  11's requirements in light of 
the near impossibility of complying with due diligence responsibilities 
during the shortened time frames imposed by shelf registration. Some 
commentators had long (and properly) observed that the industry had 
essentially played ``ostrich,'' hoping unrealistically that Rule 176 
would protect them. \111\ In WorldCom's wake, the SEC did propose some 
amendments to strengthen Rule 176 that would make it something closer 
to a safe harbor. But the SEC ultimately withdrew and did not adopt 
this proposal.
---------------------------------------------------------------------------
     \111\ See Donald Langevoort, Deconstructing Section 11: Public 
Offering Liability in a Continuous Disclosure Environment, 63 Law and 
Contemporary Problems, U.S. 62-63 (2000).
---------------------------------------------------------------------------
    As the industry now found (as of late 2004) that token or 
formalistic efforts to satisfy Section 11 would not work, it faced a 
bleak choice. It could accept the risk of liability on shelf offerings 
or it could seek to slow them down to engage in full scale due 
diligence. Of course, different law firms and different investment 
banks could respond differently, but I am aware of no firms attempting 
truly substantial due diligence on asset-backed securitizations. 
Particularly in the case of structured finance, the business risk of 
Section 11 liability seemed acceptable. After all, investment grade 
bonds did not typically default or result in class action litigation, 
and Section 11 has a short statute of limitations (one year from the 
date that the plaintiffs are placed on ``inquiry notice''). Hence, 
investment banks could rationally decide to proceed with structured 
finance offerings knowing that they would be legally exposed if the 
debt defaulted, in part because the period of their exposure would be 
brief. In the wake of the WorldCom decision, the dichotomy widened 
between the still extensive due diligence conducted in IPOs, and the 
minimal due diligence in shelf offerings. As discussed below, important 
business risks may have also motivated investment banks to decide not 
to slow down structured finance offerings for extended due diligence.
    The bottom line here then is that, at least in the case of asset-
backed shelf offerings, investment banks ceased to perform the due 
diligence intended by Congress, but instead accepted the risk of 
liability as a cost of doing business in this context. But that is only 
the beginning of the story.
    Conflicts of Interest: Traditionally, the investment bank in a 
public offering played a gatekeeping role, vetting the company and 
serving as an agent both for the prospective investors (who are also 
its clients) and the corporate issuer. Because it had clients on both 
sides of the offering, the underwriter's relationship with the issuer 
was somewhat adversarial, as its counsel scrutinized and tested the 
issuer's draft registration statement. But structured finance is 
different. In these offerings, there is no corporate issuer, but only a 
``special purpose vehicle'' (SPV) typically established by the 
investment bank. The product--residential home mortgages--is purchased 
by the investment bank from loan originators and may be held in 
inventory by the investment bank for some period until the offering can 
be effected. In part for this reason, the investment bank will 
logically want to expedite the offering in order to minimize the period 
that it must hold the purchased mortgages in its own inventory and at 
its own risk.
    Whereas in an IPO the underwriter (at least in theory) is acting as 
a watchdog testing the quality of the issuer's disclosures, the 
situation is obviously different in an assets-backed securities 
offering that the underwriter is structuring itself. It can hardly be 
its own watchdog. Thus, the quality of disclosure may suffer. Reports 
have circulated that some due diligence firms advised their 
underwriters that the majority of mortgages loans in some securitized 
portfolio were ``exception'' loans--i.e., loans outside the bank's 
normal guidelines. \112\ But the registration statement disclosed only 
that the portfolio included a ``significant'' or ``substantial'' number 
of such loans, not that it was predominantly composed of such loans. 
This is inferior and materially deficient disclosure, and it seems 
attributable to the built-in conflicts in this process.
---------------------------------------------------------------------------
     \112\ See, e.g., Vikas Bajaj and Jenny Anderson, ``Inquiry Focuses 
on Withholding of Data on Loans,'' New York Times, January 12, 2008, at 
A-1.
---------------------------------------------------------------------------
    Executive Compensation: Investment bankers are typically paid year-
end bonuses that are a multiple of their salaries. These bonuses are 
based on successful completion of fee-generating deals during the year. 
But a deal that generates significant income in Year One could 
eventually generate significant liability in Year Two or Three. In this 
light, the year-end bonus system may result in a short-term focus that 
ignores or overly discounts longer-term risks.
    Moreover, high lateral mobility characterizes investment banking 
firms, meaning that the individual investment banker may not identify 
with the firm's longer-term interests. In short, investment banks may 
face serious agency costs problems, which may partly explain their 
willingness to acquire risky mortgage portfolios without adequate 
investigation of the collateral.
    Competitive Pressure: Citigroup CEO Charles Prince's now famous 
observation that ``when the music is playing, you've got to get up and 
dance'' is principally a recognition of the impact of competitive 
pressure. If investors are clamoring for ``investment grade'' CDOs (as 
they were in 2004-2006), an investment bank understands that if it does 
not offer a steady supply of transactions, its investors will go 
elsewhere--and possibly not return. Thus, to hold onto a profitable 
franchise, investment banks sought to maintain a steady pipeline of 
transactions; this in turn lead them to seek to lock in sources of 
supply. Accordingly, they made clear to loan originators their 
willingness to buy all the ``product'' that the latter could supply. 
Some investment banks even sought billion dollar promises from loan 
originators of a minimum amount of product. Loan originators quickly 
realized that due diligence was now a charade (even if it had not been 
in the past) because the ``securitizing'' investment banks were 
competing fiercely for supply. In a market where the demand seemed 
inexhaustible, the real issue was obtaining supply, and investment 
banks spent little time worrying about due diligence or rejecting a 
supply that was already too scarce for their anticipated needs.
    Providing Time for Due Diligence: The business model for structured 
finance is today broken. Underwriters and credit rating agencies have 
lost much of their credibility. Until structured finance can regain 
credibility, housing finance in the United States will remain in scarce 
supply.
    The first lesson to be learned is that underwriters cannot be 
trusted to perform serious due diligence when they are in effect 
selling their own inventory and are under severe time pressure. The 
second lesson is that because expedited shelf registration is 
inconsistent with meaningful due diligence, the process of underwriting 
structured finance offerings needs to be slowed down to permit more 
serious due diligence. Shelf registration and abbreviated time 
schedules may be appropriate for seasoned corporate issuers whose 
periodic filings are incorporated by reference into the registration 
statement, but it makes less sense in the case of a ``special purpose 
vehicle'' that has been created by the underwriter solely as a vehicle 
by which to sell asset-backed securities. Offerings by seasoned issuers 
and by special purpose entities are very different and need not march 
to the same drummer (or the same timetable).
    An offering process for structured finance that was credible would 
look very different than the process we have recently observed. First, 
a key role would be played by the due diligence firms, but their 
reports would not go only to the underwriter (who appears to have at 
time ignored them). Instead, without editing or filtering, their 
reports would also go directly to the credit-rating agency. Indeed, the 
rating agency would specify what it would want to see covered by the 
due diligence firm's report. Some dialogue between the rating agency 
and the due diligence firm would be built into the process, and ideally 
their exchange would be outside the presence of the underwriter (who 
would still pay for the due diligence firm's services). At a minimum, 
the NRSRO rating agencies should require full access to such due 
diligence reports as a condition of providing a rating (this is a 
principle with which these firms agree, but may find it difficult to 
enforce in the absence of a binding rule).
    To enable serious due diligence to take place, one approach would 
be to provide that structured finance offerings should not qualify for 
Form S-3 (or for any similar form of expedited SEC review). If the 
process can occur in a day, the pressures on all the participants to 
meet an impossible schedule will ensure that little serious 
investigation of the collateral's quality will occur. An alternative 
(or complementary approach) would be to direct the SEC to revise 
Regulation AB to incorporate greater verification by the underwriter 
(and thus its agents) of the quality of the underlying financial 
assets.
    Does this sound unrealistic? Interestingly, the key element in this 
proposal--that that due diligence firm's report go to the credit rating 
agency--is an important element in the settlement negotiated in 2008 by 
New York State Attorney General Cuomo and the credit rating agencies. 
\113\
---------------------------------------------------------------------------
     \113\ See Aaron Lucchetti, ``Big Credit-Rating Firms Agree to 
Reforms,'' The Wall Street Journal, June 6, 2008 at p. C-3.
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    The second element of this proposal--i.e., that the process be 
slowed to permit some dialogue and questioning of the due diligence 
firm's findings--will be more controversial. It will be argued that 
delay will place American underwriters at a competitive disadvantage to 
European rivals and that offerings will migrate to Europe. But today, 
structured finance is moribund on both sides of the Atlantic. To revive 
it, credibility must be restored to the due diligence process. 
Instantaneous due diligence is in the last analysis simply a 
contradiction in terms. Time and effort are necessary if the quality of 
the collateral is to be verified--and if investors are to perceive that 
a serious effort to protect their interests is occurring.
Rehabilitating the Gatekeepers
    Credit rating agencies remain the critical gatekeeper whose 
performance must be improved if structured finance through private 
offerings (i.e., without government guarantees) is to become viable 
again. As already noted, credit rating agencies face a concentrated 
market in which they are vulnerable to pressure from underwriters and 
active competition for the rating business.
    At present, credit rating agencies face little liability and 
perform little verification. Rather, they state explicitly that they 
are assuming the accuracy of the issuer's representations. The only 
force that can feasibly induce them to conduct or obtain verification 
is the threat of securities law liability. Although that threat has 
been historically non-existent, it can be legislatively augmented. The 
credit rating agency does make a statement (i.e., its rating) on which 
the purchasers of debt securities do typically rely. Thus, potential 
liability does exist under Rule 10b-5 to the extent that it makes a 
statement in connection with a purchase or sale of a security. The 
difficult problem is that a defendant is only liable under Rule 10b-5 
if it makes a material misrepresentation or omission with scienter. In 
my judgment, there are few cases, if any, in which the rating agencies 
actually know of the fraud. But, under Rule 10b-5, a rating agency can 
be held liable if it acted ``recklessly.''
    Accordingly, I would proposed that Congress expressly define the 
standard of ``recklessness'' that creates liability under Rule 10b-5 
for a credit rating agency to be the issuance of a rating when the 
rating agency knowingly or recklessly is aware of facts indicating that 
reasonable efforts have not been conducted to verify the essential 
facts relied upon by its ratings methodology. A safe harbor could be 
created for circumstances in which the ratings agency receives written 
certification from a ``due diligence'' firm, independent of the 
promoter, indicating that it has conducted sampling procedures that 
lead it to believe in the accuracy of the facts or estimates asserted 
by the promoter. The goal of this strategy is not to impose massive 
liabilities on rating agencies, but to make it unavoidable that someone 
(either the rating agency or the due diligence firm) conduct reasonable 
verification. To be sure, this proposal would involve increased costs 
to conduct such due diligence (which either the issuer or the 
underwriter would be compelled to assume). But these costs are several 
orders of magnitude below the costs that the collapse of the structured 
finance market has imposed on the American taxpayer.
Conclusions
    1. The current financial crisis--including the collapse of the U.S. 
real estate market, the insolvency of the major U.S. investment banks, 
and the record decline in the stock market--was not the product of 
investor mania or the classic demand-driven bubble, but rather was the 
product of the excesses of an ``originate-and-distribute'' business 
model that both loan originators and investment banks followed to the 
brink of disaster--and beyond. Under this business model, financial 
institutions abandoned discipline and knowingly made non-creditworthy 
loans because they did not expect to hold the resulting financial 
assets for long enough to matter.
    2. The ``moral hazard'' problem that resulted was compounded by 
deregulatory policies at the SEC (and elsewhere) that permitted 
investment banks to increase their leverage rapidly between 2004 and 
2006, while also reducing their level of diversification. Under the 
Consolidated Supervised Entity (CSE) Program, the SEC essentially 
deferred to self-regulation by the five largest investment banks, who 
woefully underestimated their exposure to risk.
    3. This episode shows (if there ever was doubt) that in an 
environment of intense competition and under the pressure of equity-
based executive compensation systems that are extraordinarily short-
term oriented, self-regulation does not work.
    4. As a result, all financial institutions that are ``too big to 
fail'' need to be subjected to prudential financial supervision and a 
common (although risk-adjusted) standard. This can only be done by the 
Federal Reserve Board, which should be given authority to regulate the 
capital adequacy, safety and soundness, and risk management practices 
of all large financial institutions.
    5. Incident to making the Federal Reserve the systemic risk 
regulator for the U.S. economy, it should receive legislative authority 
to: (1) establish ceilings on debt/equity ratios and otherwise restrict 
leverage at all major financial institutions (including banks, hedge 
funds, money market funds, insurance companies, and pension plans, as 
well as financial subsidiaries of industrial corporations); (2) 
supervise and restrict the design, and trading of new financial 
products (particularly including over-the-counter derivatives); (3) 
mandate the use of clearinghouses, to supervise them, and in its 
discretion to require their consolidation; (4) require the writedown of 
risky assets by financial institutions, regardless of whether required 
by accounting rule; and (5) to prevent liquidate crises by restricting 
the issuance of short-term debt.
    6. Under the ``twin peaks'' model, the systemic risk regulatory 
agency would have broad powers, but not the power to override the 
consumer protection and transparency policies of the SEC. Too often 
bank regulators and banks have engaged in a conspiracy of silence to 
hide problems, lest they alarm investors. For that reason, some SEC 
responsibilities should not be subordinated to the authority of the 
Federal Reserve.
    7. As a financial technology, asset-backed securitizations have 
decisively failed. To restore credibility to this marketplace, sponsors 
must abandon their ``originate-and-distribute'' business model and 
instead commit to retain a significant portion of the most subordinated 
tranche. Only if the promoter, itself, holds a share of the weakest 
class of debt that it is issuing (and on an unhedged basis) will there 
be a sufficient signal of commitment to restore credibility.
    8. Credit rating agencies must be compelled either to conduct 
reasonable verification of the key facts that they are assuming in 
their ratings methodology or to obtain such verification from 
professionals independent of the issuer. For this obligation to be 
meaningful, it must be backstopped by a standard of liability 
specifically designed to apply to credit-rating agencies.
                                 ______
                                 
               PREPARED STATEMENT OF T. TIMOTHY RYAN, JR.
                 President and Chief Executive Officer,
         Securities Industry and Financial Markets Association
                             March 10, 2009
    Chairman Dodd, Ranking Member Shelby, Members of the Committee; My 
name is Tim Ryan and I am President and CEO of the Securities Industry 
and Financial Markets Association (SIFMA). \1\ Thank you for your 
invitation to testify at this important hearing. The purpose of my 
testimony is to share SIFMA's views on how we might improve investor 
protection as well as the regulation of our financial markets.
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     \1\ The Securities Industry and Financial Markets Association 
brings together the shared interests of more than 600 securities firms, 
banks and asset managers locally and globally through offices in New 
York, Washington, D.C., and London. Its associated firm, the Asia 
Securities Industry and Financial Markets Association, is based in Hong 
Kong. SIFMA's mission is to champion policies and practices that 
benefit investors and issuers, expand and perfect global capital 
markets, and foster the development of new products and services. 
Fundamental to achieving this mission is earning, inspiring and 
upholding the public's trust in the industry and the markets. (More 
information about SIFMA is available at http://www.sifma.org)
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Overview
    Our current financial crisis, which has affected nearly every 
American family, underscores the imperative to modernize our financial 
regulatory system. Our regulatory structure and the plethora of 
regulations applicable to financial institutions are based on 
historical distinctions among banks, securities firms, insurance 
companies, and other financial institutions--distinctions that no 
longer conform to the way business is conducted. Today, financial 
services institutions perform many similar activities without regard to 
their legacy charters, and often provide investors with similar 
products and services, yet may be subject to different rules and to the 
authority of different regulatory agencies because of the functions 
performed in a bygone era.
    Regulators continue to operate under authorities largely 
established many decades ago. They also often operate without 
sufficient coordination and cooperation and without a complete picture 
of the market as a whole. For example, the Securities and Exchange 
Commission (SEC) oversees brokerdealer activity. Futures firms are 
regulated by the Commodity Futures Trading Commission (CFTC), while the 
insurance industry is regulated by 50 State insurance regulators. 
Thrifts are regulated by the Office of Thrift Supervision, and banks 
may be overseen at the Federal level by the Office of the Comptroller 
of the Currency, the Federal Reserve Board, or the Federal Deposit 
Insurance Corporation. At the same time, some financial institutions, 
such as hedge funds, largely escape regulation altogether.
    As a result, our current regulatory framework is characterized by 
duplicative or inconsistent regulation, and in some instances 
insufficient or insufficiently coordinated oversight. The negative 
consequences to the investing public of this patchwork of regulatory 
oversight are real and pervasive. Investors do not have comparable 
protections across the same or similar financial products. Rather, the 
disclosures, standards of care and other key investor protections vary 
based on the legal status of the intermediary or the product or service 
being offered. For example, similar financial advisory services may be 
delivered to retail clients via a broker-dealer, an investment adviser, 
an insurance agent, or a trustee, thereby subjecting similar advisory 
activities to widely disparate regulatory requirements. From the 
perspective of financial institutions, many are subject to duplicative, 
costly, and unnecessary regulatory burdens, including multiple 
rulebooks, and multiple examinations and enforcement actions for the 
same activity, that provide questionable benefits to investors and the 
markets as a whole.
    This regulatory hodgepodge unnecessarily exposes investors, market 
participants, and regulators alike to the potential risk of under-
regulation, overregulation, or inconsistent regulation, both within the 
U.S. and globally. A complex and overlapping regulatory structure 
results in higher costs on all investors, depriving them of investment 
opportunities. Simply enhancing regulatory cooperation among the many 
different regulators will not be sufficient to address these issues.
    In light of these concerns, SIFMA advocates simplifying and 
reforming the financial regulatory structure to maximize and enhance 
investor protection and market integrity and efficiency. More 
specifically, we believe that a reformed--and sound--regulatory 
structure should accomplish the following goals: First, it must 
minimize systemic risk. Second, through a combination of structural and 
substantive reforms, it must be as effective and efficient as possible, 
while at the same time promoting and enhancing fair dealing and 
investor protection. Finally, it should encourage consistent regulation 
across the same or similar businesses and products, from country to 
country, to minimize regulatory arbitrage.
Creation of a Financial Markets Stability Regulator
    Systemic risk has been at the heart of the current financial 
crisis. While there is no single, commonly accepted definition of 
systemic risk, we think of ``systemic risk'' as the risk of a system 
wide financial crisis characterized by a significant risk of the 
contemporaneous failure of a substantial number of financial 
institutions or of financial institutions or a financial market 
controlling a significant amount of financial resources that could 
result in a severe contraction of credit in the U.S. or have other 
serious adverse effects on economic conditions or financial stability. 
SIFMA has devoted considerable time and resources to thinking about 
systemic risk, and what can be done to identify it, minimize it, 
maintain financial stability and resolve a financial crisis in the 
future. A regulatory reform committee of our members has met regularly 
in recent months to consider these issues and to develop a workable 
proposal to address them. We have sponsored roundtable discussions with 
former regulators, financial services regulatory lawyers and our 
members, as well as other experts, policymakers, and stakeholders to 
develop solutions to the issues that have been exposed by the financial 
crisis and the challenges facing our financial markets and, ultimately 
and most importantly, America's investors.
    Through this process, we have identified a number of questions and 
tradeoffs that will confront policymakers in trying to mitigate 
systemic risk. Although our members continue to consider this issue, 
there seems to be consensus that we need a financial markets stability 
regulator as a first step in addressing the challenges facing our 
overall financial regulatory structure. The G30, in its report on 
financial reform, supports a central body with the task of promoting 
and maintaining financial stability, and the Treasury, in its 
blueprint, also has supported a market stability regulator.
    We are realistic in what we believe a financial markets stability 
regulator can accomplish. It will not be able to identify the causes or 
prevent the occurrence of all financial crises in the future. But at 
present, no single regulator (or collection of coordinated regulators) 
has the authority or the resources to collect information system-wide 
or to use that information to take corrective action in a timely manner 
across all financial institutions and markets regardless of charter. We 
believe that a single, accountable financial markets stability 
regulator will improve upon the current system.
    While our position on the mission of the financial markets 
stability regulator is still evolving, we currently believe that its 
mission should consist of mitigating systemic risk, maintaining 
financial stability and addressing any financial crisis, all of which 
will benefit the investing public. It should have authority over all 
markets and market participants, regardless of charter, functional 
regulator or unregulated status. In carrying out its duties, the 
financial markets stability regulator should coordinate with the 
relevant functional regulators, as well as the President's Working 
Group, as applicable, in order to avoid duplicative or conflicting 
regulation and supervision. It should also coordinate with regulators 
responsible for systemic risk in other countries. It should have the 
authority to gather information from all financial institutions and 
markets, adopt uniform regulations related to systemic risk, and act as 
a lender of last resort. It should probably have a more direct role in 
supervising systemically important financial organizations, including 
the power to conduct examinations, take prompt corrective action and 
appoint or act as the receiver or conservator of all or part of a 
systemically important organization. These more direct powers would end 
if a financial group were no longer systemically important.
Other Reforms That Would Enhance Investor Protection and Improve Market 
        Efficiency
    While we believe that a financial markets stability regulator will 
contribute to enhancing investor protection and improving market 
efficiency, we also believe, as a second step, that we must work to 
rationalize the broader financial regulatory framework to eliminate 
regulatory gaps and imbalances that contribute to systemic risk. 
Specifically, SIFMA believes that more effective and efficient 
regulation of financial institutions--resulting in greater investor 
Protection--is likely to be achieved by regulating similar activities 
and firms in a similar manner and by consolidating certain financial 
regulators.
Core Standards Governing Business Conduct
    Currently, the regulation of the financial industry is based 
predominantly on rules that were first established during the 1930s and 
1940s, when the products and services offered by banks, broker-dealers, 
investment advisors and insurance companies were distinctly different. 
Today, however, the lines and distinctions among these companies and 
the products and services they offer have become largely blurred. 
Development of a single set of standards governing business conduct of 
financial institutions towards individual and institutional investors, 
regardless of the type of industry participant or the particular 
products or services being offered, would promote and enhance investor 
protection, and reduce potential regulatory arbitrage and 
inefficiencies that are inherent in the existing system of multiple 
regulators and multiple, overlapping rulebooks.
    The core standards should be crafted so as to be flexible enough to 
adapt to new products and services as well as evolving market 
conditions, while providing sufficient direction for firms to establish 
enhanced compliance systems. As Federal Reserve Board Chairman Ben 
Bernanke once suggested, ``a consistent, principles-based, and risk-
focused approach that takes account of the benefits as well as the 
risks that accompany financial innovation'' is an effective way 
toprotect investors while maintaining the integrity of the marketplace. 
\2\
---------------------------------------------------------------------------
     \2\ See Ben S. Bernanke, Federal Reserve Board Chairman, Remarks 
at the Federal Reserve Bankof Atlanta's 2007 Financial Markets 
Conference, Sea Island, Georgia (May 15, 2007), at http://
www.federalreserve.gov/boarddocs/Speeches/2007/20070515/default.htm
---------------------------------------------------------------------------
    This core standards approach, however, must be accompanied by 
outcome-oriented rules (where rules are necessary), an open dialogue 
between the regulator and regulated, and enforcement efforts focused on 
addressing misconduct and fraud and protecting the investing public.
Harmonize Investment Advisor and Broker-Dealer Regulation
    SIFMA has long advocated the modernization and harmonization of the 
disparate regulatory regimes for investment advisory, brokerage and 
other financial services in order to promote investor protection. A 
2007 RAND Corporation report commissioned by the SEC found that efforts 
to describe a financial service provider's duties or standard of care 
in legalistic terms, such as ``fiduciary duty'' or ``suitability,'' 
contributes to--rather than resolves--investor confusion. \3\ Further 
complicating matters, the laws that apply to many customer accounts, 
such as ERISA (for employer-sponsored retirement plans) or the Internal 
Revenue Code (for IRAs), have different definitions of fiduciaries, and 
prohibitions on conduct and the sale of products that differ from those 
under the Investment Advisers Act and state law fiduciary concepts. The 
RAND report makes clear that individual investors generally do not 
understand, appreciate, or care about such legal distinctions.
---------------------------------------------------------------------------
     \3\ Investor and Industry Perspectives on Investment Advisers and 
Broker-Dealers, RAND Institutefor Civil Justice, December 31, 2007, 
available at http://www.sec.gov/news/press/2008/2008-
1_randiabdreport.pdf
---------------------------------------------------------------------------
    Rather than perpetuating an obsolete regulatory regime, SIFMA 
recommends the adoption of a ``universal standard of care'' that avoids 
the use of labels that tend to confuse the investing public, and 
expresses, in plain English, the fundamental principles of fair dealing 
that individual investors can expect from all of their financial 
services providers. Such a standard could provide a uniform code of 
conduct applicable to all financial professionals. It would make clear 
to individual investors that their financial professionals are 
obligated to treat them fairly by employing the same core standards 
whether the firm is a financial planner, an investment adviser, a 
securities broker-dealer, a bank, an insurance agency or another type 
of financial services provider. A universal standard would not limit 
the ability of individual investors to contract for and receive a broad 
range of services from their financial services providers, from pure 
execution of customer orders to discretionary investment advice, nor 
would it limit the ability of clients to define or modify relationships 
with their financial services providers in ways they so choose.
    As Congress contemplates regulatory reform, particularly in the 
wake of the Madoff and Stanford scandals and the recent turbulence in 
our financial markets, we believe that the time has come to focus on 
the adoption of a universal investor standard of care.
    In addition, we urge Congress to pursue a regulatory framework for 
financial services providers that is understandable, practical and 
provides flexibility sufficient for these intermediaries to provide 
investors with both existing and future products and services. Such a 
framework must also avoid artificial or vague distinctions (such as 
those based on whether any investment advice is ``solely incidental'' 
to brokerage or whether any compensation to the financial services 
provider is ``special''). Finally, the framework should support 
investor choice through appropriate relief from the SEC's rigid 
prohibitions against principal trading, particularly with respect to 
products traded in liquid and transparent markets, which has had the 
effect of foreclosing investors from obtaining more favorable pricing 
on transactions based on the requirement for transaction-by-transaction 
consent.
Broaden the Authority of the MSRB
    The Municipal Securities Rulemaking Board (MSRB) regulates the 
conduct of only broker-dealers in the municipal securities market. We 
feel it is important to level the regulatory playing field by 
increasing the MSRB's authority to encompass the regulation of 
financial advisors, investment brokers and other intermediaries in the 
municipal market to create a comprehensive regulatory framework that 
prohibits fraudulent and manipulative practices; requires fair 
treatment of investors, state and local government issuers of municipal 
bonds and other market participants; ensures rigorous standards of 
professional qualifications; and promotes market efficiencies.
Merge the SEC and CFTC
    The United States is the only jurisdiction that splits the 
oversight of securities and futures activities between two separate 
regulatory bodies. When the CFTC was formed, financial futures 
represented a very small percentage of futures activity. Now, an 
overwhelming majority of futures that trade today are financial 
futures. These products are nearly identical to SEC regulated 
securities options from an economic standpoint, yet they are regulated 
by the CFTC under a very different regulatory regime. This disparate 
regulatory treatment detracts from the goal of investor protection. An 
entity that combines the functions of both agencies could be better 
positioned to apply consistent rules to securities and futures.
OTC Derivatives
    Although OTC derivatives transactions generally are limited to 
institutional participants, the use of OTC derivatives by American 
businesses to manage risks and reduce funding costs provides important 
benefits for our economy and, consequently, for individual investors as 
well. At the same time, problems with OTC derivatives can adversely 
affect the financial system and individual investors. Accordingly, we 
believe that steps should be taken to further develop the 
infrastructure that supports the OTC derivatives business and to 
improve the regulatory oversight of that activity.
    In particular, we strongly support our members' initiative to 
establish a clearinghouse for credit default swaps (CDS) and we are 
pleased to note that ICE US Trust LLC opened its doors for clearing CDS 
transactions yesterday. We believe that development of a clearinghouse 
for credit derivatives is an effective way to reduce counterparty 
credit risk and, thus, promote market stability. In addition to 
reducing risk, the clearinghouse will facilitate regulatory oversight 
by providing a single access point for information about the CDS 
transactions it processes.
    We also believe that all systemically significant participants in 
OTC derivatives markets should be subject to oversight by a single 
systemic regulator. (It is noteworthy that the AIG affiliate that was 
an active participant in the CDS market was not subject to meaningful 
regulatory supervision.) The systemic regulator should be given broad 
authority to promulgate rules and regulations to promote sound 
practices and reduce systemic risk. We recognize that effective 
regulation requires timely access to relevant information and we 
believe the systemic regulator should have the necessary authority to 
assure there is appropriate regulatory transparency.
Investor Protection Through International Cooperation and Coordination
    Finally, the current financial crisis reminds us that markets are 
global in nature and so are the risks of contagion. To promote investor 
protection through effective regulation and the elimination of 
disparate regulatory treatment, we believe that common regulatory 
standards should be applied consistently across markets. Accordingly, 
we urge that steps be taken to foster greater cooperation and 
coordination among regulators in major markets in the U.S., Europe, 
Asia, and elsewhere around the world. There are several international 
groups in which the U.S. participates that work to further regulatory 
cooperation and establish international standards, including IOSCO, the 
Joint Forum, the Basel Committee on Banking Supervision, and the 
Financial Stability Forum. Congress should support and encourage the 
efforts of these groups.
Conclusion
    Recent challenges have highlighted the necessity of reforms to 
enhance investor protection. SIFMA strongly supports these efforts and 
commits to be a constructive participant in the process. SIFMA stands 
ready to assist the Committee as it considers regulatory reform to 
minimize systemic risk, promote consistent and efficient regulation, 
eliminate regulatory arbitrage, and promote capital formation--all of 
which serve, directly or indirectly, the interest of investor 
protection. We are confident that through our collective efforts, we 
have the capacity to emerge from this crisis with stronger and more 
modern regulatory oversight that will not only prepare us for the 
challenges facing financial firms today and in the future, but also 
help the investing public meet its financial needs and support renewed 
economic growth and job creation.
                                 ______
                                 
               PREPARED STATEMENT OF PAUL SCHOTT STEVENS
                 President and Chief Executive Officer,
                      Investment Company Institute
                             March 10, 2009
Executive Summary
Overview: Recommendations for Financial Services Regulatory Reform
    The current financial crisis provides policymakers with the 
        public mandate needed to take bold steps to strengthen and 
        modernize our financial regulatory system. It is imperative to 
        registered investment companies (also referred to as 
        ``funds''), as both issuers of securities to investors and 
        purchasers of securities in the market, that the regulatory 
        system ensure strong investor protection and foster competition 
        and efficiency in the capital markets. The ultimate outcome of 
        reform efforts will have a direct and lasting effect on the 
        fund industry and the millions of investors who choose funds to 
        help them save for the future.

    As detailed in a recently released white paper (attached as 
        Appendix A), ICI recommends: (1) establishing a Systemic Risk 
        Regulator; (2) creating a Capital Markets Regulator 
        representing the combined functions of the Securities and 
        Exchange Commission and the Commodity Futures Trading 
        Commission; (3) considering consolidation of the bank 
        regulatory structure and authorization of an optional federal 
        charter for insurance companies; and (4) enhancing coordination 
        and information sharing among federal financial regulators.

    If enacted, these reforms would improve regulators' 
        capability to monitor and mitigate risks across the financial 
        system, enhance regulatory efficiency, limit duplication, close 
        regulatory gaps, and emphasize the national character of the 
        financial services industry.
Systemic Risk Regulator
    The Systemic Risk Regulator should have responsibility for: 
        (1) monitoring the financial markets broadly; (2) analyzing 
        changing conditions in domestic and overseas markets; (3) 
        evaluating the risks of practices as they evolve and 
        identifying those that are of such nature and extent that they 
        implicate the health of the financial system at large; and (4) 
        acting in coordination with other responsible regulators to 
        mitigate such risks.

    Careful consideration should be given to how the Systemic 
        Risk Regulator will be authorized to perform its functions and 
        its relationship with other, specialized regulators.
Capital Markets Regulator
    The Capital Markets Regulator should have oversight 
        responsibility for the capital markets, market participants, 
        and all financial investment products. It should be the 
        regulatory standard setter for funds, including money market 
        funds.

    The agency's mission should focus on investor protection 
        and law enforcement, as well as maintaining the integrity of 
        the capital markets. Like the SEC, it should be required to 
        consider whether proposed regulations protect investors and 
        promote efficiency, competition, and capital formation.

    The Capital Markets Regulator should be an independent 
        agency, with the resources to fulfill its mission and the 
        ability to attract experienced personnel who can fully grasp 
        the complexities of today's markets. ICI's white paper offers 
        recommendations for organizing and managing the new agency and 
        for how the agency can maximize its effectiveness.
Selected Other Areas for Reform
    The Capital Markets Regulator should have express authority 
        to regulate in areas where there are currently gaps that have 
        the potential to impact the capital markets and market 
        participants, and to modernize regulation that has not kept 
        pace with changes in the marketplace. These areas include: (1) 
        hedge funds; (2) derivatives; (3) municipal securities; and (4) 
        the regulation of investment advisers and broker-dealers.
Recent Market Events and Money Market Funds
    Money market funds, stringently regulated by the SEC, are 
        one of the most notable product innovations in American 
        history. These funds--which seek to offer investors stability 
        of principal, liquidity, and a market-based rate of return, all 
        at a reasonable cost--serve as an effective cash management 
        tool for retail and institutional investors, and are an 
        exceptionally important source of short-term financing in the 
        U.S. economy.

    Until September 2008, money market funds, in some cases 
        with support from their sponsors, largely weathered severe 
        pressures in the fixed income markets that had been striking 
        banks and other financial services firms since 2007. In mid-
        September, a series of extraordinary developments, including 
        the failure of Lehman Brothers, roiled financial markets around 
        the globe, affecting all market participants. In the midst of 
        this market storm, one money market fund holding a substantial 
        amount of Lehman commercial paper was unable to sustain its 
        $1.00 price per share. The news of this fund ``breaking the 
        buck,'' combined with broader concerns about the building 
        stresses in the money market and possible failures of other 
        financial institutions, led to heavy redemptions in prime money 
        market funds as investors sought safety and liquidity in 
        Treasury securities.

    Unprecedented government initiatives--designed to provide 
        stability and liquidity to the markets and to support money 
        market funds--successfully bolstered investor confidence. To 
        date, the Treasury Temporary Guarantee Program for Money Market 
        Funds has received no claims for its guarantee, and none are 
        anticipated. Assuming continued progress in restoring the 
        health of the money market, there will be no need to extend the 
        Temporary Guarantee Program beyond its current one-year maximum 
        period.

    To capture the lessons learned from recent experience, ICI 
        formed a Money Market Working Group of senior fund industry 
        leaders, led by John J. Brennan of The Vanguard Group. The 
        Working Group has conducted a thorough examination of how the 
        money market can function better, and how all funds operating 
        in that market, including registered money market funds, should 
        be regulated. The Working Group intends to report its findings, 
        conclusions, and recommendations later this month. We believe 
        that prompt implementation of its recommendations will help 
        assure a smooth transition away from the Temporary Guarantee 
        Program.
Introduction
    My name is Paul Schott Stevens. I am President and CEO of the 
Investment CompanyInstitute, the national association of U.S. 
investment companies, including mutual funds, closed-end funds, 
exchange-traded funds (ETFs), and unit investment trusts (UITs). 
Members of ICI manage total assets of $9.88 trillion and serve over 93 
million shareholders. ICI is pleased to testify today about investor 
protection and the regulation of securities markets.
    This hearing takes place at a time when the United States and a 
host of other nations are grappling with the most significant financial 
crisis in generations. In this country, the crisis has revealed 
significant weaknesses in our current system for oversight of financial 
institutions. At the same time, it offers an important opportunity for 
robust dialogue about the way forward. And it provides policymakers 
with the public mandate needed to take bold steps to strengthen and 
modernize regulatory oversight of the financial services industry. We 
strongly commend this Committee for the substantial attention it is 
devoting to examining the causes of the current crisis and considering 
how the regulatory system can best be improved, with particular focus 
on protecting consumers and investors.
    It is no exaggeration that the ultimate outcome of these reform 
efforts will have a direct and lasting impact on the future of our 
industry. By extension, the decisions you make will affect the millions 
of American investors who choose registered investment companies (also 
referred to as ``funds'') as investment vehicles to help them meet the 
costs of college, their retirement needs, or other financial goals. 
Funds themselves are among the largest investors in U.S. companies, 
holding about one quarter of those companies' outstanding stock. Funds 
also hold approximately 40 percent of U.S. commercial paper, an 
important source of short-term funding for corporate America, and more 
than one third of tax-exempt debt issued by U.S. municipalities. It is 
thus imperative to funds, as both issuers of securities to investors 
and purchasers of securities in the market, that our financial 
regulatory system ensure strong protections for investors and foster 
competition and efficiency within the capital markets.
    Like other stakeholders, we have been thinking very hard about how 
to revamp our current system so that our nation emerges from this 
crisis with stronger, well-regulated institutions operating within a 
fair, efficient, and transparent marketplace. Last week, ICI released a 
white paper outlining detailed recommendations on how to reform the 
U.S. financial regulatory system, with particular emphasis on reforms 
most directly affecting the functioning of the capital markets and the 
regulation of investment companies. \1\ Section II of my testimony 
provides a summary of these recommendations.
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     \1\ See Investment Company Institute, Financial Services 
Regulatory Reform: Discussion and Recommendations (March 3, 2009), 
available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf and attached 
as Appendix A.
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    In addition to demonstrating the need to reform our financial 
regulatory system, events of the past year have highlighted the need 
for greater protections for both investors and the marketplace in 
several specific areas. Section III of my testimony outlines ICI's 
recommendations for legislative authority to address certain regulatory 
gaps that have the potential to affect the capital markets and market 
participants, and to modernize regulation that has not kept pace with 
changes in the marketplace.
    Finally, as discussed in Section IV of my testimony, events of the 
past year have brought into sharp focus the significance of money 
market funds and the critical role they play as a low-cost funding 
vehicle for the American economy. While the regulatory regime for money 
market funds has proven to be flexible and resilient, lessons learned 
from recent events suggested the need for a thorough examination of how 
the money market can function better and how all funds operating in 
that market should be regulated. To that end, ICI last November formed 
a working group of senior fund industry leaders with a broad mandate to 
develop recommendations in these areas. The Money Market Working Group 
is chaired by John J. Brennan, Chairman of The Vanguard Group, and 
expects to issue a detailed report by the end of March. We would 
welcome the opportunity to discuss with this Committee the 
recommendations of the Money Market Working Group following the release 
of its report.
Financial Services Regulatory Reform
Overview of ICI Recommendations
    Broadly speaking, ICI recommends changes to our regulatory 
structure that would create a framework to enhance regulatory 
efficiency, limit duplication, close regulatory gaps, and emphasize the 
national character of the financial services industry. To improve the 
government's capability to monitor and mitigate risks across the 
financial system, ICI supports the designation of a new or existing 
agency or inter-agency body as a ``Systemic Risk Regulator.'' A new 
``Capital Markets Regulator'' should encompass the combined functions 
of the Securities and Exchange Commission and the Commodity Futures 
Trading Commission, thus creating a single independent federal 
regulator responsible for oversight of U.S. capital markets, market 
participants, and all financial investment products. ICI further 
recommends that Congress consider consolidating the regulatory 
structure for the banking sector and authorizing an optional federal 
charter for insurance companies. Such a regulatory framework--with one 
or more dedicated regulators to oversee each major financial services 
sector--would maintain specialized regulatory focus and expertise, as 
well as avoid the potential for one industry sector to take precedence 
over the others in terms of regulatory priorities or the allocation of 
resources.
    To ensure the success of this new financial regulatory structure, 
there must be effectivecoordination and information sharing among the 
financial regulators, including in particular the Systemic Risk 
Regulator. Stronger links among these regulators should greatly assist 
in developing sound policies and should facilitate U.S. cooperation 
with the international regulatory community. In our white paper, we 
discuss why the President's Working Group on Financial Markets, with 
certain modifications, may be the most logical mechanism through which 
to accomplish these purposes.
Systemic Risk Regulator
    The current financial crisis has exposed the vulnerability of our 
financial system to risks that have the potential to spread rapidly 
throughout the system and cause significant damage. Analyses of the 
causes of the current crisis suggest that systemic risks may be 
occasioned by, for example, excessive leveraging, lack of transparency 
regarding risky practices, and gaps in the regulatory framework.
    ICI agrees with the growing consensus that our regulatory system 
needs to be better equipped to anticipate and address systemic risks 
affecting the financial markets. Some have called for the establishment 
of a ``Systemic Risk Regulator.'' Subject to important cautions, ICI 
supports designating a new or existing agency or inter-agency body to 
serve in this role. We recommend that the Systemic Risk Regulator have 
responsibility for: (1) monitoring the financial markets broadly; (2) 
analyzing changing conditions in domestic and overseas markets; (3) 
evaluating the risks of practices as they evolve and identifying those 
that are of such nature and extent that they implicate the health of 
the financial system at large; and (4) acting in coordination with 
other responsible regulators to mitigate such risks.
    The specifics of creating and empowering the Systemic Risk 
Regulator will require careful attention. By way of example, to perform 
its monitoring functions, this regulator likely will need information 
about a range of financial institutions and market sectors. The types 
of information that the regulator may require, and how the regulator 
will obtain that information, are just two of the discrete issues that 
will need to be fully considered.
    In ICI's view, legislation establishing the Systemic Risk Regulator 
should be crafted to avoid imposing undue constraints or inapposite 
forms of regulation on normally functioning elements of the financial 
system, or stifling innovations, competition, or efficiencies. For 
example, it has been suggested that a Systemic Risk Regulator could be 
given the authority to identify financial institutions that are 
``systemically significant'' and to oversee those institutions 
directly. Despite its seeming appeal, such an approach could have very 
serious anticompetitive effects if the identified institutions were 
viewed as ``too big to fail'' and thus judged by the marketplace as 
safer bets than their smaller, ``less significant'' competitors.
    Additionally, the Systemic Risk Regulator should be carefully 
structured so as not to simply add another layer of bureaucracy or to 
displace the primary regulators responsible for capital markets, 
banking, or insurance. Legislation establishing the Systemic Risk 
Regulator thus should define the nature of the relationship between 
this new regulator and the primary regulators for these industry 
sectors. The authority granted to the Systemic Risk Regulator should be 
subject to explicit limitations, and the specific areas in which the 
Systemic Risk Regulator and the primary regulators should work together 
will need to be identified. We believe, for example, that the primary 
regulators have a critical role to play as the first line of defense 
for detecting potential risks within their spheres of expertise.
Capital Markets Regulator
    Currently, securities and futures--and their respective markets and 
market participants--are subject to separate regulatory regimes under 
different federal regulators. This system reflects historical 
circumstances and is out of step with the increasing convergence of 
these two industries. It has resulted in jurisdictional disputes, 
regulatory inefficiency, and gaps in investor protection. To bring a 
consistent policy focus to U.S. capital markets, ICI recommends the 
creation of a Capital Markets Regulator as a new agency that would 
encompass the combined functions of the SEC and the CFTC. As the 
federal regulator responsible for overseeing the capital markets and 
all financial investment products, the Capital Markets Regulator--like 
the SEC and the CFTC--should be established as an independent agency, 
with an express statutory mission and the rulemaking and enforcement 
powers necessary to carry out that mission.
    It is critically important that the Capital Markets Regulator's 
statutory mission focus theagency sharply on investor protection and 
law enforcement, as distinct from the safety and soundness of regulated 
entities. At the same time, the Capital Markets Regulator (like the SEC 
today) should be required to consider, in determining whether a 
proposed regulation is consistent with the public interest, both the 
protection of investors and whether the regulation would promote 
efficiency, competition, and capital formation. The Capital Markets 
Regulator's mission also should include maintaining the integrity of 
the capital markets, which will benefit both market participants and 
consumers. Congress should ensure that the agency is given the 
resources it needs to fulfill its mission. Most notably, the Capital 
Markets Regulator must have the ability to attract personnel with the 
necessary market experience to fully grasp the complexities of today's 
global marketplace.
    ICI envisions the Capital Markets Regulator as the regulatory 
standard setter for registered investment companies, including money 
market funds (as is the case now with the SEC). In so authorizing this 
new agency, Congress would be continuing the important benefits that 
have flowed from the shared system of federal and state oversight 
established by the National Securities Markets Improvement Act of 1996. 
Under this system, federal law governs all substantive regulation of 
investment companies, and states have concurrent authority to protect 
against fraud. We believe that this approach is consistent with the 
national character of the market in which investment companies operate 
and would continue to achieve the regulatory efficiencies Congress 
intended, without compromising investor protection in any way.
    The Capital Markets Regulator should continue to regulate 
registered investment companies under the Investment Company Act of 
1940. While funds are not immune to problems, the substantive 
protections embodied in the Investment Company Act and related rules 
have contributed significantly to the protection of investors and the 
continuing integrity of funds as an investment model. Among these 
protections are: (1) daily pricing and redeemability of the fund's 
shares, with a requirement to use mark-to-market valuation; (2) 
separate custody of fund assets (typically with a bank custodian); (3) 
restrictions on complex capital structures and leveraging; (4) 
prohibitions or restrictions on affiliated transactions and other forms 
of self-dealing; and (5) diversification requirements. In addition, 
funds are subject to more extensive disclosure and transparency 
requirements than any other financial product. This regulatory 
framework has proven resilient through difficult market conditions, and 
has shielded fund investors from some of the problems associated with 
other financial products and services. Indeed, recent experience 
suggests that consideration should be given to extending the greater 
discipline that has worked so well in core areas of fund regulation--
such as valuation, \2\ independent custody, affiliated transaction 
prohibitions, leveraging restrictions, diversification, and 
transparency--to other marketplace participants.
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     \2\ From the perspective of funds as investors in corporate and 
fixed income securities, ICI believes that financial reporting that 
requires the use of mark-to-market or fair value accounting to measure 
the value of financial instruments serves the interests of investors 
and the capital markets better than alternative cost-based measures. 
For a more detailed discussion of our views, see Letter from Paul 
Schott Stevens, President and CEO, Investment Company Institute, to The 
Honorable Christopher Cox, Chairman, U.S. Securities and Exchange 
Commission, dated November 14, 2008, available at http://www.ici.org/
statements/cmltr/08_sec_mark-to-market_com.html
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    With the establishment of a new Capital Markets Regulator, Congress 
has a very valuable opportunity to ``get it right'' in terms of how the 
new agency is organized and managed. Our white paper outlines several 
recommendations in this regard, including the need for high-level focus 
on management of the agency. We stress the importance, for example, of 
the agency's having open and effective lines of internal communication, 
mechanisms to facilitate internal coordination and information sharing, 
and a comprehensive process for setting regulatory priorities and 
assessing progress.
    ICI's white paper also suggests ways in which the Capital Markets 
Regulator would be able to maximize its effectiveness in performing its 
responsibilities. I would like to highlight two of the most significant 
suggestions for the Committee. First, the Capital Markets Regulator 
should seek to facilitate close, cooperative interaction with the 
entities it regulates as a means to identify and resolve problems, to 
determine the impact of problems or practices on investors and the 
market, and to cooperatively develop best practices that can be shared 
broadly with market participants. Incorporating a more preventative 
approach would likely encourage firms to step forward with self-
identified problems and proposed resolutions. Second, the Capital 
Markets Regulator should establish mechanisms to stay abreast of market 
and industry developments. Ways to achieve this end include hiring more 
agency staff with significant prior industry experience and 
establishing by statute a multidisciplinary ``Capital Markets Advisory 
Committee'' comprised of private-sector representatives from all major 
sectors of the capital markets.
Expected Benefits of These Reforms
    If implemented, the recommended reforms outlined above and 
discussed in detail in our white paper would help to establish a more 
effective and efficient regulatory structure for the U.S. financial 
services industry. Most significantly, these reforms would:

    Improve the U.S. government's capability to monitor and 
        mitigate risks across our nation's financial system;

    Create a regulatory framework that enhances regulatory 
        efficiency, limits duplication, and emphasizes the national 
        character of the financial services industry;

    Close regulatory gaps to ensure appropriate oversight of 
        all market participants and investment products;

    Preserve specialized regulatory focus and expertise while 
        avoiding the potential for uneven attention to different 
        industries or products;

    Foster a culture of close consultation and dialogue among 
        U.S. financial regulators to facilitate collaboration on issues 
        of common concern; and

    Facilitate coordinated interaction with regulators in other 
        jurisdictions, including with regard to risks affecting global 
        capital markets.

    We recognize that some have criticized sector-based regulation 
because it may not provide any one regulator with a full view of a 
financial institution's overall business, and does not give any single 
regulator authority to mandate actions designed to mitigate systemic 
risks across financial markets as a whole. Our proposed approach would 
address those concerns through the establishment of the Systemic Risk 
Regulator to undertake this market-wide monitoring of the financial 
system and through specific measures to strengthen inter-agency 
coordination and information sharing.
    We further believe that retaining some elements of the current 
multi-agency structure would offer advantages over a single, integrated 
regulator approach. Even though a single regulator could be organized 
with separate units or departments focusing on different financial 
services sectors, it is our understanding that, in practice, there can 
be a tendency for agency leadership or staff to gravitate to certain 
areas and devote insufficient attention to financial sectors perceived 
to be less high profile or prone to fewer problems. Such a result has 
the potential to stifle innovation valuable to consumers and produce 
regulatory disparities.
    Finally, we believe that a streamlining of the current regulatory 
structure may be more effective and workable than an approach that 
assigns regulatory responsibilities to separate agencies based on broad 
regulatory objectives, such as market stability, safety and soundness, 
and business conduct. These functions often are highly interrelated. 
Not only could separating them prove quite challenging, but it would 
force regulators to view institutions in a less integrated way and to 
operate with a narrower, less informed knowledge base. For example, a 
Capital Markets Regulator is likely to be more effective in protecting 
investors if its responsibilities require it to maintain a thorough 
understanding of capital market operations and market participants. And 
while an objective-based structure could be one way to promote 
consistent regulation of similar financial products and services, it is 
not the only way. Under our proposed approach, minimizing regulatory 
disparities for like products and services would be an express purpose 
of enhanced inter-agency coordination and information sharing efforts.
Selected Other Areas for Reform
    Recent experiences in the markets have underscored the need for the 
Capital Markets Regulator (or, until Congress creates such a new 
agency, the SEC) to have express authority to regulate in certain areas 
where there are currently gaps that have the potential to impact the 
capital markets and market participants, and to modernize regulation 
that has not kept pace with changes in the marketplace. \3\ ICI 
supports reforms for these purposes in the areas discussed below.
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     \3\ Although not necessitating legislative action, another area 
for reform is regulation of credit rating agencies. ICI has long 
supported increased regulatory oversight, disclosure, and transparency 
requirements for credit rating agencies. We strongly support recent 
regulatory initiatives that will impose additional disclosure, 
reporting, and recordkeeping requirements on a nationally recognized 
statistical ratings organization (NRSRO) for products that it rates. 
These requirements, which are intended to increase disclosure and 
transparency surrounding NRSRO policies and procedures for issuing 
ratings and to increase an NRSRO's accountability for its ratings, are 
a welcome step forward that should help to restore investor confidence 
in the integrity of credit ratings and, ultimately, the market as a 
whole. We expect to file a comment letter on the SEC's latest proposal 
to enhance NRSRO regulation at the end of this month.

    Hedge funds and other unregulated private pools of capital. 
        The Capital Markets Regulator should have the power to oversee 
        hedge funds and other unregulated pooled products with respect 
        to, at a minimum, their potential impact on the capital 
        markets. For example, the Capital Markets Regulator should 
        require nonpublic reporting of information, such as investment 
        positions and strategies, that could bear on systemic risk and 
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        adversely impact other market participants.

    Derivatives. The Capital Markets Regulator should have 
        clear authority to adopt measures to increase transparency and 
        reduce counterparty risk of certain over-the-counter 
        derivatives, while not unduly stifling innovation.

    Municipal Securities. The Capital Markets Regulator should 
        be granted expanded authority over the municipal securities 
        market, and should use this authority to ensure that investors 
        have timely access to relevant and reliable information about 
        municipal securities offerings. Currently, the SEC and the 
        Municipal Securities Rulemaking Board are prohibited from 
        requiring issuers of municipal securities to file disclosure 
        documents before the securities are sold. As a result, existing 
        disclosures are limited, non-standardized, and often stale, and 
        there are numerous disparities from the corporate issuer 
        disclosure regime.

    Investment Advisers and Broker-Dealers. The Capital Markets 
        Regulator should have explicit authority to harmonize the 
        regulatory regimes governing investment advisers and broker-
        dealers. What once were real distinctions in the businesses of 
        advisers and brokerdealers are no longer so clear, to the point 
        that retail investors are largely unable to distinguish the 
        services of an adviser from those of a broker-dealer. These two 
        types of financial intermediaries, and their customers and 
        clients, deserve a coherent regulatory structure that provides 
        adequate investor protections without overlapping or 
        unnecessary regulation. Of particular importance is devising a 
        consistent standard of care in which investor protection must 
        be paramount. The standard thus should be a high one. We 
        recommend that both types of intermediaries be held to a 
        fiduciary duty to their clients. \4\
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     \4\ See Securities and Exchange Commission v. Capital Gains 
Research Bureau, Inc., 375 U.S. 180, 84 S. Ct. 275 (1963) (holding that 
Section 206 of the Investment Advisers Act of 1940 imposes a fiduciary 
duty on investment advisers by operation of law).
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Recent Market Events and Money Market Funds
Evolution and Current Significance of Money Market Funds
    Money market funds are registered investment companies that seek to 
maintain a stable net asset value (NAV), typically $1.00 per share. 
They are comprehensively regulated under the Investment Company Act and 
subject to the special requirements of Rule 2a-7 under that Act that 
limit the funds' exposure to credit risk and market risk.
    These strong regulatory protections, administered by the SEC for 
nearly three decades, have made money market funds an effective cash 
management tool for retail and institutional investors. Indeed, money 
market funds represent one of the most notable product innovations in 
our nation's history, with assets that have grown more than 2,000 
percent (from about $180 billion to $3.9 trillion) since Rule 2a-7 was 
adopted in 1983. Money market fund assets thus represent about one 
third of an estimated $12 trillion U.S. ``money market,'' the term 
generally used to refer to the market for debt securities with a 
maturity of one year or less. \5\
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     \5\ Other participants in the money market include corporations, 
state and local governments, unregistered cash pools, commercial banks, 
broker-dealers, and pension funds.
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    Money market funds also are an exceptionally important source of 
short-term financing in the U.S. economy. They lower the cost of 
borrowing to the U.S. Treasury, businesses, and banks and finance 
companies by investing in a wide array of money market instruments. By 
way of example, money market funds hold roughly 40 percent of the 
commercial paper issued by U.S. corporations. In addition, tax-exempt 
money market funds are a significant source of funding for state and 
local governments. As of December 2008, these funds had $491 billion 
under management. Tax-exempt money market funds held more than 20 
percent of all state and local government debt outstanding.
    Money market funds seek to offer investors stability of principal, 
liquidity, and a market-based rate of return, all at a reasonable cost. 
Although there is no guarantee that money market funds can always 
achieve these objectives (and investors are explicitly warned of this), 
they have been highly successful in doing so. Since Rule 2a-7 was 
adopted over 25 years ago, $325 trillion has flowed in and out of money 
market funds. Yet only twice has a money market fund failed to repay 
the full principal amount of its shareholders' investments. One of 
these instances is directly related to recent market events and is 
discussed below. The other occurred in 1994, when a small institutional 
money market fund ``broke the buck'' because it had a large percentage 
of its assets in adjustable-rate securities that did not return to par 
at the time of an interest rate readjustment. Shareholders in that fund 
ultimately received $0.96 per share (representing a 4 percent loss of 
principal). In contrast, during roughly the same time period, nearly 
2,400 commercial banks and savings institutions have failed in the 
United States.
Impact of Recent Market Events
    Until September 2008, money market funds largely had weathered 
severe pressures in the fixed income market that had been striking 
banks and other financial services firms since 2007. \6\ That changed 
as a series of extraordinary events, in rapid succession, roiled 
financial markets both in the United States and around the globe:
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     \6\ During the period from September 2007 to September 2008, many 
money market fund advisers or related persons did purchase structured 
investment vehicles from, or enter into credit support arrangements 
with, their affiliated funds to avoid any fund shareholder losses.

    On September 7, the U.S. Government placed Fannie Mae and 
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        Freddie Mac intoreceivership, wiping out shareholder equity;

    Long-circulated rumors about the stability of Merrill 
        Lynch, AIG, and Lehman Brothers gained traction;

    Over the weekend of September 13-14, Merrill Lynch hastily 
        arranged to be sold to Bank of America;

    On September 15, the federal government declined to support 
        Lehman Brothers, despite having arranged a buyout of Bear 
        Stearns, a smaller investment bank, earlier in the year. Unable 
        to find a buyer, Lehman declared bankruptcy; and

    On September 16, the Federal Reserve Board announced a 
        bailout of AIG, in which the Federal Reserve Bank of New York 
        agreed to lend AIG up to $85 billion and to take a nearly 80 
        percent stake in the company.

    Beginning with news of the Lehman bankruptcy on Monday, September 
15, money markets in the U.S. and elsewhere began to freeze, with a 
severity that was unexpected. Although Lehman's viability had been 
questioned for several months, its failure--and that of Bear Stearns 
several months earlier--led to mounting concerns about the health of 
other financial institutions such as Wachovia, Citigroup, and many 
foreign banks. There was also growing uncertainty about whether and how 
the U.S. and foreign governments would support these institutions and 
their creditors.
    With investors running for cover, yields on Treasury securities 
fell, while those on commercial paper jumped. Inter-bank rates soared 
with the uncertainty about financial institutions' exposure to Lehman 
and other failing financial institutions. Governments around the globe, 
attempting to calm panicked markets, injected billions of dollars of 
liquidity into their markets. The U.S. stock market declined nearly 5 
percent on September 15 alone, reflecting broad losses to financial 
companies.
    Certainly the Federal Reserve seems to have been surprised by the 
market's reaction to this chain of events. Appearing before this 
Committee on September 23, 2008, Federal Reserve Chairman Ben Bernanke 
noted:

        The failure of Lehman posed risks. But the troubles at Lehman 
        had been well known for some time, and investors clearly 
        recognized--as evidenced, for example, by the high cost of 
        insuring Lehman's debt in the market for credit default swaps--
        that the failure of the firm was a significant possibility. 
        Thus, we judged that investors and counterparties had had time 
        to take precautionary measures. While perhaps manageable in 
        itself, Lehman's default was combined with the unexpectedly 
        rapid collapse of AIG, which together contributed to the 
        development last week of extraordinarily turbulent conditions 
        in global financial markets.

    Intense pressure in the money market was brought to bear, affecting 
all market participants. In the midst of this market storm, a further 
pressure point occurred for money market funds. The Lehman bankruptcy 
meant that securities and other instruments issued by Lehman became 
ineligible holdings for money market funds, in accordance with the 
requirements of Rule 2a-7. One such fund that held a substantial amount 
of Lehman Brothers commercial paper, the $62 billion Reserve Primary 
Fund, received $25 billion in redemption requests on September 15; the 
following day, September 16, its NAV dropped below $1.00 per share. 
News of this development, combined with investors' broader concerns 
about the building stresses in the money market and possible failures 
of other financial institutions, led to heavy redemptions in prime 
money market funds as investors sought safety and liquidity in Treasury 
securities. To meet these unprecedented redemption requests, many money 
market funds were forced to sell commercial paper and other assets. It 
should be emphasized that other market participants, including 
unregistered cash pools seeking to maintain a stable NAV but not 
subject to Rule 2a-7, and money market funds in other jurisdictions, 
experienced difficulties as least as great as those experienced by U.S. 
registered money market funds.
Actions by Federal Regulators To ``Unfreeze'' the Credit Markets
    The Federal Reserve and U.S. Treasury Department, seeking to cope 
with completely illiquid short-term fixed income markets, on September 
19 announced a series of unprecedented initiatives designed to provide 
market stability and liquidity, including programs designed to support 
money market funds and the commercial paper market. The Federal Reserve 
established the Asset-Backed Commercial Paper Money Market Mutual Fund 
Liquidity Facility (AMLF) and the Commercial Paper Funding Facility 
(CPFF). \7\ The Treasury Department announced its Temporary Guarantee 
Program for Money Market Funds, which guaranteed account balances as of 
September 19 in money market funds that signed up for, qualified for, 
and paid a premium to participate in the program. According to press 
reports, virtually all money market funds signed up for the initial 
term of the Treasury Temporary Guarantee Program.
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     \7\ The AMLF provided non-recourse loans at the primary credit 
rate to U.S. depository institutions and bank holding companies to 
finance purchases of high-quality asset-backed commercial paper (ABCP) 
from money market funds. The CPFF provided a backstop to U.S. issuers 
of commercial paper through a special purpose vehicle that would 
purchase three-month unsecured commercial paper and ABCP directly from 
eligible issuers. On February 3, 2009, the Federal Reserve extended 
these and other programs for an additional six months, until October 
30, 2009.
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    The government's programs successfully bolstered investor 
confidence in the money market and in money market funds. Shortly after 
the programs were announced, prime money market funds stabilized and, 
by mid-October 2008, began to see inflows once again. By February 2009, 
owing to renewed confidence in money market funds at both the retail 
and institutional levels, assets of money market funds had achieved an 
all-time high of just less than $3.9 trillion.
    The initial three-month term of the Treasury Temporary Guarantee 
Program expired on December 18, 2008, but the Treasury Department 
extended the program until April 30, 2009. If extended again, the 
program will expire by its own terms no later than September 18, 2009. 
At the time of this hearing, an estimated $813 million has been paid in 
premiums. \8\ There has been--and we are hopeful that there will be--no 
occasion for the Treasury Guarantee Program to pay any claim. Assuming 
continued progress in restoring the health of the money market, we 
would not anticipate any need to extend the Treasury Guarantee Program 
beyond the one-year maximum period.
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     \8\ See Shefali Anand, ``Treasury Pads Coffers in Bailout,'' The 
Wall Street Journal (February 17, 2009), available at http://
online.wsj.com/article/SB123483112001495707.html
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Industry-Led Reform Initiative
    The market events described above have brought into sharp focus the 
significance of money market funds and the critical role they play as a 
low-cost funding vehicle for the American economy. To us, these events 
and their impact also signaled a need to devote serious effort to 
capturing the lessons learned--by conducting a thorough examination of 
how the money market can function better, and how all funds operating 
in that market, including registered money market funds, should be 
regulated.
    To that end, in November 2008 ICI formed a Money Market Working 
Group, led by John J. Brennan, Chairman of The Vanguard Group. The 
Working Group was given a broad mandate to develop recommendations to 
improve the functioning of the money market as a whole, and the 
operation and regulation of funds investing in that market. The Working 
Group intends to report its findings, conclusions, and recommendations 
later this month, and we look forward to sharing that information with 
the Committee at that time. We believe that prompt implementation of 
the Working Group's recommendations will help assure a smooth 
transition away from the Treasury Guarantee Program.
Conclusion
    ICI applauds the Committee for its diligent efforts on the very 
important issues discussed above, and we thank you for the opportunity 
to testify. We believe our recommendations for reforming financial 
services regulation would have significant benefits for investors and 
the capital markets. We look forward to continuing to work with the 
Committee and its staff on these matters.
APPENDIX A
Investment Company Institute Financial Services Regulatory Reform: 
        Discussion and Recommendations--March 3, 2009
EXECUTIVE SUMMARY
    Today's financial crisis has demonstrated that the current system 
for oversight of U.S. financial institutions is insufficient to address 
modern financial markets. Yet it also affords policymakers with the 
public mandate necessary to take bold steps to strengthen and modernize 
regulatory oversight of the financial services industry. In this paper, 
the Investment Company Institute (ICI), the national association of 
U.S. investment companies, offers its recommendations on how to achieve 
meaningful reforms, with particular emphasis on those reforms that most 
directly affect the functioning of the capital markets and the 
regulation of investment companies (also referred to as ``funds'').
    To improve the U.S. government's capability to monitor and mitigate 
risks across our nation's financial system, ICI supports the 
designation of a new or existing agency or inter-agency body as a 
``Systemic Risk Regulator.'' As the financial crisis has shown, our 
system is vulnerable to risks that have the potential to spread rapidly 
throughout the system and cause significant damage. The Systemic Risk 
Regulator should have responsibility for: (1) monitoring the financial 
markets broadly; (2) analyzing changing conditions in domestic and 
overseas markets; (3) evaluating the risks of practices as they evolve 
and identifying those that are of such nature and extent that they 
implicate the health of the financial system at large; and (4) acting 
to mitigate such risks in coordination with other responsible 
regulators. At the same time, very careful consideration should be 
given to the specifics of how the Systemic Risk Regulator will be 
authorized to perform its functions and how it will relate to other 
financial regulators.
    More broadly, ICI recommends changes to create a regulatory 
framework that enhances regulatory efficiency, limits duplication, 
closes regulatory gaps, and emphasizes the national character of the 
financial services industry. A new ``Capital Markets Regulator'' should 
encompass the combined functions of the Securities and Exchange 
Commission and the Commodity Futures Trading Commission, thus creating 
a single independent federal regulator responsible for oversight of 
U.S. capital markets, market participants, and all financial investment 
products. Also to achieve these goals, ICI recommends that Congress 
consider consolidation of the regulatory structure for the banking 
sector and authorization of an optional federal charter for insurance 
companies. Such a regulatory framework--with one or more dedicated 
regulators to oversee each major financial services sector--would 
maintain specialized regulatory focus and expertise, as well as avoid 
the potential for one industry sector to take precedence over the 
others in terms of regulatory priorities or the allocation of 
resources.
    To preserve regulatory efficiencies achieved under the National 
Securities Markets Improvement Act of 1996, Congress should affirm the 
role of the Capital Markets Regulator as the regulatory standard setter 
for all registered investment companies. The Capital Markets 
Regulator's jurisdiction should include money market funds. \1\ ICI 
further envisions the Capital Markets Regulator as the first line of 
defense with respect to risks across the capital markets. The new 
agency should be granted explicit authority to regulate in certain 
areas where there are currently gaps in regulation--in particular, with 
regard to hedge funds, derivatives, and municipal securities--and 
explicit authority to harmonize the legal standards applicable to 
investment advisers and broker-dealers. In performing its mission, the 
Capital Markets Regulator should maintain a sharp focus on investor 
protection and law enforcement. It also should be required to carefully 
consider the impact of its rulemaking activity on efficiency, 
competition and capital formation.
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     \1\ ICI has formed a Money Market Working Group that is developing 
recommendations to improve the functioning of the money market and the 
operation and regulation of funds investing in that market. The group 
will identify needed improvements in market and industry practices; 
regulatory reforms, including improvements to SEC rules governing money 
market funds; and possibly legislative proposals. The Working Group 
expects to report its recommendations in the first quarter of 2009.
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    Establishing the Capital Markets Regulator presents a very valuable 
opportunity to ``get it right'' in terms of how the agency is organized 
and managed. It is imperative, for example, that the Capital Markets 
Regulator be able to keep current with market and industry developments 
and understand their impact on regulatory policy. Ways to achieve this 
end include hiring more agency staff with significant prior industry 
experience and establishing a multidisciplinary ``Capital Markets 
Advisory Committee'' comprised of private sector representatives from 
all major sectors of the capital markets. There should be a high-level 
focus on agency management, perhaps through the designation of a Chief 
Operating Officer. To perform effectively, the agency must have open 
and effective lines of internal communication, and mechanisms to 
facilitate internal coordination and information sharing. We further 
suggest that the agency would benefit from a comprehensive process for 
setting regulatory priorities and assessing progress.
    Finally, if a new U.S. financial regulatory structure is to be 
successful in protecting the interests of our nation's savers and 
investors, there is a critical need for effective coordination and 
information sharing among the financial regulators, including in 
particular the Systemic Risk Regulator. Stronger links between 
regulators and an overriding sense of shared purpose would greatly 
assist in sound policy development, prioritization of effort, and 
cooperation with the international regulatory community. ICI observes 
that the President's Working Group on Financial Markets, with certain 
modifications, may be the most logical mechanism through which to 
accomplish this purpose.
    We strongly believe that the future of the fund industry depends 
upon the existence of strong, wellregulated financial institutions 
operating within a well-regulated financial marketplace that will 
promote investor confidence, attract global financial business, and 
enable our institutions to compete more effectively. ICI looks forward 
to working with other stakeholders and policymakers to strengthen the 
U.S. financial services regulatory system and to improve its ability to 
meet new challenges posed by the continuing evolution of the financial 
markets, market participants, and financial products.
Introduction
    Well before mainstream Americans felt the widespread effects of the 
current financial crisis, many policymakers and commentators were 
calling for financial services regulatory reform. \2\ These efforts 
reflected general agreement that our current organization for oversight 
of financial institutions is insufficient to address modern financial 
markets. Recent market events have served to put into much sharper 
focus the many weaknesses of the current system and the many important 
linkages that exist between and among the U.S. financial markets and 
the markets of other developed nations.
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     \2\ See, e.g., The Department of the Treasury Blueprint for a 
Modernized Financial Regulatory Structure (March 2008) (``Treasury 
Blueprint''), available at http://www.treas.gov/press/releases/reports/
Blueprint.pdf; Report and Recommendations: Commission on the Regulation 
of U.S. Capital Markets in the 21st Century, U.S. Chamber of Commerce 
(March 2007), available at http://www.capitalmarketscommission.com/
portal/capmarkets/default.htm; Sustaining New York's and the US' Global 
Financial Services Leadership (report by McKinsey & Co., Jan. 2007), at 
http://www.senate.gov/schumer/SchumerWebsite/pressroom/special_reports/
2007/NY_REPORT%20_FINAL.pdf; Interim Report of the Committee on Capital 
Markets Regulation (Nov. 30, 2006), available on the Committee's Web 
site at http://www.capmktsreg.org/research.html
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    Yet the current financial crisis also offers an important 
opportunity--the chance to have a frank and robust public dialogue 
about what works and what does not. It further affords policymakers 
with the public mandate necessary to take bold steps to strengthen and 
modernize regulatory oversight of the financial services industry.
    The debate over financial services regulatory reform will require 
careful consideration of a multitude of complicated and interconnected 
issues, and there are many stakeholders in the eventual outcomes of 
this debate--most importantly, the nation's savers and investors. In 
this paper, the Investment Company Institute (ICI), the national 
association of U.S. investment companies, \3\ offers its 
recommendations on how to achieve meaningful reform of financial 
services regulation. We give particular emphasis to reforms that most 
directly affect the functioning of the capital markets and the 
regulation of investment companies (also referred to as ``funds'').
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     \3\ ICI members include mutual funds, closed-end funds, exchange-
traded funds (ETFs) and unit investment trusts (UITs).
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    Investment companies have a unique perspective on our regulatory 
system, as both issuers of securities and investors in domestic and 
international securities markets. It has been our experience that, in 
large measure, the needs of issuers and investors are aligned--that 
both will benefit from broad and efficient markets, transparency of 
information, strong investor protections, and within that context, the 
elimination of unnecessary regulatory impediments to innovation.
    We strongly believe that the future of our industry depends upon 
the existence of strong, well-regulated financial institutions 
operating within a well-regulated financial marketplace that will 
promote investor confidence, attract global financial business and 
enable our institutions to compete more effectively. The reforms 
suggested in this paper should help to build and foster such a 
financial system.
    Our recommendations and the benefits they are designed to achieve 
are summarized in Section II below. We elaborate on our recommendations 
in Section III (Establishment of a Systemic Risk Regulator), Section IV 
(Formation of a New Capital Markets Regulator), Section V (Regulatory 
Structure Affecting Other Financial Institutions), and Section VI 
(Enhanced Inter-agency Coordination and Information Sharing). In 
Section VII, we discuss in detail the expected benefits from these 
reforms.
    A host of different reform proposals are being advanced--by the new 
Administration, members of Congress, industry groups, academics, and 
others. ICI will closely follow these developments and participate in 
this debate on behalf of the fund industry. We also may refine as 
appropriate the views expressed in this paper.
Summary of Recommendations and Expected Benefits
Recommendations for Reform
    ICI recommends that Congress:

    Designate a new or existing agency or inter-agency body to 
        act as a Systemic Risk Regulator.

    Establish a new Capital Markets Regulator encompassing the 
        combined functions of the Securities and Exchange Commission 
        and the Commodity Futures Trading Commission. The Capital 
        Markets Regulator should:

        be the regulatory standard setter for all registered 
        investment companies, including money market funds;

        have explicit authority to regulate in certain areas 
        where there are currently gaps in regulation and to harmonize 
        the legal standards that apply to investment advisers and 
        broker-dealers;

        maintain a sharp focus on investor protection and law 
        enforcement;

        carefully consider as well the impact of its rulemaking 
        activity on efficiency, competition and capital formation;

        serve as the first line of defense with respect to 
        risks across the capital markets as a whole; and

        take proactive steps to maximize its continuing 
        effectiveness, including: establishing the conditions necessary 
        for ongoing dialogue with the regulated industry; establishing 
        mechanisms to stay abreast of market/industry developments; and 
        developing strong capability to conduct economic analysis to 
        support sound rulemaking and oversight.

    Consider consolidation of the regulatory structure for the 
        banking sector.

    Authorize an optional federal charter for insurance 
        companies.

    Enhance inter-agency coordination and information sharing 
        efforts, including by modernizing the Executive Order 
        authorizing the President's Working Group on Financial Markets.
Expected Benefits of These Reforms
    ICI believes the principal benefits of these reforms would be to:

    Improve the U.S. government's capability to monitor and 
        mitigate risks across our nation's financial system.

    Create a regulatory framework that enhances regulatory 
        efficiency, limits duplication, and emphasizes the national 
        character of the financial services industry.

    Close regulatory gaps to ensure appropriate oversight of 
        all market participants and investment products.

    Preserve specialized regulatory focus and expertise and 
        avoid potential uneven attention to different industries or 
        products.

    Foster a culture of close consultation and dialogue among 
        U.S. financial regulators to facilitate collaboration on issues 
        of common concern.

    Facilitate coordinated interaction with regulators in other 
        jurisdictions, including with regard to risks affecting global 
        capital markets.
Establishment of a Systemic Risk Regulator
    Over the past year, various policymakers and other commentators 
have called for the establishment of a formal mechanism for 
identifying, monitoring, and managing risks to the financial system as 
a whole. For example, in a March 2008 speech, House Financial Services 
Committee Chairman Barney Frank (D-MA) recommended that Congress 
consider establishing a ``Financial Services Systemic Risk Regulator'' 
that has the capacity and power to assess risk across financial markets 
and to intervene when appropriate. \4\ Around the same time, then-
Senator Barack Obama highlighted the need for a process that identifies 
systemic risks to the financial system. \5\
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     \4\ See Frank Calls for Significant Changes in Financial Services 
Regulation, Press Release (March 20, 2008), available at http://
financialservices.house.gov/press110/press0320082.shtml. Likewise, the 
Treasury Blueprint issued shortly thereafter suggested that an optimal 
regulatory structure would include the designation of a market 
stability regulator responsible for overall issues of financial market 
stability.
     \5\ See Remarks of Senator Barack Obama: Renewing the American 
Economy, New York, NY (March 27, 2008), available at http://
www.barackobama.com/2008/03/27/remarks_of_senator_barack_obam_54.php
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    The deepening financial crisis has further exposed the 
vulnerability of our financial system to risks that have the potential 
to spread rapidly throughout the system and cause significant damage. 
It has led to a growing consensus that bold steps are needed to equip 
regulators to better anticipate and address such risks. Analyses of the 
causes of the current crisis suggest that systemic risks may be 
occasioned by, for example: (1) excessive leveraging by financial 
institutions; (2) a lack of transparency regarding risky practices; and 
(3) institutions or activities that fall through gaps in the regulatory 
framework. Systemic risks--whether they are attributable to excessive 
risk taking by some market participants or to other causes--can 
negatively impact investment companies, thereby making it more 
difficult for their shareholders to achieve important financial goals.
    Subject to important cautions, ICI supports the designation of a 
new or existing agency or inter-agency body as a ``Systemic Risk 
Regulator.'' Broadly stated, the goal in establishing a Systemic Risk 
Regulator should be to provide greater overall stability to the 
financial system as a whole. The Systemic Risk Regulator should have 
responsibility for: (1) monitoring the financial markets broadly; (2) 
analyzing changing conditions in domestic and overseas markets; (3) 
evaluating the risks of practices as they evolve and identifying those 
that are of such nature and extent that they implicate the health of 
the financial system at large; and (4) acting to mitigate such risks in 
coordination with other responsible regulators.
    Very careful consideration must be given to the specifics of how 
the Systemic Risk Regulator will be authorized to perform its 
functions. In particular, the legislation establishing the Systemic 
Risk Regulator should be crafted to avoid imposing undue constraints or 
inapposite forms of regulation on normally functioning elements of the 
financial system, or stifling innovations, competition or efficiencies. 
By way of example, it has been suggested that a Systemic Risk Regulator 
could be given the authority to identify financial institutions that 
are ``systemically significant'' and to oversee those institutions 
directly. Despite its seeming appeal, such an approach could have very 
serious anticompetitive effects if the identified institutions were 
viewed as ``too big to fail'' and thus judged by the marketplace as 
safer bets than their smaller, ``less significant'' competitors. \6\
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     \6\ See, e.g., Peter J. Wallison, Regulation Without Reason: The 
Group of Thirty Report, AEI Financial Services Outlook (Jan. 2009), 
available at http://www.aei.org/publications/pubID.29285/pub_detail.asp
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    Additionally, the Systemic Risk Regulator should not be structured 
to simply add another layer of bureaucracy or to displace the primary 
regulator(s) responsible for capital markets, banking or insurance. 
Legislation establishing the Systemic Risk Regulator thus should define 
the nature of the relationship between this new regulator and the 
primary regulator(s) for each industry sector. This should involve 
placing explicit limitations on the extent of the authority granted to 
the Systemic Risk Regulator, as well as identifying specific areas in 
which the Systemic Risk Regulator and primary regulator(s) should work 
together. We believe, for example, that the primary regulators have a 
critical role to play by acting as the first line of defense with 
regard to detecting potential risks within their spheres of expertise.
    How these issues are resolved will have a very real impact on 
registered investment companies, as both issuers and investors in the 
capital markets. Money market funds, for example, are comprehensively 
regulated under the Investment Company Act of 1940 and subject to 
special requirements that limit the fund's exposure to credit risk and 
market risk. \7\ These strong regulatory protections, administered by 
the SEC for nearly three decades, have made money market funds an 
effective cash management tool for retail and institutional investors 
and an important source of short-term financing for American business 
and municipalities. Given the size of this industry segment \8\ and its 
important role in our nation's money markets, money market funds are 
likely to be on the radar screen of the Systemic Risk Regulator as it 
monitors the financial markets. The type of information about money 
market funds that the Systemic Risk Regulator may need to perform this 
function, and how the regulator will obtain that information, are just 
two of the specific issues that will need to be carefully considered. 
As a threshold matter, however, ICI firmly believes that regulation and 
oversight of money market funds must be the province of the Capital 
Markets Regulator.
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     \7\ The term ``credit risk'' refers to the exposure of securities, 
through default or otherwise, to risks associated with the 
creditworthiness of the issuer. The term ``market risk'' refers to the 
exposure of securities to significant changes in value due to changes 
in prevailing interest rates.
     \8\ Money market funds had assets of approximately $3.9 trillion 
under management as of February 2009.
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    ICI will closely follow the debate over the establishment of a 
Systemic Risk Regulator, and will inform policymakers as to the fund 
industry's views of future proposals.
Formation of a New Capital Markets Regulator
    Currently, securities and futures are subject to separate 
regulatory regimes under different federal regulators. This system 
reflects historical circumstances that have changed significantly. As 
recently as the mid-1970s, for example, agricultural products accounted 
for most of the total U.S. futures exchange trading volume. By the late 
1980s, a shift from the predominance of agricultural products to 
financial instruments and currencies was readily apparent in the volume 
of trading on U.S. futures exchanges. In addition, as new, innovative 
financial instruments were developed, the lines between securities and 
futures often became blurred. The existing, divided regulatory approach 
has resulted in jurisdictional disputes, regulatory inefficiency, and 
gaps in investor protection. With the increasing convergence of 
securities and futures products, markets, and market participants, the 
current system makes little sense. To bring a consistent policy focus 
to U.S. capital markets, we recommend the creation of a Capital Markets 
Regulator as a new agency that would encompass the combined functions 
of the SEC and the CFTC.
    As the federal regulator responsible for overseeing all financial 
investment products, it is imperative that the Capital Markets 
Regulator--like the SEC and the CFTC--be established by Congress as an 
independent agency, with an express statutory mission and the 
rulemaking and enforcement powers necessary to carry out that mission. 
\9\ A critical part of that mission should be for the new agency to 
maintain a sharp focus on investor protection and law enforcement. And 
Congress should ensure that the agency is given the resources it needs 
to fulfill its mission. Most notably, the Capital Markets Regulator 
must have the ability to attract personnel with the necessary market 
experience to fully grasp the complexities of today's global 
marketplace.
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     \9\ Currently, regulatory oversight of both the securities and 
futures industries involves various self-regulatory organizations. In 
establishing the Capital Markets Regulator, Congress will need to 
determine the appropriate role for any such organization(s).
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Scope of Authority
    ICI recommends that the Capital Markets Regulator assume on an 
integrated basis the responsibilities currently handled by the SEC and 
the CFTC. For the SEC, those functions include requiring public 
companies to disclose financial and other information to the public; 
overseeing various market participants, including securities exchanges, 
broker-dealers, investment advisers, and investment companies; and 
enforcing the securities laws. The SEC also oversees the setting of 
accounting standards for public companies. For its part, the CFTC 
regulates the commodity futures and option markets. It oversees various 
entities including exchanges, clearing facilities, and market 
participants such as futures commission merchants, commodity pool 
operators, and commodity trading advisors. Through its oversight and 
enforcement powers, it seeks to protect market users and the public 
from fraud, manipulation, and abusive practices.
    Of particular importance to the fund industry is to ensure that the 
Capital Markets Regulator is authorized: (1) to act as the regulatory 
standard setter for all registered investment companies, as is the case 
now with the SEC; (2) to regulate in certain areas where there are 
currently gaps that have the potential to impact the capital markets 
and market participants; and (3) to regulate broker-dealers and 
investment advisers in a consistent manner when they provide similar 
services to investors.
    1. Regulation of Registered Investment Companies: In creating the 
new regulator, Congress should take note of the important benefits that 
have flowed from the shared system of federal-state oversight 
established by the National Securities Markets Improvement Act of 1996 
(NSMIA). Under this system, federal law governs all substantive 
regulation of investment companies and states have concurrent authority 
to protect against fraud. NSMIA represented the judgment of Congress 
that ``the system of dual federal and state securities regulation ha[d] 
resulted in a degree of duplicative and unnecessary regulation . . . 
that, in many instances, [was] redundant, costly, and ineffective.'' 
\10\ In recognition of the national character of the market in which 
investment companies operate, and to secure the regulatory efficiencies 
Congress intended, Congress should affirm the role of the Capital 
Markets Regulator as the regulatory standard setter for registered 
investment companies. The Capital Markets Regulator's regulatory 
jurisdiction should include the authority to regulate money market 
funds. \11\
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     \10\ Joint Explanatory Statement of the Committee of Conference, 
Conference Report--National Securities Markets Improvement Act of 1996, 
H.R. 3005, H.R. Conf. Rep. No. 104-864 (1996).
     \11\ ICI has formed a Money Market Working Group that is 
developing recommendations to improve the functioning of the money 
market and the operation and regulation of funds investing in that 
market. The group will identify needed improvements in market and 
industry practices; regulatory reforms, including improvements to SEC 
rules governing money market funds; and possibly legislative proposals. 
The Working Group expects to report its recommendations in the first 
quarter of 2009.
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    2. Regulatory Gaps: The Capital Markets Regulator should have 
express regulatory authority in the following areas:

    Hedge funds and other unregulated private pools of capital. 
        The Capital Markets Regulator should be authorized to provide 
        oversight over hedge funds and other unregulated pooled 
        products with respect to, at a minimum, their potential impact 
        on the capital markets (e.g., require nonpublic reporting of 
        information such as investment positions and strategies that 
        could bear on systemic risk and adversely impact other market 
        participants).

    Derivatives. The Capital Markets Regulator should have 
        clear authority to adopt measures to increase transparency and 
        reduce counterparty risk of certain over-the-counter 
        derivatives, while not unduly stifling innovation.

    Municipal Securities. The Capital Markets Regulator should 
        be granted expanded authority over the municipal securities 
        market, and use this authority to ensure that investors have 
        timely access to relevant and reliable information about 
        municipal securities offerings. Currently, the SEC and the 
        Municipal Securities Rulemaking Board are prohibited from 
        requiring issuers of municipal securities to file disclosure 
        documents before the securities are sold. As a result, existing 
        disclosures are limited, non-standardized and often stale, and 
        there are numerous disparities from the corporate issuer 
        disclosure regime.

    3. Regulation of Investment Advisers and Broker-Dealers: The 
Capital Markets Regulator also should have explicit authority to 
harmonize the regulatory regimes governing investment advisers and 
broker-dealers. What once were real distinctions in the businesses of 
advisers and broker-dealers are no longer so clear, to the point that 
retail investors are largely unable to distinguish the services of an 
adviser from those of a broker-dealer. These two types of financial 
intermediaries, and their customers and clients, deserve a coherent 
regulatory structure that provides adequate investor protections--
including, in particular, a consistent standard of care--without 
overlapping or unnecessary regulation.
Mission
    The SEC describes its mission as ``to protect investors, maintain 
fair, orderly and efficient markets, and facilitate capital 
formation.'' For its part, the CFTC states that its mission is ``to 
protect market users and the public from fraud, manipulation and 
abusive practices related to the sale of commodity and financial 
futures and options, and to foster open, competitive, and financially 
sound futures and options markets.'' The differing focus expressed in 
these two mission statements is reflective of historical distinctions 
in the securities and futures industries, including with regard to the 
purposes of their respective markets and the participants in those 
markets. As growing convergence within these two industries suggests 
the creation of a unified regulator for the capital markets, it is 
important to consider how the mission statement for the new regulator 
can best reflect this convergence.
    From the perspective of the fund industry, the mission of the 
Capital Markets Regulator must involve maintaining a sharp focus on 
investor protection, supported by a comprehensive enforcement program. 
This core feature of the SEC's mission has consistently distinguished 
the agency from the banking regulators, who are principally concerned 
with the safety and soundness of the financial institutions they 
regulate, and it has generally served investors well over the years.
    At the same time, the SEC is required by NSMIA to consider, in 
determining whether a proposed regulation is consistent with the public 
interest, both the protection of investors and whether the regulation 
would promote efficiency, competition and capital formation. This NSMIA 
requirement suggests that Congress did not view investor protection and 
efficiency, competition, and capital formation as being competing 
considerations, but rather determined that each is relevant to the 
development of sound capital markets regulation. We strongly believe 
that the Capital Markets Regulator should be subject to the same 
requirements. \12\ Investors are not well served, for example, by 
rulemaking actions that create significant inefficiencies or have anti-
competitive effects in the marketplace, which ultimately result in 
increased costs for investors.
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     \12\ Curiously, the SEC's description of its own mission (see 
http://www.sec.gov/about/whatwedo.shtml) omits any reference to 
promoting competition--notwithstanding the specific requirement under 
NSMIA to consider this factor.
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    Combining the market-related missions of the SEC and CFTC should be 
more straightforward. Generally speaking, each agency is called upon to 
maintain the integrity of the markets under its jurisdiction. The same 
must be true for the new Capital Markets Regulator. As the ongoing 
financial crisis demonstrates, it is imperative that the task of 
maintaining market integrity be viewed broadly to include monitoring 
and addressing risks across the markets as a whole. Formally assigning 
some level of responsibility to the Capital Markets Regulator in this 
area makes sense. Given its expertise and its position as the primary 
regulator of these markets, the Capital Markets Regulator can serve as 
the first line of defense with regard to detecting problems in the 
capital markets. While this approach could result in some potential 
overlap with the responsibilities of the Systemic Risk Regulator, we 
believe that any inefficiencies may be minimized through effective 
coordination and information sharing.
Agency Management and Organization
    It is axiomatic in the private sector that a company's success is 
directly related to the soundness of its management. The same principle 
holds true for public sector entities. But management improvements take 
time and serious attention, not to mention allocation of resources. 
Given that they often experience frequent turnovers in leadership and 
strained resources, it is not surprising that government agencies can 
find it particularly difficult to undertake and sustain significant 
management reforms. Establishing a new agency presents a very valuable 
opportunity to ``get it right'' as part of that process.
    There is also an opportunity to make sound decisions up-front about 
how to organize the new agency. In so doing, it is important not to 
simply use the current structure of the SEC and/or the CFTC as a 
starting point. In the case of the SEC, for example, its current 
organizational structure largely took shape in the early 1970s and 
reflects the operation of the securities markets of that day. Rather, 
the objective should be to build an organization that not only is more 
reflective of today's markets, market participants and investment 
products, but also will be flexible enough to regulate the markets and 
products of tomorrow.
    We offer the following thoughts with regard to management and 
organization of the Capital Markets Regulator:

    Ensure high-level focus on agency management. One approach 
        would be to designate a Chief Operating Officer for this 
        purpose.

    Implement a comprehensive process for setting regulatory 
        priorities and assessing progress. It may be helpful to draw 
        upon the experience of the United Kingdom's Financial Services 
        Authority, which seeks to follow a methodical approach that 
        includes developing a detailed annual business plan 
        establishing agency priorities and then reporting annually the 
        agency's progress in meeting prescribed benchmarks.

    Promote open and effective lines of communication among the 
        regulator's Commissioners and between its Commissioners and 
        staff. Such communication is critical to fostering awareness of 
        issues and problems as they arise, thus increasing the 
        likelihood that the regulator will be able to act promptly and 
        effectively. A range of approaches may be appropriate to 
        consider in meeting this goal, including whether sufficient 
        flexibility is provided under the Government in the Sunshine 
        Act, and whether the number of Commissioners should be greater 
        than the current number at the SEC and at the CFTC (currently, 
        each agency has five).

    Align the inspections and examinations functions and the 
        policymaking divisions. This approach would have the benefit of 
        keeping staff in the policymaking divisions updated on current 
        market and industry developments, as well as precluding any de 
        facto rulemaking by the regulator's inspections staff.

    Develop mechanisms to facilitate coordination and 
        information sharing among the policymaking divisions. These 
        mechanisms would help to ensure that the regulator speaks with 
        one voice.
Additional Steps To Maximize Effectiveness
    ICI believes that the following proactive steps will greatly 
enhance the ability of the Capital Markets Regulator to fulfill its 
mission successfully when carrying out its regulatory responsibilities 
and should be priorities for the new agency.
    1. Establish the conditions necessary for constructive, ongoing 
dialogue with the regulated industry: The Capital Markets Regulator 
should seek to facilitate closer, cooperative interaction with the 
entities it regulates to identify and resolve problems, to determine 
the impact of problems or practices on investors and the market, and to 
cooperatively develop best practices that can be shared broadly with 
market participants. Incorporating a more preventative approach would 
likely encourage firms to step forward with self-identified problems 
and proposed resolutions. The net result is that the Capital Markets 
Regulator would pursue its investor protection responsibilities through 
various means not always involving enforcement measures, although 
strong enforcement must remain an important weapon in the regulator's 
arsenal.
    2. Establish mechanisms to stay abreast of market and industry 
developments: The Capital Markets Regulator would benefit from the 
establishment of one or more external mechanisms designed to help the 
agency stay abreast of market and industry issues and developments, 
including developments and practices in non-U.S. jurisdictions as 
appropriate. For example, several federal agencies--including both the 
SEC and CFTC--utilize a range of advisory committees. Such committees, 
which generally have significant private sector representation, may be 
established to provide recommendations on a discrete set of issues 
facing the agency (e.g., the SEC's Advisory Committee on Improvements 
to Financial Reporting) or to provide regular information and guidance 
to the agency (e.g., the CFTC's Agricultural Advisory Committee).
    ICI believes that a multidisciplinary ``Capital Markets Advisory 
Committee'' could be a very effective mechanism for providing the 
Capital Markets Regulator with ``real world'' perspectives and insights 
on an ongoing basis. We recommend that such a committee be comprised 
primarily of private sector representatives from all major sectors of 
the capital markets, and include one or more members representing funds 
and asset managers. Additionally, the Capital Markets Advisory 
Committee should be specifically established in, and required by, the 
legislation creating the Capital Markets Regulator. Such a statutory 
mandate would emphasize the importance of this advisory committee to 
the agency's successful fulfillment of its mission.
    The establishment of an advisory committee would complement other 
efforts by the Capital Markets Regulator to monitor developments 
affecting the capital markets and market participants. These efforts 
should include, first and foremost, hiring more staff members with 
significant prior industry experience. Their practical perspective 
would enhance the agency's ability to keep current with market and 
industry developments and better understand the impact of such 
developments on regulatory policy.
    3. Apply reasonably comparable regulation to like products and 
services: Different investment products often are subject to different 
regulatory requirements, often with good reason. At times, however, 
heavier regulatory burdens have been placed on funds than on other 
investment products that share similar features and are sold to the 
same customer base. It does not serve investors well if the regulatory 
requirements placed on funds--however well-intentioned--end up 
discouraging investment advisers from entering or remaining in the fund 
business, dissuading portfolio managers from managing funds as opposed 
to other investment products, or creating disincentives for brokers and 
other intermediaries to sell fund shares. It is critically important 
for the Capital Markets Regulator to be sensitive to this dynamic in 
its rulemakings. Among other things, in analyzing potential new 
regulatory requirements for funds, the Capital Markets Regulator should 
consider whether other investment products raise similar policy 
concerns and thus should be subject to comparable requirements.
    4. Develop strong capability to conduct economic analysis to 
support sound rulemaking and oversight: The Capital Markets Regulator 
will be best positioned to accomplish its mission if it conducts 
economic analysis in various aspects of the agency's work, including 
rulemaking, examinations, and enforcement. Building strong economic 
research and analytical capabilities is an important way to enhance the 
mix of disciplines that will inform the agency's activities. From 
helping the agency look at broad trends that shed light on how markets 
or individual firms are operating to enabling it to demonstrate that 
specific policy initiatives are well-grounded, developing the agency's 
capability to conduct economic analysis will be well worth the long-
term effort required. The agency should consider having economists 
resident in each division to bring additional, important perspectives 
to bear on regulatory challenges.
    It is important that economic analysis play an integral role in the 
rulemaking process, because many regulatory costs ultimately are borne 
by investors. When new regulations are required, or existing 
regulations are amended, the Capital Markets Regulator should 
thoroughly examine all possible options and choose the alternative that 
reflects the best trade-off between costs to, and benefits for, 
investors. Effective cost-benefit analysis does not mean compromising 
protections for investors or the capital markets. Rather, it challenges 
the regulator to consider alternative proposals and think creatively to 
achieve appropriate protections while minimizing regulatory burdens, or 
to demonstrate that a proposal's costs and burdens are justified in 
light of the nature and extent of the benefits that will be achieved. 
\13\
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     \13\ See, e.g., Special Report on Regulatory Reform, Congressional 
Oversight Panel (submitted under Section 125(b)(2) of Title I of the 
Emergency Economic Stabilization Act of 2008) (Jan. 2009) (``In 
tailoring regulatory responses . . . the goal should always be to 
strike a reasonable balance between the costs of regulation and its 
benefits. Just as speed limits are more stringent on busy city streets 
than on open highways, financial regulation should be strictest where 
the threats--especially the threats to other citizens--are greatest, 
and it should be more moderate elsewhere.'').
---------------------------------------------------------------------------
    5. Modernize regulations that no longer reflect current market 
structures and practices: Financial markets and related services are 
constantly evolving, frequently at a pace that can make the regulations 
governing them (or the rationale behind those regulations) become less 
than optimal, if not entirely obsolete. Requiring industry participants 
to comply with outmoded regulations imposes unnecessary costs on both 
firms and investors, may impede innovation, and, most troubling of all, 
could result in inadequate protection of investors. It is thus 
important that the Capital Markets Regulator engage in periodic reviews 
of its existing regulations to determine whether any such regulations 
should be modernized or eliminated.
    6. Give heightened attention to investor education: During the 
course of their lives, investors are called upon to make a variety of 
investment decisions as their personal circumstances change. These 
decisions may involve saving to buy a home or to finance a child's 
education, building an adequate nest egg for retirement, or investing 
an inheritance, to name a few. Whether they make their investment 
decisions individually or with the help of a financial adviser, 
investors need to be able to make informed decisions based upon their 
individual needs.
    The recent turmoil in the financial markets has underscored how 
important it is that investors be knowledgeable and understand their 
investments. Well-informed investors are more likely to develop 
realistic expectations, take a long-term perspective, and understand 
the trade-off between risk and reward. They are less likely to panic 
and make mistakes.
    To better equip investors to make good decisions about their 
investments, the Capital Markets Regulator should assign a high 
priority to pursuing regulatory initiatives that will help educate 
investors. The SEC's new rule allowing mutual funds and exchange-traded 
funds to provide a ``summary prospectus'' containing key fund 
information to investors--while making additional information available 
online or by mail or e-mail upon request--is an excellent example of a 
forward thinking approach to better informing investors. It should 
serve as a model for future disclosure improvement efforts, such as 
reform of fund shareholder reports. Regulatory efforts to promote 
investor education also should extend beyond funds. Investors who 
purchase other types of investment products or services, such as 
separately managed accounts, likewise would benefit from clear, 
concise, understandable disclosure. In addition, appropriately 
fashioned point of sale disclosure would help investors in all types of 
retail investment products assess and evaluate broker recommendations.
    The SEC has an Office of Investor Education and Advocacy and 
provides some investor education resources on its Web site. These types 
of efforts should be expanded, possibly in partnership with other 
governmental or private entities, and better publicized. Many industry 
participants, too, have developed materials and other tools to help 
educate investors; additional investor outreach efforts should be 
encouraged.
Process of Merging the SEC and CFTC
    Legislation to merge the SEC and CFTC should outline a process by 
which to harmonize the very different regulatory philosophies of the 
two agencies, as well as to rationalize their governing statutes and 
current regulations. We note that there is potential peril in leaving 
open-ended the process of merging the two agencies. We accordingly 
recommend that the legislation creating the Capital Markets Regulator 
set forth a specific timetable, with periodic benchmarks and 
accountability requirements, so as to ensure that the merger of the SEC 
and CFTC is completed as expeditiously as possible.
    The process of merging the two agencies will be lengthy, complex, 
and have the potential to disrupt the functioning of the SEC, CFTC, and 
their regulated industries. We suggest that, in anticipation of the 
merger, the SEC and CFTC undertake detailed consultation on all 
relevant issues and take all steps possible toward greater 
harmonization of the agencies. This work should be facilitated by the 
Memorandum of Understanding the two agencies signed last year regarding 
coordination in areas of common regulatory interest. \14\ ICI believes 
that its recommendations with respect to the Capital Markets Regulator 
may provide a helpful framework for these efforts.
---------------------------------------------------------------------------
     \14\ See SEC, CFTC Sign Agreement to Enhance Coordination, 
Facilitate Review of New Derivative Products (SEC press release dated 
March 11, 2008), available at http://www.sec.gov/news/press/2008/2008-
40.htm
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Regulatory Structure Affecting Other Financial Institutions
    Earlier in this paper, we have recommended the establishment of a 
Systemic Risk Regulator, and we have discussed at length the need for a 
new Capital Markets Regulator to oversee markets and market 
participants in the securities and futures industries. In this section 
and the one immediately following, we comment briefly on reforms 
affecting the regulators overseeing other sectors of the U.S. financial 
system (specifically, banking and insurance) and how all regulators 
within the system can work together more effectively.
    Regulation of the banking and insurance industries is, quite 
obviously, not ICI's primary area of focus. That said, regulation of 
these industries greatly affects the performance of the U.S. financial 
system as a whole and the ability of investment companies to function 
within that system.
    ICI believes it is important, therefore, for policymakers to 
carefully consider how to achieve a more rational regulatory structure 
for the banking sector that consolidates duplicative regulatory 
agencies and clarifies regulatory missions. Any such analysis would no 
doubt need to address difficult issues concerning the future role of 
state banking regulators if we are to have a more rational regulatory 
system at the national level.
    With regard to the insurance industry, ICI supports in concept the 
idea of creating a regulator at the federal level, a reform that has 
been sought by some insurance companies as a means of providing a 
streamlined and efficient alternative to the current system of state 
regulation. Authorizing an optional federal charter for insurers 
appears to be a logical way to bridge the gap between what exists today 
and the more comprehensive approach that is required for all financial 
institutions operating in truly national and often international 
markets. We also believe that a federal insurance regulator would 
provide an important and practical enhancement to federal inter-agency 
coordination and information sharing efforts, as discussed below.
Enhanced Inter-Agency Coordination and Information Sharing
    A recent report examined the benefits and shortcomings of the four 
primary approaches to regulatory supervision currently used in 
jurisdictions around the world. \15\ The report observed that, 
regardless of the type of supervisory system in place, virtually all 
financial supervisors emphasized the importance of inter-agency 
coordination and information sharing for successful oversight of the 
financial system as a whole and for mitigation of systemic risk.
---------------------------------------------------------------------------
     \15\ See Group of Thirty, The Structure of Financial Supervision: 
Approaches and Challenges in a Global Marketplace (Oct. 6, 2008), 
available at http://www.deloitte.com/dtt/cda/doc/content/
us_fsi_banking_G30%20Final%20Report%2010-3-08.pdf
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    Effective inter-agency coordination also plays a critical role when 
there is a need to engage on financial services regulatory issues at an 
international level. The variety of supervisory systems around the 
world and the increasing globalization of financial markets make 
coordination among U.S. regulatory agencies all the more important.
    In the United States at present, a variety of mechanisms are used 
to promote coordination and information sharing within our complex 
regulatory system, including arrangements at both the Federal and State 
levels and arrangements among federal and state agencies. These 
arrangements may be specifically mandated by Congress, such as the 
inter-agency Federal Financial Institutions Examination Council, or may 
be initiated by the regulators themselves, such as the July 2008 
Memorandum of Understanding between the Federal Reserve and the SEC to 
foster greater coordination and information sharing. \16\ One 
particularly important mechanism for the past two decades has been the 
President's Working Group on Financial Markets, whose members are the 
heads of the Treasury Department, Federal Reserve, SEC and CFTC. As 
described in the Treasury Blueprint, the role of the PWG has evolved 
beyond the scope of the 1988 Executive Order creating it, so that the 
PWG has become a key communication and coordination mechanism for 
financial policy.
---------------------------------------------------------------------------
     \16\ See, e.g., SEC, FRB Sign Agreement to Enhance Collaboration, 
Coordination, and Information Sharing (SEC press release dated July 7, 
2008), available at http://www.sec.gov/news/press/2008/2008-134.htm
---------------------------------------------------------------------------
    If efforts to streamline the U.S. financial regulatory structure 
are to be successful, some of these coordination mechanisms would 
almost certainly require modification or perhaps would no longer be 
necessary. There would, however, still be a very critical need for 
coordination and information sharing among the remaining regulatory 
bodies, presumably with involvement in particular by the Systemic Risk 
Regulator. The President's Working Group, with necessary modifications, 
would appear to be the easiest way to achieve this end.
    ICI concurs with the recommendation in the Treasury Blueprint that 
the Executive Order authorizing the PWG should be modernized ``to 
reinforce the group's mission and purpose . as an ongoing mechanism for 
coordination and communication on financial policy matters including 
systemic risk, market integrity, investor and consumer protection, and 
capital markets competitiveness.'' We suggest that any new Executive 
Order also discuss the following additional areas where inter-agency 
coordination and information sharing are critically important: (1) the 
regular exchange of information about the latest market and industry 
developments, including international trends and developments; (2) the 
discussion of policy initiatives that extend across jurisdictional 
lines; (3) the minimization of regulatory disparities for like 
financial products and services; and (4) the need to balance financial 
innovation with appropriate market and investor protection safeguards.
    Equally important, in ICI's view, is the role of the PWG in 
fostering a culture of close consultation and dialogue among senior 
officials within each regulatory sector that will carry over into each 
regulator's dealings with one another. Stronger links between 
regulators and an overriding sense of shared purpose would greatly 
assist in sound policy development, prioritization of effort, and 
cooperation with the international regulatory community.
Expected Benefits From These Reforms
    If implemented, the recommended reforms outlined above would help 
to establish a more effective and efficient regulatory structure for 
the U.S. financial services industry. Most significantly, these reforms 
would:

    Improve the U.S. government's capability to monitor and 
        mitigate risks across our nation's financial system.

    Create a regulatory framework that enhances regulatory 
        efficiency, limits duplication, and emphasizes the national 
        character of the financial services industry.

    Close regulatory gaps to ensure appropriate oversight of 
        all market participants and investment products.

    Preserve specialized regulatory focus and expertise and 
        avoid potential uneven attention to different industries or 
        products.

    Foster a culture of close consultation and dialogue among 
        U.S. financial regulators to facilitate collaboration on issues 
        of common concern.

    Facilitate coordinated interaction with regulators in other 
        jurisdictions, including with regard to risks affecting global 
        capital markets.

    Of significant import to registered investment companies, creation 
of a consolidated Capital Markets Regulator would provide a single 
point of regulatory authority and consistent rulemaking and oversight 
for investment products, the capital markets, and market participants. 
It would create regulatory efficiencies by eliminating areas where 
responsibilities overlap and by ensuring against regulatory gaps and 
potential inconsistencies. A strong, integrated regulator for the 
capital markets that can see ``the whole picture'' will be better 
equipped to face the challenges of these rapidly evolving markets, and 
thus to protect the interests of investors.
    More generally, increased consolidation of financial services 
regulators, combined with the establishment of a Systemic Risk 
Regulator and more robust inter-agency coordination and information 
sharing, should facilitate monitoring and mitigation of risks across 
the financial system. It also should result in increased regulatory 
efficiency, including less duplication, and help to eliminate 
regulatory gaps.
    Consolidation of regulatory agencies also may further the 
competitive posture of the U.S. financial markets. It may make it 
easier to harmonize U.S. regulations with regulations in other 
jurisdictions when that is appropriate. And reducing the number of U.S. 
regulatory agencies, while also strengthening the culture of 
cooperation and dialogue among senior officials of the agencies, will 
likely facilitate coordinated interaction with regulators around the 
world.
    By providing for one or more dedicated regulators to oversee each 
major financial services sector, the proposed structure would maintain 
the specialized focus and expertise that is a hallmark of effective 
regulation. This structure also would allow appropriate tailoring of 
regulation to accommodate fundamental differences in regulated 
entities, products and activities. Additionally, it would avoid the 
potential for one industry sector to take precedence over the others in 
terms of regulatory priorities or approaches or the allocation of 
regulatory resources.
    ICI recognizes that some have criticized sector-based regulation 
because it may not provide any one regulator with a full view of a 
financial institution's overall business, and does not give any single 
regulator authority to mandate actions designed to mitigate systemic 
risks across financial markets as a whole. Our proposed approach would 
address those concerns through the establishment of the Systemic Risk 
Regulator and specific measures to strengthen inter-agency coordination 
and information sharing.
    We further believe that retaining some elements of the current 
multi-agency structure likely would offer advantages over a single, 
integrated regulator approach. Even though a single regulator could be 
organized with separate units or departments focusing on different 
financial services sectors, it is our understanding that, in practice, 
there can be a tendency for agency staff to ``gravitate'' to certain 
areas and devote insufficient attention to financial sectors perceived 
to be less high profile or prone to fewer problems. Such a result has 
the potential to stifle innovation valuable to consumers and produce 
regulatory disparities.
    Finally, we believe that a streamlining of the current regulatory 
structure may be more effective and workable than an approach that 
assigns regulatory responsibilities to separate agencies based on broad 
regulatory objectives (e.g., market stability, safety and soundness, 
and business conduct). These functions often are highly interrelated. 
Not only could separating them prove quite challenging, but it would 
force regulators to view institutions in a less integrated way and to 
operate with a narrower, less informed knowledge base. For example, a 
Capital Markets Regulator is likely to be more effective in protecting 
investors if its responsibilities require it to maintain a thorough 
understanding of capital market operations and market participants. And 
while an objective-based structure could be one way to promote 
consistent regulation of similar financial products and services, it is 
not the only way. Under our proposed approach, minimizing regulatory 
disparities for like products and services would be an express purpose 
of enhanced inter-agency coordination and information-sharing efforts.
                                 ______
                                 
                PREPARED STATEMENT OF MERCER E. BULLARD
                          Associate Professor,
              University of Mississippi School of Law, and
                               President,
                          Fund Democracy, Inc.
                             March 11, 2009
    Chairman Dodd, Ranking Member Shelby, Members of the Committee, 
thank you for the opportunity to appear before you to discuss investor 
protection issues. It is an honor and a privilege to appear before the 
Committee today.
    I am the Founder and President of Fund Democracy, a nonprofit 
advocacy group for mutual fund shareholders, and an Associate Professor 
of Law at the University of Mississippi School of Law. I founded Fund 
Democracy in January 2000 to provide a voice and information source for 
mutual fund shareholders on operational and regulatory issues that 
affect their fund investments. Fund Democracy has attempted to achieve 
this objective in a number of ways, including filing petitions for 
hearings, submitting comment letters on rulemaking proposals, 
testifying on legislation, publishing articles, lobbying the financial 
press, and creating and maintaining an Internet Web site for the 
posting of information. I also have served as a consultant and expert 
witnesses for plaintiffs and defendants in a variety of securities 
cases, including some that are discussed in this testimony.
    This testimony focuses on investor protection issues related to 
investment management and investment advisory services. Some of these 
issues have arisen in connection with the current financial crisis, 
such as the question of prudential regulation of money market funds. 
This testimony begins with a discussion of different aspects of this 
question. But many investor protection issues reflect longstanding 
problems that have been left unattended by the SEC. There continue to 
be significant gaps in mutual fund fee disclosure rules, reform of fund 
distribution regulation is long overdue, and the SEC's fund governance 
initiative seems to have been all but forgotten. The SEC continues to 
allow hedge funds to offer their shares to unsophisticated investors, 
and brokers continue to receive undisclosed selling compensation that 
creates an incentive to sell the most remunerative funds even if they 
are not the best funds for the client.
    On the whole, however, the investment management industry has fared 
well in the current crisis. Equity mutual funds have experienced their 
largest single year loss in history, yet net redemptions have remained 
small. Employee benefit plan participants generally have continued to 
make regular investors in funds. The mutual fund structure has been 
shown to be remarkably resilient in this time of stress. Investors seem 
to have faith in mutual funds' promise to convert their accounts to 
cash in short order at their next computed NAV, which is based on 
actual market values as opposed to malleable accounting principles. 
More money has flowed out of broker-managed accounts than mutual funds. 
Only one money market fund has experienced a loss of principal 
(compared with the failure of dozens of banks), and, with the playing 
field with banks temporarily leveled by the Treasury's temporary 
insurance program, money market funds have increased their total 
assets. The investment management industry's success depends, however, 
on its and its regulators' keeping pace with the needs of investors.
MONEY MARKET FUNDS
Money Market Fund Insurance \1\
---------------------------------------------------------------------------
     \1\ See generally Mercer Bullard, Federally Insured Money Market 
Funds and Narrow Banks: The Path of Least Insurance (Mar. 2, 2009) 
available at http://ssrn.com/abstract=1351987
---------------------------------------------------------------------------
    As discussed above, mutual funds have been a singular success story 
in the midst of the current financial crisis. Money market funds 
arguably have been the best illustration of this success. As often 
happens when those who succeed are surrounded by failed competitors, 
however, some have responded to the failure of a single retail money 
market fund--the first in history--by demanding that money market funds 
be converted to and regulated as banks. A former Fed chairman explained 
this position as follows: ``If they are going to talk like a bank and 
squawk like a bank, they ought to be regulated like a bank.'' The 
problem with this argument is that money markets do not fail like 
banks.
    Since 1980, more than 3,000 U.S. banks have failed, costing 
taxpayers hundreds of billions of dollars. During the same time period, 
two money market funds have failed, costing taxpayers zero dollars. \2\ 
The lesson that the Group of 30 takes from this history is that it is 
money market funds that should be regulated as banks. The lesson that 
Congress should take from this history is that banks should be 
regulated more like money market funds. As discussed further below, 
banks routinely fail because they are permitted to invest deposits that 
can be withdrawn at a moment's notice in illiquid, long-term, risky 
assets. In comparison, money market funds invest in liquid, short-term, 
safe assets. The Group of 30 has disparaged money market funds as 
``underscor[ing] the dangers of institutions with no capital, no 
supervision, and no safety net,'' yet the extraordinary stability of 
money market funds relative to banks makes a mockery of their argument.
---------------------------------------------------------------------------
     \2\ Ironically, money market funds to date have provided a net 
positive contribution to the ongoing bailout of financial institutions. 
The Treasury has collected more than $800 million in money market fund 
insurance premiums only a small fraction of which, if any, are likely 
ever to be paid out in claims.
---------------------------------------------------------------------------
    It is banks that should be regulated like money market funds, with 
the investment of insured bank deposits being limited to liquid, short-
term, safe assets. There is no longer any good policy reason to insure 
bank deposits backed by longterm, risky assets. The current financial 
crisis has demonstrated that banks no longer play a special role in 
this market. Many types of entities now play a significant role in the 
creation of liquidity through investment in long-term assets that 
historically was dominated by banks. And many of these entities rely on 
shortterm liabilities (i.e., funds subject to payment on demand), 
including mutual funds, to fund such investments. Any regulatory regime 
that seeks to mitigate the systemic risk inherent in the investment of 
short-term funds in long-term ventures must consider the full spectrum 
liquidity-creation mechanisms and reject a bank-centric view of finance 
that distorts efficient investment and leaves unregulated large areas 
of financial activities.
    What should be insured is cash accounts on which the stability of 
the payments system depends. The current crisis has demonstrated the 
need to ensure that the cash management vehicles that form the 
foundation of our payments system are absolutely secure. Deposit 
insurance provides this security. Its weakness, however, is that it 
also insures risks that are necessary to the provision of transactional 
services. Banks are permitted to invest insured bank deposits in 
longterm risky ventures, thereby destabilizing the payments system and 
inflicting large losses on the insurance fund and taxpayers. Money 
market funds have been a paragon of stability because they are 
permitted to invest only in a diversified pool of short-term, high-
quality assets.
    The answer to whether money market fund insurance should be made 
permanent seems obvious. Terminating the temporary insurance program 
could lead to another run on money market funds and require that the 
program immediately be restored. Even if a run does not follow 
termination of the program, money market funds will continue to 
represent a major source of transactional services the failure of which 
would threaten the viability of our payments system. Money market fund 
shareholders know this. The question of whether there is an implied 
federal guarantee of money market funds has been answered. The next 
time that a run on money market funds seems imminent, a federal entity 
will have to stop the run with a guarantee, except that without an 
insurance program in place it will not have collected any premiums that 
(if risk-based) might have reduced risktaking and that would have 
provided non-taxpayer funds with which to cover losses. Taxpayers will 
be left to back up this guarantee.
    At the same time that federal insurance is extended to all 
significant sources of transaction accounts, it should be used to 
reduce exposure to risk from the investment of short-term deposits in 
long-term, risky assets. To some extent, this would be accomplished by 
making money market fund insurance permanent. The higher yields 
historically offered by money market funds would siphon even more 
deposits from banks reduce the attendant risk of their investment in 
risky assets. Federal insurance also should be extended to a new kind 
of bank that was required to invest deposits in the same kinds of 
assets as money market funds. In order to enable compete such ``narrow 
banks'' to compete effectively, they would be relieved of burdens 
unique to banks, such as the requirements of the Community Reinvestment 
Act. Narrow banks also would continued to have the advantage of access 
to the discount window. Without making any changes to existing deposit 
insurance coverage, extending coverage to money market funds and narrow 
banks would reduce the amount of deposits subject to long-term risk and 
the likelihood of failure.
Prudential Regulation
    Prudential regulation, as used herein, refers to government-imposed 
rules designed to ensure that adequate assets stand behind the 
liabilities of financial institutions. Prudential regulation is an 
inherently suboptimal approach to risk because free markets are far 
more efficient at pricing risk than governments. Governments cannot 
avoid injecting political considerations into the underwriting of risk, 
which results in inevitably inefficient risk-minimization structures. 
Nonetheless, short-term social instability can cause permanent damage 
to social, political and commercial institutions. In some cases, 
government intervention is necessary to mitigate potentially 
destabilizing fluctuations in free markets.
    Under this admittedly oversimplified framework for government 
intervention in the capital markets, I would argue that our payments 
systems creates the kind of risk that should not be left to free market 
forces. The payments system refers to the network of providers of 
transactional services that enable a non-specie-based economic system 
of exchange to operate. The temporary collapse of our payments system 
could leave economic activity to be conducted on a strictly barter or 
specie basis until the payments system was restored. The difficulty 
with leaving the payments system to the mercy of free markets is that 
the social and political upheaval that might result from a temporary 
collapse of our payments system could turn the collapse into a long-
term event with long-term political, social and economic consequences. 
On this basis, it is advisable to support the payments system with an 
unconditional government guarantee of cash accounts on which the 
payments is primarily based. Notwithstanding the likely inefficiencies 
of such an insurance regime, they are outweighed by the potential 
benefits of protecting the payments system.
    One purpose that deposit insurance serves is to guarantee bank 
deposits and thereby stabilize an important foundation for the payments 
system. There are two difficulties with deposit insurance, however. 
First, deposit insurance covers risks that are not necessarily 
attendant upon the operation of cash accounts. Cash accounts can serve 
as an important linchpin of the payments system without being invested 
in long-term, high-risk assets such as the types of assets in which 
banks typically invest deposits. Money market funds also provide an 
important linchpin on the payments system, and they do so without 
taking such risks.
    Second, deposit insurance is exclusive to bank deposits. It is not 
available to other types of cash accounts even if those accounts pose a 
similar systemic threat to the payments system. When a run on money 
market funds seemed imminent in late September 2008, there was no 
government guarantee to prevent the run from turning into a wholesale 
transfer of assets out of money market funds. With $4 trillion in 
assets, such a stampede could have shut down the payments system with 
potentially devastating long-term effects. The Treasury Department 
prudently installed a government guarantee and halted the run. With 
temporary money market fund insurance in place, the vast majority of 
assets in transaction accounts are covered by a federal guarantee.
    Thus, insuring money market funds and narrow banks would promote 
appropriate prudential regulation that was designed to protect the 
stability of our payments system without transferring unnecessary risk 
to the government and taxpayers.
Prudential Regulator
    The current financial crisis has exposed a persistent flaw in our 
regulatory structure. Prudential oversight should be provided through a 
regulatory structure that is amenable to the regulatory philosophy that 
prudential oversight entails. Prudential regulators are risk averse. 
Their purpose is to prevent loss. A regulator that is tasked with 
protecting investors and promoting free and efficient markets, on the 
other hand, will not be risk averse. The securities laws focus on full 
disclosure of material information is designed to promote and reward 
risk-taking based on the efficient flow of capital to its highest value 
use, even when some uses entail significant risk. Permitting such risk-
taking is inimical to the essence of prudential regulation.
    In more concrete terms, the SEC's roles: (1) in protecting 
investors and promoting free, efficient markets, and (2) as the 
prudential regulator of brokerdealers and money market funds, are in 
conflict. Similarly, banking regulators' consumer protection role has 
always suffered in the shadow of its primary prudential regulator role. 
The SEC's and banking regulators' contradictory positions on fair value 
accounting reflect this conflict. The SEC favors accurate pricing that 
reflects market values; banking regulators favor pricing that will 
restore investor confidence. As a prudential regulator, the SEC's 
failure to properly administer net capital rules has led to 
disappearance of the five largest investment banks as independent 
entities and its approach to money market funds has necessitated the 
intervention of a true prudential regulator, the Treasury Department, 
to stop a run on money market funds. Conversely, banking regulators' 
record of consumer protection has been abysmal, with their role more 
often undermining consumer protection than enhancing it.
    In short, the areas of financial activity that necessitate 
prudential regulation should be administered by a prudential regulator. 
Investor protection and free markets should be handled by a different 
regulator. Although I support the creation of a single prudential 
regulator in theory, I believe it would be more realistic to shift 
prudential regulation to existing banking regulators and to locate 
consumer protection responsibility with respect to financial products 
and services with the SEC or FTC. If prudential regulation for 
insurance companies were established at the federal level, a special 
prudential regulator may be needed. It is not clear that the unique 
characteristics of insurance liabilities would be good fit for a 
prudential regulator that was responsible for other types of financial 
products. Insurance products that have predominantly investment 
characteristics (e.g., equity-indexed annuities), however, should be 
regulated by the SEC as to sales practices and disclosure, and by the 
same federal prudential regulator that would be responsible for 
overseeing money market funds and banks.
Electronic Filing of Portfolios
    In January 2008, my advocacy group, Fund Democracy, and the 
Consumer Federation of America, Consumer Action, AFL-CIO, Financial 
Planning Association and National Association of Personal Financial 
Advisors petitioned the SEC to adopt a rule requiring money market 
funds to file their portfolios electronically with the SEC. \3\ The 
letter was motivated by our concern that the SEC's ad hoc practice of 
allowing fund sponsors to bail out their money market funds before they 
broke a dollar was inadequate in a time of market turmoil. The letter 
proved to be, unfortunately, prescient. Within the year, a retail money 
market fund broke a dollar for the first time.
---------------------------------------------------------------------------
     \3\ Petition from Fund Democracy, Consumer Federation of America, 
Consumer Action, AFL-CIO, Financial Planning Association and National 
Association of Personal Financial Advisors, to Nancy Morris, Secretary, 
U.S. Securities and Exchange Commission (Jan. 16, 2008) available at 
http://www.funddemocracy.com/MMF%20Rulemaking%20Petition.pdf
---------------------------------------------------------------------------
    Money market fund regulation, whether administered by the SEC or a 
true prudential regulator, should include an electronic, portfolio-
filing requirement. Electronic filing would enable the regulator to 
monitor, among other things, the prices at which different money market 
funds are carrying the same securities. Although small pricing 
discrepancies would be inevitable and no cause for concern, large 
pricing discrepancies would indicate that some fund was underpricing 
or, more importantly, overpricing its shares. Moreover, filings would 
show the liquidity of the market for securities and thereby provide 
insight into the credibility of prevailing prices in more thinly traded 
issues. As stated by the SEC when it made a similar proposal 1995, 
money market fund portfolio filing would enhance regulators' ability: 
``to monitor money fund compliance with the federal securities laws, 
target its limited onsite examination resources, and respond in the 
event of a significant market event affecting money funds and their 
shareholders.'' The SEC's own justification for this proposal is far 
stronger today that it was twelve years ago.
Sponsor Support
    The SEC has historically dealt with the risk of a money market 
fund's breaking a dollar by granting no-action relief to fund sponsors 
to purchase the problem assets at par, pump cash into the fund, extend 
guarantees, or take other steps to restore the fund's per share net 
asset value. This continues to be an appropriate tool for addressing 
the risk of money market fund failure, but it has become far too 
routine. The frequent granting of no-action relief for transactions 
that generally violate the affiliated transaction prohibitions of the 
Investment Company Act undermines the rule of law and encourages lax 
oversight by fund managers.
    First, the SEC should amend the rule that exempts certain of these 
transactions to cover a broader range of sponsor support mechanisms. 
Sponsors should then be expected to have established written procedures 
that address scenarios in which their funds may need support and the 
mechanisms that the fund expects to use to provide it, if any.
    Second, the sponsor's rescue policy should be disclosed in its 
Statement of Additional Information (a fund filing that investors can 
obtain on request or on the SEC's Web site). As indicated by Fitch's 
recent announcement that it intends to revise its money market fund 
rating system to reflect sponsors' rescue plans, these plans have 
become material aspects of a fund's stability. Banking regulators have 
previously indicated that they might not permit a bank affiliate to 
bail out its money market fund. This risk also should be disclosed to 
investors. As discussed in the consumer groups' January 2008 letter, 
the 11th hour negotiation of the terms of sponsor support between 
sponsors and SEC staff behind closed doors should not be the model by 
which the SEC and the fund industry manage unexpected market events. 
\41\
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     \4\ If money market fund insurance is made permanent, such sponsor 
support arrangements should be formalized and made mandatory. Sponsor 
support of money market funds is the functional equivalent of the 
equity buffer that insured banks are required to maintain under banking 
regulations. In this respect, it should be noted that claims that money 
market funds have no ``capital'' are misleading. Money market funds do 
have capital; it is the sponsor support that has, in dozens of 
instances prevented money market funds from breaking a dollar and 
resulted in a record of only two failures in almost 30 years. The 
problem is that the capital support is informal and voluntary.
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Liquidation Procedures
    The haphazard liquidation of certain Reserve Funds has exposed a 
significant gap in the regulatory structure for money market funds. The 
complete liquidation of any mutual fund, even a highly liquid money 
market fund, cannot be accomplished overnight, but there should be no 
delay in the distribution of some percentage of a money market fund's 
assets in short order. Money market fund shareholders use these funds 
as the functional equivalent of bank accounts on which they often rely 
for daily living expenses. The SEC should require that money market 
fund compliance manuals include procedures that set forth the manner in 
which immediate redemptions can be effected in the event that 
circumstances cause the suspension of regular distributions. The FDIC 
generally is able to ensure that insured depositors receive a 
substantial part of their funds almost immediately following the 
closure of an insured bank. While it is reasonable for some money 
market fund assets to be withheld pending a final resolution by a 
receiver, there is no excuse for not releasing some percentage of 
shareholders' accounts in short order.
Liquidity Oversight
    Many of the problems underlying the current crisis result from a 
failure to incorporate liquidity risk into prudential regulation. 
Although money market funds present less liquidity risk because of the 
short maturity, high quality and diversification of their assets, Rule 
2a-7 should require that money market fund directors specifically 
consider the liquidity risk posed by the fund's portfolio. Fund 
directors should be required to ensure that procedures have been 
adopted and implemented that are reasonably designed to ensure that the 
pricing of portfolio securities has been tested against various market 
failure scenarios.
MUTUAL FUNDS
Excessive Fees
    Section 36(b) of the Investment Company Act, which was passed in 
1970, provides that a fund director and fund manager shall have a 
fiduciary duty with respect to the fees charged by the fund, and tasks 
the Commission with bringing actions against directors and fund 
managers who violate this duty. The Commission has never brought a case 
for excessive fees. \5\ No plaintiff has ever prevailed in litigated 
claim under this provision although there have been some significant 
settlements.
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     \5\ I am aware of two cases that the Commission has brought under 
Section 36(b), neither of which involved an excessive fees claim. See 
In the Matter of American Birthright Trust Management Company, Inc., 
Litigation Rel. No. 9266, 1980 SEC LEXIS 26 (Dec. 30, 1980); SEC v. 
Fundpack, Inc., No. 79-859, 1979 WL 1238 (D.D.C., Aug. 10, 1979).
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    Recent developments have made it unlikely that a section 36(b) 
claim will ever survive a motion to dismiss. Defense experts often have 
argued that mutual fund fees are set in a competitive marketplace and 
therefore are necessarily fair under section 36(b). In a Seventh 
Circuit decision, Judge Easterbrook adopted this theory, thereby 
effectively repealing the Act's private cause of action. In a split en 
banc opinion, Judge Posner rejected Judge Easterbrook's analysis, 
arguing that markets are not always efficient. The same Seventh Circuit 
also recently ruled that an Erisa fiduciary has no duty when selecting 
investments for a 401(k) plan not to choose funds that charge excessive 
fees. The court granted defendants' motion to dismiss even after 
accepting as true, among other things, plaintiffs' allegation that the 
plan sponsor had lied to plan beneficiaries about absorbing all of the 
costs of administering the plan (beneficiaries actually paid part of 
the costs). The Department of Labor filed an amicus brief opposing the 
defendants' position in that case.
    The Supreme Court has granted certiorari in the Seventh Circuit's 
36(b) case. Unfortunately, the Court has been quite hostile to private 
claims under the federal securities. I support many of the statutory 
limits on private claims that Congress has enacted over the last 15 
years, as well as some of the interpretive restrictions imposed by the 
Court. But some decisions have gone too far and/or created absurd 
results. There is significant risk that the Court's decision will 
result in a complete evisceration of section 36(b). This will leave 
mutual fund investors at the mercy of opaque fee disclosure and no 
private claim against fund managers that charge excessive fees. It is 
therefore imperative that Congress strengthen the fiduciary duty 
standard under section 36(b) and implement long-overdue reforms in fee 
disclosure requirements.
Fiduciary Duty Standard
    Section 36(b) applies a fiduciary duty to directors only with 
respect to fees paid to the fund manager. When a fund's excessive fees 
are attributable not to fees paid to the fund manager, but to fees paid 
on account of the administrative expense of operating a small fund, 
this fiduciary duty is not triggered. Thus, a fund director's decision 
to offer a fund with an 8 percent or 10 percent expense ratio may be 
reviewable only under the toothless state law standard that section 
36(b) was designed to supplement. \6\
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     \6\ A number of years ago, my research assistant was able to 
identify 18 funds in Morningstar's database with expense ratios in 
excess of 5 percent, yet the average management fee for the same funds 
was only 1.06 percent, and only one fund's management fee exceeded 1.29 
percent.
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    Congress should enact legislation that creates a fiduciary duty for 
fund directors that would require, for example, that directors 
affirmatively find that the fund could be a reasonable investment in 
light of its investment objective, performance history and expenses. If 
a fund's fees were so high so as to render the investment irrational, 
the directors would have to take action to cure the problem, such as by 
merging the fund into another fund with lower fees.
Fee Disclosure
    As the Commission has recognized, fund fees ``can have a dramatic 
effect on an investor's return. A 1 percent annual fee, for example, 
will reduce an ending account balance by 18 percent on an investment 
held for 20 years.'' \7\ Notwithstanding the importance of fees, ``the 
degree to which investors understand mutual fund fees and expenses 
remains a significant source of concern.'' \8\ The Department of Labor 
has found that employee benefit ``plan participants on average pay fees 
that are higher than necessary by 11.3 basis points per year.'' \9\
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     \7\ Shareholder Reports and Quarterly Portfolio Disclosure of 
Registered Management Investment Companies, Investment Company Act 
Release No. 25870, Part I.B (Dec. 18, 2002).
     \8\ Id. (citing a joint report of the Commission and the Office of 
the Comptroller of the Currency that ``found that fewer than one in 
five fund investors could give any estimate of expenses for their 
largest mutual fund and fewer than one in six fund investors understood 
that higher expenses can lead to lower returns'').
     \9\ See Fiduciary Requirements for Disclosure in Participant-
Directed Individual Account Plans, Employee Benefits Security 
Administration, U.S. Department of Labor, 73 F.R. 43014, n.13 (July 23, 
2008) (``DoL Proposal'').
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    In many respects, investors' lack of understanding is directly 
attributable to the way in which fees are disclosed. The current 
expense ratio is misleading because it excludes what can be a fund's 
single largest expense: portfolio transaction costs. 12b-1 fees are 
misleading because they create the impression that funds that do not 
charge 12b-1 fees therefore do not incur distribution expenses. Fund 
fees are disclosed in dollars based on hypothetical amounts, rather 
than a shareholder's actual costs, and the location of this disclosure 
makes it unlikely that investors will pay attention to this 
information. Nowhere are funds required to put their fees in context by 
comparing them to fees charged by index funds and comparable managed 
funds. The Commission has failed to support or actively opposed reforms 
designed to address each of these problems.
    Portfolio Transaction Costs: The current expense ratio, which to be 
accurate should be referred to as the ``partial expense ratio,'' 
excludes portfolio transaction costs. Portfolio transaction costs are 
the costs incurred by a fund when it trades its portfolio securities. 
Some portfolio transaction costs are easy to measure. For example, 
commissions paid by funds are disclosed as a dollar amount in the 
Statement of Additional Information, which is provided to shareholders 
only upon request. Other portfolio transaction costs must be measured 
indirectly, such as spread costs, but their existence and their 
substantial impact on fund expenses is no less certain.
    The Commission concedes that portfolio transaction costs constitute 
a significant expense for fund shareholders. ``[F]or many funds, the 
amount of transaction costs incurred during a typical year is 
substantial. One study estimates that commissions and spreads alone 
cost the average equity fund as much as 75 basis points.'' \10\ A 2004 
study commissioned by the Zero Alpha Group, a nationwide network of 
fee-only investment advisory firms, found that commissions and spread 
costs for large equity funds, the expenses and turnover of which are 
well below average, exceeded 43 percent of the funds' expense ratios. A 
2004 survey by Lipper identified at least 86 equity funds for which the 
total amount paid in commissions alone exceeded the fund's total 
expense ratio, in some cases by more than 500 percent. The Department 
of Labor expressly cited, as a significant failing of the mutual fund 
expense ratio, its omission of portfolio transaction costs, which can 
equal many multiples of a fund's other expenses. \11\
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     \10\ Request for Comments on Measures to Improve Disclosure of 
Mutual Fund Transaction Costs, Investment Company Act Rel. No. 26313, 
at Part I (Dec. 19, 2003) (``Concept Release'') (citing John M.R. 
Chalmers, Roger M. Edelen, Gregory B. Kadlec, Fund Returns and Trading 
Expenses: Evidence on the Value of Active Fund Management, at 10 (Aug. 
30, 2001) (available at http://finance.wharton.upenn.edu/edelen/PDFs/
MF_tradexpenses.pdf). ``These estimates omit the effect of market 
impact and opportunity costs, the magnitude of which may exceed 
commissions and spreads.'' Id.
     \11\ See DoL Proposal, supra, at n.13.
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    Notwithstanding the significance of portfolio transaction costs, 
the Commission has opposed including these costs in the mutual fund 
expense ratio. In a June 9, 2003, memorandum, the Commission 
demonstrated that it had already prejudged the issue of the disclosure 
of portfolio transaction costs. It concluded that ``it would be 
inappropriate to account for commissions as a fund expense'' and 
unequivocally answered the question of ``whether it is currently 
feasible to quantify and record spreads, market impacts, and 
opportunity costs as a fund expense. We believe that the answer is 
`no.' '' \12\ Only after reaching this decision did the Commission 
proceed with the formality of issuing a concept release asking for 
comment on disclosure of portfolio transaction costs, apparently for 
the purpose of considering any alternative other than full inclusion in 
the expense ratio. \13\ Six years later, the Commission has not taken 
any action on its proposal other than to include turnover ratios (an 
indirect and opaque reflection of portfolio transaction costs) with the 
fee table in new the summary prospectus. The expense ratio continues to 
be a partial expense ratio.
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     \12\ Memorandum from Paul F. Roye, Director, Division of 
Investment Management, Securities and Exchange Commission to William H. 
Donaldson, Chairman, Securities and Exchange Commission, at 28 and 30 
(June 3, 2003) (available at http://financialservices.house.gov/media/
pdf/02-14-70%20memo.pdf) (``Donaldson Memorandum'').
     \13\ See Concept Release, supra.
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    The Commission's position is flatly inconsistent with its 
responsibility to provide the information that the marketplace needs to 
promote price competition. By requiring funds to use the partial 
expense ratio, the Commission is effectively forcing the public to 
choose funds based on the Commission's view of the proper measure of 
fund costs. The Commission's decision to second-guess the market by 
deciding for investors which kinds of information they are capable of 
understanding contradicts basic market principles and is inconsistent 
with our capitalist system of free enterprise.
    Investors logically look to the Commission to provide standardized 
reporting of expenses, and it is appropriate for the Commission to 
provide this service. But once the Commission has provided the 
important service of providing standardized information, it should 
remove itself from the market-driven determination of which information 
provides the best measure of a fund's true costs.
    The Commission has argued that including portfolio transaction 
costs might distort fund managers' behavior. As noted above, this is 
not for the Commission to judge. The marketplace should decide which 
expense ratio--the partial expense ratio or a total expense that 
includes portfolio transaction costs--is the best measure of a fund's 
costs.
    Furthermore, it is the partial expense ratio that distorts fund 
managers' and investors' behavior alike. The partial expense ratio 
distorts fund managers' behavior by not holding them accountable for 
their decisions to spend a substantial amount of fund assets on trading 
securities.
    As illustrated in Exhibit A, for example, the Commission believes 
that investors should only be told that the expense ratio for the PBHG 
Large Cap Fund is 1.16 percent, and that they should not be told that 
when commissions and spread costs are included, the Fund's expense 
ratio for the period shown is 8.59 percent. \14\ The true cost of that 
Fund is more than seven times the amount shown in the Commission's 
expense ratio. How can it be in the best interests of investors or 
consistent with free market economics to require, much less permit, the 
Fund to show its total costs of 1.16 percent? The partial expense ratio 
is misleading because it impliedly represents, in conjunction with 
other shareholder expenses listed in the fee table, the total cost of 
fund ownership.
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     \14\ Exhibit A also shows that, when commissions and spread are 
included, the expenses of the Strong Discovery Fund rise from 1.50 
percent to 4.50 percent, the CGM Focus Fund from 1.20 percent to 4.48 
percent, and the RS Mid Cap Opportunities Fund from 1.47 percent to 
7.52 percent.
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    The data in Exhibit A does not reflect outliers, but randomly 
selected examples from funds with more than $100 million in assets. If 
smaller funds with high turnover were considered, the differentials 
would be so large as to render the Commission's partial expense ratio 
fraudulent. For example, Lipper reports that the Rydex Telecom Fund's 
commissions for the fiscal year ending March 31, 2003, equaled 8.04 
percent of assets. By applying the Zero Alpha Group study's methodology 
of estimating spread costs, we can estimate that total spread costs 
during that period equaled 8.75 percent of assets. Thus, whereas the 
Commission tells us that the Rydex Telecom Fund's is only 1.37 percent, 
its true costs are 18.16 percent, or 13 times higher. \15\ The 
Commission's partial expense ratio distorts investors' behavior because 
investors obviously would make different investment decisions if they 
knew the true costs of owning certain funds.
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     \15\ The Lipper data show that at least 31 funds' expense ratios 
would exceed 10 percent if they include commissions and spread costs.
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    The Commission's partial expense ratio also distorts managers' 
behavior because it creates an incentive for them to pay for non-
execution expenses with fund commissions. Under current law, fund 
managers can payer higher commissions--that is, more than it would cost 
merely to execute the fund's trades--in return for non-execution 
services. By paying for these non-execution services with commissions, 
or what are known as soft dollars, fund managers effectively move these 
costs out of the expense ratio where they belong. This enables the fund 
that uses soft dollars to show a lower partial expense ratio than a 
fund that does not--even if the fund managers use identical services 
and have identical operating expenses. The Commission itself has 
conceded that ``[t]he limited transparency of soft dollar commissions 
may provide incentives for managers to misuse soft dollar services.'' 
\16\
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     \16\ Concept Release at Part III.A, supra.
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    Furthermore, the nondisclosure of portfolio transaction costs 
exacerbates the conflict of interest that is inherent in the payment of 
soft dollars. As the Commission has recognized,

        [s]oft dollar arrangements create incentives for fund advisers 
        to (i) direct fund brokerage based on the research provided to 
        the adviser rather than the quality of execution provided to 
        the fund, (ii) forego opportunities to recapture brokerage 
        costs for the benefit of the fund, and (iii) cause the fund to 
        overtrade its portfolio to fulfill the adviser's soft dollar 
        commitments to brokers. \17\
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     \17\ Donaldson Memorandum, supra, at 36. Regarding directed 
brokerage, the Commission recently stated: ``We believe that the way 
brokerage has been used to pay for distribution involves unmanageable 
conflicts of interest that may harm funds and fund shareholders.'' 
Prohibition on the Use of Brokerage Commissions to Finance 
Distribution, Investment Company Act Rel. No. 26356 at Part II (Feb. 
24, 2004).

    The continued concealment of portfolio transaction costs permits 
the soft dollar conflict to operate virtually unchecked by market 
forces, whereas including portfolio transaction costs in a total 
expense ratio would, at least, permit the marketplace to judge the 
efficacy of soft dollar arrangements. If Congress does not take steps 
to eradicate soft dollars, at least it can require that these costs be 
disclosed so that the market can reach its own judgments regarding 
their efficacy.
    Dollar Disclosure of Fees: Under current disclosure rules, funds 
are not required to disclose to investors how much they pay in fees. 
Many other financial services documents show investors exactly how much 
they are paying the service provider, including bank statements, 
insurance bills, credit card statements, mortgage loans and a host of 
other documents. But mutual funds provide only an expense ratio (and a 
partial one, at that, see supra) and the dollar amount of a 
hypothetical account.
    Congress should require that funds provide individualized dollar 
disclosure of fund expenses in shareholder statements, as recommended 
by the Government Accounting Office \18\ and proposed for employee 
benefit plans by the Department of Labor. \19\ This requirement is 
necessary for two reasons. First, although the expense ratio is 
appropriate for providing comparability across different funds, it does 
not pack the same import as a dollar amount. Providing investors with 
the amount in dollars that they actually spent will give concrete form 
to an indefinite concept and make investors consider more fully the 
costs of different investment options.
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     \18\ Government Accounting Office, Mutual Funds: Information On 
Trends In Fees and Their Related Disclosure (March 12, 2003).
     \19\ See DoL Proposal, supra.
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    Second, placing the dollar amount of expenses in the shareholder 
statement will direct shareholders' attention to the actual costs of 
fund ownership. No document is more likely to be read than a 
shareholder statement that shows the value of the shareholder's account 
and transaction activity during the period. Whereas the prospectus and 
shareholder report typically go directly from the mailbox to the trash 
can, even the most uninformed investors normally open their statements 
to check on the status of their accounts. There is no better way to 
draw shareholders' attention to the costs of investing than to require 
that the dollar amount of fees for the period be disclosed next to the 
value of the investor's account.
    Some members of the fund industry have opposed informing investors 
about the actual costs of their fund investments on the grounds that 
doing so would be too costly and might mislead investors. It appears 
that MFS Investment Management, one of the largest mutual fund managers 
in America, disagrees. MFS offers to include actual dollar disclosure 
in investor statements, which undercuts industry arguments that 
providing this information is economically infeasible. The Department 
of Labor has proposed to require dollar disclosure of fees for plan 
participants and the Government Accountability has recommended that the 
SEC do the same.
    The Commission opposes disclosure of shareholders' actual costs and 
opposes including dollar disclosure in shareholder statements. The 
Commission concluded its consideration of a proposal some years ago to 
require funds to disclose individualized costs in shareholder 
statements by expressly rejecting both concepts. Instead, the 
Commission decided to require disclosure of the hypothetical fees paid 
on a $1,000 account in the shareholder report, despite the facts that 
the hypothetical fees paid on a $10,000 account are already disclosed 
in the prospectus, and shareholders who most need to have their 
attention directed to the fees that they pay are least likely to read 
the shareholder report. In view of the Commission's, express opposition 
to effective disclosure of actual fees paid by shareholders, 
shareholders will receive disclosure of their actual fees in 
shareholder statements only if Congress requires funds to provide that 
information.
    Fee Comparisons: Congress should take additional steps to promote 
price competition in the mutual fund industry by requiring that funds 
disclose fees charged by comparable funds and, for managed funds, the 
fees charged by index funds. Without any context, current fee 
disclosure provides no information about whether a fund's fees are 
higher or lower than its peers. Current disclosure rules also do not 
show the premium paid to invest in a managed funds as opposed to an 
index fund. Requiring comparative information in the fee table would 
enable investors to consider a fund's fees in context and evaluate how 
they compare to fees across the industry.
    Distribution Fees: The Commission currently requires that 12b-1 
fees be disclosed on a separate line that describes those fees as 
``distribution fees.'' It does not require that the fee table show the 
amount spent on distribution by the fund manager out of its management 
fee. This is inherently misleading, as investors often use the presence 
of 12b-1 fees as a negative screen that they use to avoid paying any 
distribution fees. In fact, investors in non-12b-1 fee funds may 
actually pay as much or more in distribution expenses than some 
investors in 12b-1 fee funds. \20\
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     \20\ In 1999, Paul Haaga, Chairman of the Investment Company 
Institute and Executive Vice President of the Capital Research and 
Management Company, stated at an SEC roundtable: ``the idea that 
investors ought to prefer the funds that don't tell what they're 
spending on distribution over the ones that do is nonsense. You know, 
if you're spending money on distribution, say it. If you're not pending 
money on distribution don't say it; but don't pretend that there are no 
expenses there for a fund that doesn't have a 12b-1 plan.'' Conference 
on the Role of Investment Company Directors, Washington, D.C. (Feb. 23 
& 24, 1999) (Haaga was not ICI Chairman at this time).
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    Congress should overrule the Commission's position and require 
that, if distribution fees are stated separately in the fee table, they 
must reflect all distribution expenses paid by a fund, directly or 
indirectly. Alternatively, Congress should require that fund expenses 
be displayed in a pie chart that shows how much of a fund's fees were 
spent on each type of service. The Commission's current fee table is 
misleading and understates the amount of fund assets spent on 
distribution.
    Disclosure of Brokers' Compensation: For virtually all securities 
transactions other than purchases of mutual fund shares, investors 
receive a transaction confirmation that shows how much the broker was 
paid in connection with the transaction. Permitting brokers to hide 
their compensation on the sale of mutual funds has spawned a Byzantine 
and harmful array of selling arrangements, including revenue sharing 
(also known as payments for shelf space), directed brokerage, and non-
cash compensation. Mutual fund shareholders should be entitled to 
receive the same information as other investors in securities in the 
form of full disclosure of their brokers' compensation on fund 
transaction confirmations. Such disclosure also should show how 
breakpoints applied to the transaction, as well as any special 
compensation received by brokers for selling particular funds.
    Brokers also should be required to provide, at or before the time 
the investor places the order, an estimate of compensation to be 
received by the broker in connection with the transaction and the total 
costs of investing in the fund. When buying a house, purchasers are 
provided with an estimate of their total closing costs before making a 
final decision. As discussed immediately above, however, fund 
shareholders do not even receive a final statement of their actual 
costs, much less an up-front estimate of such costs.
    In January 2004, the Commission proposed to require brokers to 
provide, both at the point-of-sale and in the transaction confirmation, 
disclosure of the costs and conflicts of interest that arise from the 
distribution of mutual fund shares. \21\ More than 5 years later, the 
Commission has failed to take final action on its proposal. Congress 
should require that the SEC take final action on disclosure 
requirements that will result in brokers' customers receiving 
disclosure of the broker's economic incentives in the transaction.
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     \21\ Confirmation Requirements and Point of Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, Investment 
Company Act Rel. No. 26341 (Jan. 29, 2004).
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Distribution Arrangements
12b-1 Fees
    When Congress enacted the Investment Company Act of 1940, it 
expressly prohibited fund managers from using fund assets to finance 
the distribution of the fund's shares. Section 12(b) of the Act 
recognized the inherent conflict of interest between the manager's 
desire to increase fund assets in order to increase its fees on the one 
hand, and the fund's desire to hold down costs on the other hand. 
Unfortunately, the policy underlying Section 12(b) has long been 
abandoned, as fund assets are used for a wide range of distribution 
expenses that benefit fund managers at the expense of fund 
shareholders.
    The policy of separating the product from its distribution was 
first abandoned by the Commission when, after a prolonged review, it 
adopted Rule 12b-1 in 1980. In the 1970s, mutual funds experienced 
periods of net redemptions that prompted fund managers to lobby the 
Commission to permit the use of fund assets to finance the distribution 
of the funds' shares. Fund managers argued that net redemptions 
resulted in increased costs and that the financing of distribution by 
the fund would help reduce or eliminate net redemptions.
    The Commission initially rejected these arguments, but ultimately 
relented, provided that certain conditions were observed. For example, 
the Commission required that the fund's independent directors approve 
the 12b-1 plan. Among the factors that the Commission said a fund's 
directors should consider when evaluating whether to adopt or renew a 
12b-1 plan was the plan's effectiveness in remedying the problem that 
it was designed to address, i.e., increased costs resulting from net 
redemptions.
    The Commission's most significant concern regarding 12b-1 fees was 
the conflict of interest that they created between the fund and its 
adviser. The Commission feared that 12b-1 fees would result in higher 
advisory fees and the fund's adviser would not share the benefits of 
asset growth. \22\ Some would argue that this is precisely what has 
happened, with any growth-based economies of scale realized from 12b-1 
fees being pocketed by fund managers and not shared with fund 
shareholders.
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     \22\ See Donaldson Memorandum, supra, at 70-71 (``When a fund 
bears its own distribution expenses, the fund's investment adviser is 
spared the cost of bearing those expenses itself, and the adviser 
benefits further if the fund's distribution expenditures result in an 
increase in the fund's assets and a concomitant increase in the 
advisory fees received by the adviser.'').
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    Of course, this analysis goes primarily to the use of 12b-1 fees 
for marketing the fund, which is what Rule 12b-1 was intended to 
permit. It does not address the ways in which 12b-1 are actually used 
today and that were wholly unanticipated by the Commission when Rule 
12b-1 was adopted. According to and Investment Company Institute 
report, only 5 percent of 12b-1 fees are spent on advertising and sales 
promotion, whereas 63 percent of 12b-1 fees are spent on broker 
compensation. \23\
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     \23\ Use of Rule 12b-1 Fees by Mutual Funds in 1999, Investment 
Company Institute, 9 Fundamentals 2 (April 2000). Funds spend the other 
32 percent of 12b-1 fees on administrative services. Id.
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    The use of fund assets to compensate brokers is precisely what 
Section 12(b) was intended to prohibit. This practice puts the fund 
squarely in the position of underwriting its own securities. The fund's 
assets are used to incentivize brokers to recommend the fund over 
competing funds. The lesser the quality of the fund, the greater the 
pressure on the fund and its manager to pay brokers more to sell the 
fund.
    This irreconcilable conflict is mirrored on the distribution side 
of the business. When brokers are paid by the funds, rather than their 
customers, they have an incentive to recommend the fund that offers the 
biggest payout, rather than the fund that will provide the best 
investment for their customers. \24\ There is another incentive for 
brokers to favor arrangements whereby they are compensated by funds, 
and that is the fact that the compensation from the fund is not 
transparent. Whereas the payment of a front-end load is relatively 
evident to the investor, the payment of a 12b-1 fee is not. It is even 
less clear that the already opaque 12b-1 fee is ending up in the 
broker's pocket. For this reason, brokers and investors have begun to 
favor classes of fund shares where the broker is compensated by the 
fund, regardless of whether that class is in the best interests of 
shareholders. \25\
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     \24\ See Laura Johannes and John Hechinger, Conflicting Interests: 
Why a Brokerage Giant Pushes Some Mediocre Mutual Funds, Wall St. J. 
(Jan. 9, 2004); see also In the Matter of Morgan Stanley DW Inc., 
Exchange Act Rel. No. 48789 (Nov. 17, 2003).
     \25\ See Complaint, Benzon v. Morgan Stanley, No. 03-03-0159 (M.D. 
Tenn.). The SEC has banned the use of brokerage as compensation for 
fund brokerage.
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    Thus, the Commission has created a distribution compensation 
structure that is directly at odds with the interests of investors and 
the Investment Company Act. Rather than tying brokers' compensation to 
their relationships with their customers, where the Investment Company 
Act requires that it be placed, the Commission has tied brokers' 
compensation to their relationships with the funds, where the 
Investment Company Act expressly forbade its placement.
    Congress should reaffirm the supremacy of Section 12(b) and 
prohibit funds from compensating brokers for selling fund shares. 
Although this will necessarily entail the repeal of Rule 12b-1, it will 
in no way limit the ways in which investors can choose to pay their 
brokers. It will simply require that however brokers are compensated--
through a front-end load, back-end load, level-load, or any combination 
thereof--they are compensated by their customers, not by the funds. 
Thus, if a customer chooses to pay his broker on an installment basis, 
at 0.50 percent each year, for example, that amount would be paid by 
the customer directly or deducted from his fund account.
    One might argue that, to maintain perfect legislative coherence, 
Congress should also prohibit fund managers from paying for general 
marketing services that are not connected to specific sales. I 
disagree. The conflict is substantially reduced in this situation 
because the fund manager's and the fund's interests are generally 
aligned. General marketing payments do not create a direct incentive 
for brokers to favor one fund group over another. General marketing 
does what advertising for decades has been shown to do: promote 
competition. Indeed, by locating these payments in the management fee, 
the manager will be spending its own money and accordingly will have an 
incentive to minimize costs. With an express requirement that 
independent fund directors evaluate the efficacy of fund manager 
expenditures on marketing and determine that resulting economies have 
been shared with fund shareholders, expressly permitting fund managers 
to use the management fee to pay for marketing would be appropriate.
Revenue Sharing
    Over the last two decades, a compensation practice has evolved that 
strikes at the heart of the principle of full disclosure of conflicts 
of interest. Known as ``revenue sharing,'' this practice involves the 
payment of a part of fees collected by a mutual fund manager to a third 
party in return for administrative and/or distribution services. 
Notwithstanding the somewhat pejorative term ``revenue sharing,'' there 
is nothing necessarily inappropriate about the practice itself. 
Broadside critiques of revenue sharing are off base. Revenue sharing 
primarily reflects a compensation structure that can be a more 
efficient method of compensation than direct charges by each service 
provider to the client. Indeed, 12b-1 fees are functionally a kind of 
revenue sharing that are subject to enhanced (but still inadequate, see 
supra) disclosure requirements.
    That being said, the regulation and practice of revenue sharing 
disclosure has been abysmal. Revenue sharing payments are generally 
included in the total fees charged by a fund. Unlike 12b-1 fees, they 
are not, and are not required to be, broken out separately in the 
mutual fund fee table. More importantly, they are not necessarily 
disclosed by the service provider that receives them. Revenue sharing 
constitutes compensation to service provider that is not part of the 
fees charged directly to the client, so the client often is unaware of 
the service provider's economic incentive to sell the fund. When a 
broker recommends funds to clients, the broker does not disclose, and 
has not been required to disclose by the SEC or FINRA, that the broker 
will receive different amounts of revenue sharing payments depending on 
the fund purchased. The revenue sharing payments are made under the 
table; this blatant conflict of interest goes undisclosed.
    This is a significant problem in the context of brokers' mutual 
fund sales. The SEC and FINRA continue to defend a suitability standard 
for brokers that does not require full disclosure of conflicts of 
interest, even when the broker is providing individualized investment 
advice to the client (as opposed to acting solely as a salesperson). 
This means that brokers can recommend funds that are ``suitable'' 
without disclosing that they are receiving higher revenue sharing 
payments from that fund's manager than they would receive from the 
manager of a more suitable fund. The fees are not trivial. One SEC 
settlement involving revenue sharing payments revealed that brokers 
were receiving payments equal to 25 percent of the fund advisory fee in 
revenue sharing payments on every sale of that fund's shares. It is 
inexcusable that brokers are not required to disclose this payment 
differential to their clients.
    Unlike brokers subject only to a suitability standard, fiduciaries 
generally have been required to disclose revenue sharing to their 
clients. In SEC v. Capital Gains Research Bureau, the Supreme Court 
held that that an investment adviser, as a fiduciary, was required to 
disclose all material conflicts of interest to clients. Courts have 
generally applied this principle to the disclosure of revenue sharing 
payments on the ground that this information would be of importance to 
advisory clients. The Seventh Circuit recently held, however, that an 
Erisa fiduciary has no obligation to disclose revenue sharing payments 
to beneficiaries as long as the total fees being paid are disclosed. 
This is a truly remarkable position, especially in the wake of recent 
legislation that permits conflicted persons to provide investment 
advice to 401(k) plan participants on the condition that their 
compensation be the same regardless of the investment option selected. 
In other words, while Congress has been addressing the conflicted 
advice problem by flatly prohibiting differential compensation, the 
Seventh Circuit has decided not only that differential compensation can 
be received by an Erisa fiduciary, it does not even need to be 
disclosed.
    Both the SEC and FINRA have proposed rules that, depending on their 
final form, would require the disclosure of differential compensation. 
These rules, like many important investment management initiatives, 
have been pending for years. While the SEC has been paralyzed with 
indecision, state attorneys general have sued fund managers and brokers 
for their failure to disclose revenue sharing arrangements in their 
prospectuses and to their clients. The SEC's failure to take a position 
one way or the other has created an unpredictable patchwork of 
regulation that benefits no one, especially not those who appropriately 
use revenue sharing in their compensation structures. And the SEC's 
failure to require the disclosure of revenue sharing payments has 
allowed the practice to flourish.
    Congress should not continue to wait for regulators to recognize 
the obvious policy imperative of requiring full disclosure of conflicts 
of interest to financial services clients. In the last six years, a 
number of bills have been proposed that would, in one form or another, 
require the disclosure of revenue sharing and other forms of 
differential compensation. Congress should act promptly to enact some 
form of this legislation. The committee reports should make it clear 
that payments that create potential conflicts of interest must be 
disclosed and that the legislation is intended to overrule the Seventh 
Circuit's Deere decision.
Misleading Fund Share Classes
    Mutual funds often offer several classes of shares that reflect 
different ways of paying for distribution services. Typically, Class A 
shares carry a front-end load, Class B shares a back-end load, and 
Class C shares carry a level load. An investor is usually better off 
buying Class A shares if he intends to hold his shares for the 
longterm, and Class C shares if he may sell in the short-term. When 
Class B shares are best option, it is for the shareholder who holds for 
the mid-term. In some cases, however, there is virtually no shareholder 
for whom Class B shares are the best option.
    The Commission does not prohibit funds from offering Class B 
shares, even when there is no shareholder for whom Class B shares could 
be the best investment option. The Commission even rejected a rule 
amendment that would have required that funds illustrate in the 
prospectus the relative costs of each class of shares. Following the 
Commission's lead, a federal court held in January 2004 that, even 
assuming that there was no rational investor for whom Class B shares 
would be the best investment, the fund had no duty to disclose this 
fact in the prospectus. \26\
---------------------------------------------------------------------------
     \26\ See Benzon v. Morgan Stanley, 2004 WL 62747 (M.D. Tenn.).
---------------------------------------------------------------------------
    It is unconscionable that under current Commission positions a fund 
can offer a class of shares that would not be the best investment for 
any rational investor. Congress should require that multi-class funds 
illustrate, in a graphic format, the costs of investing in different 
classes over a 15-year period. In addition, Congress should require 
that the fund's independent directors find, subject to a fiduciary duty 
as described above, that each class of shares offered could be a 
reasonable investment alternative.
Fund Advertising
    Throughout the late 1990s, the Commission frequently berated the 
fund industry for misleading investors by advertising short-term 
performance. Funds with short life-spans routinely advertised one-year, 
sometimes even 2- and 3-year annualized investment returns in excess of 
100 percent. With the crash of the stock bubble in 2000, the 
Commission's concerns were validated, as many of these funds 
experienced huge losses, in some cases in excess of 70 percent of their 
value.
    The Commission's actions have not reflected its words, however. In 
September 2003, the Commission adopted advertising rules that utterly 
failed to address the very problems that it had identified in the late 
1990s. \27\ The rules require funds to provide a telephone number or 
web address where current performance information is available, as if 
the problem with short-term performance was that it wasn't current 
enough. The Commission also required that the text in fund ads include 
the statement that ``current performance may be higher or lower than 
the performance data quoted.''
---------------------------------------------------------------------------
     \27\ Amendments to Investment Company Advertising Rules, 
Investment Company Rel. No. 26195 (Sep. 29, 2003).
---------------------------------------------------------------------------
    Fund advertisements posted following market declines in 2000-2002 
demonstrate the inadequacy of the Commission's new rules. After three 
years of negative returns, stock funds had a banner year in 2003. Many 
of those funds are now advertising their stellar one-year performance 
without any disclosure of their poor returns in 2000, 2001, and 2002. 
Because they are required only to show their one-, five- and ten-year 
returns, the negative returns of 2000 to 2002 are hidden from view. The 
ads create a misleading impression by showing the outsized returns of 
2003 without any mitigating disclosure of the down years that preceded 
them and the performance volatility that those years' returns 
illustrate.
    For example, one ad shows SEC-mandated performance for four funds, 
each of which experienced superior returns in 2003, but experienced 
losses or substantially lower performance in each year from 2000 to 
2002. As illustrated in the table below, the disclosure of each fund's 
annual performance in the years preceding 2003 would have presented a 
very different, far more accurate picture. The Commission's rulemaking 
has done nothing to prevent such misleading ads, which have appeared 
routinely in business and personal finance magazines in the first few 
months of this year.


----------------------------------------------------------------------------------------------------------------
                                      Disclosed*                            Not Disclosed**
              Funds              -------------------------------------------------------------------------------
                                         2003                2002                2001                2000
----------------------------------------------------------------------------------------------------------------
Fund #1.........................             51.68%            (21.27%)             (7.56%)            (18.10%)
Fund #2.........................             42.38%             (9.37%)            (12.99%)             (8.96%)
Fund #3.........................             23.36%            (20.44%)             (3.74%)              12.25%
Fund #4.........................             29.96%            (17.16%)             (5.02%)               8.54%
----------------------------------------------------------------------------------------------------------------
* Source: Business 2.0 (March 2004).
** Source: Fund Prospectuses.


    The Commission's rulemaking also did nothing to address the problem 
of the disconnect between the advertised performance of funds and the 
actual returns experienced by shareholders. As confirmed by a recent 
DALBAR study, ``[i]nvestment return is far more dependent on investment 
behavior than on fund performance.'' \28\ DALBAR found that the average 
equity fund investor earned 2.57 percent annually over the last 19 
years, in comparison with the S&P 500's 12.22 percent annual return 
during the same period. This translates into a cumulative return for 
the S&P 500 of 793.34 percent from 1984 to 2002, compared with equity 
fund investors' actual cumulative return of 62.11 percent during the 
same period.
---------------------------------------------------------------------------
     \28\ DALBAR, Quantitative Analysis of Investor Behavior at 2 
(2003).
---------------------------------------------------------------------------
    These stunning and disheartening data illustrate, in part, a 
failure of investor education and individual choice. Investors have 
consistently chased the best performing funds just before they crashed, 
and dumped the worst performing funds just before they recovered. This 
sell-high, buy-low mentality is only encouraged by the Commission's 
current approach to fund performance advertising, which permits funds 
to present outsized returns with no meaningful caveats regarding their 
volatility and the likelihood that performance will soon revert to the 
mean. \29\
---------------------------------------------------------------------------
     \29\ Notably, the Commission requires that the prospectus include 
a bar chart that shows a fund's return for each of the preceding ten 
years. If such a disclosure is necessary to make the prospectus not 
misleading, it is unclear why the same reasoning is not applicable in 
the context of a fund advertisement.
---------------------------------------------------------------------------
    Not only do current rules fail to require meaningful disclosure 
about the volatility of fund returns, but they also fail to place 
outsized, one-year returns in the context of the market as a whole. To 
illustrate, the performance of the S&P 500 for 2003 was 28.68 percent, 
which puts the 51.68 percent return of the Fund cited above in a light 
very different (albeit still positive) from one in which the 
performance data stands alone. The Fund's advertised ten-year return of 
10.58 percent would tell a different story if it were required to be 
juxtaposed against the S&P 500's 11.07 percent ten-year return.
    The Commission also has recognized the need for investment returns 
to be considered in the context of fees, yet its rules do virtually 
nothing to benefit investors in this respect. In its proposing release, 
the Commission promised that its new rule would ``ensure that fund 
advertisements remind fund shareholders about the availability of 
information about fund charges and expenses.'' \30\ Yet the final rule 
required only that fund advertisements refer investors to the 
prospectus for consideration of fund expenses, among other things. \31\ 
In contrast, the NASD has proposed that fund advertisements include a 
box that shows both the fund's maximum sales charge and its expense 
ratio. \32\
---------------------------------------------------------------------------
     \30\ Proposed Amendments to Investment Company Advertising Rules, 
Investment Company Rel. No. 25575, Part II.C (May 17, 2002).
     \31\ Amendments to Investment Company Advertising Rules, supra.
     \32\ See Disclosure of Mutual Fund Expense Ratios in Performance 
Advertising, National Association of Securities Dealers (Jan. 23, 
2004).
---------------------------------------------------------------------------
    Congress should require that fund advertisements include all 
information necessary to make the information presented not misleading. 
This must include, at a minimum, investment returns for each individual 
year where such returns differ materially from fund's one-year 
performance, disclosure of the fund's total expense ratio (i.e., 
including the fund's portfolio transaction costs) and sales charges, 
and the performance and expenses of a comparable index fund.
Soft Dollars
    The term ``soft dollars'' generally refers to brokerage commissions 
that pay for both execution and research services. The use of soft 
dollars is widespread among investment advisers. For example, total 
third-party research purchased with soft dollars alone is estimated to 
have exceeded $1 billion in 1998. \33\ An executive with American 
Century Investment Management has testified that the research component 
of soft dollar commissions costs six times the value of the execution 
component. \34\
---------------------------------------------------------------------------
     \33\ Inspection Report on the Soft Dollar Practices of Broker-
Dealers, Investment Advisers and Mutual Funds, Securities and Exchange 
Commission, at text accompanying note 1 (Sep. 22, 1998).
     \34\ Testimony of Harold Bradley, Senior Vice President, American 
Century Investment Management, before the Subcommittee on Capital 
Markets, Insurance and Government Sponsored Enterprises, Committee on 
Financial Services, U.S. House of Representatives, at 5 (Mar. 12, 
2003).
---------------------------------------------------------------------------
    Soft dollar arrangements raise multiple policy concerns. The 
payment of soft dollars by mutual funds creates a significant conflict 
of interest for fund advisers. Soft dollars pay for research that fund 
advisers would otherwise have to pay for themselves. Advisers therefore 
have an incentive to cause their fund to engage in trades solely to 
increase soft dollar benefits. \35\
---------------------------------------------------------------------------
     \35\ Id. at 2 (the statutory safe harbor permitting soft dollars 
arrangements ``encourages investment managers to use commissions paid 
by investors as a source of unreported income to pay unreported 
expenses of the manager'').
---------------------------------------------------------------------------
    Soft dollar arrangements normally would be prohibited by the 
Investment Company Act because they involve a prohibited transaction 
between the fund and its adviser. \36\ Section 28(e) of the Securities 
Exchange Act, however, provides a safe harbor from the Investment 
Company Act for soft dollar arrangements as long as the brokerage and 
research services received are reasonable in relation to the amount of 
the commissions paid.
---------------------------------------------------------------------------
     \36\ See Investment Company Act Section 17(e); Inspection Report 
at 38, supra.
---------------------------------------------------------------------------
    The conflicts of interest inherent in soft dollar arrangements are 
exacerbated by current disclosure rules. The amount of fund assets 
spent on soft dollars is not publicly disclosed to shareholders, so 
they are unable to evaluate the extent, and potential cost, of the 
adviser's conflict.
    Current disclosure rules reward advisers for using soft dollars 
because this practice creates the appearance that a fund is less 
expensive. The expense ratio does not include commissions, which gives 
advisers an incentive to pay for services with soft dollars, thereby 
enabling them to lower their management fees and the fund's expense 
ratio. Advisers can effectively reduce their expense ratios by spending 
more on soft dollars, while the fund's actual net expenses remain 
unchanged.
    Finally, current disclosure rules may encourage excessive spending 
on soft dollars. Advisers would tend to spend less on soft dollars if 
they knew that they would be held publicly accountable for their 
expenditures.
    The Commission has frequently recognized but declined to address 
the problem of soft dollars. As discussed above, the Commission is 
opposed to including portfolio transaction costs in funds' expense 
ratios, which would have the benefit of enabling the market to 
determine for itself the efficacy of soft dollar arrangements. The 
Commission previously proposed a rule that would require that soft 
dollars costs be quantified, but decided against adopting it. \37\ When 
the Commission staff last evaluated soft dollar arrangements in 1998, 
it concluded that additional guidance was needed in a number of areas. 
\38\ For example, the staff found that many advisers were treating 
basic computer hardware--and even the electrical power needed to run 
it--as research services qualifying under the Section 28(e) safe 
harbor. \39\ The staff recommended that the Commission issue 
interpretive guidance on these and other questionable uses of soft 
dollars, but it has failed to do so.
---------------------------------------------------------------------------
     \37\ Donaldson Memorandum at 13-17, supra. Fidelity recently 
recommended that the Commission reconsider its decision not to require 
the quantification of soft dollar costs. Ann Davis, Fidelity Wants 
Trading Costs To Be Broken Down, Wall Street Journal (Mar. 15, 2004).
     \38\ Inspection Report on the Soft Dollar Practices of Broker-
Dealers, Investment Advisers and Mutual Funds, Securities and Exchange 
Commission, at text accompanying note 1 (Sep. 22, 1998) (``Section 
28(e) Report'').
     \39\ Id. at Section V.C.4.
---------------------------------------------------------------------------
    In fact, the only formal action that the Commission has taken in 
recent years is to expand the use of soft dollars. In December 2001, 
the Commission took the position that the safe harbor should apply to 
markups and markdowns in principal transactions, although Section 28(e) 
expressly applies only to ``commissions.'' \40\ This position directly 
contradicts not only the plain text of the statute, but also the 
position taken by the Commission in 1995 that section 28(e) ``does not 
encompass soft dollar arrangements under which research services are 
acquired as a result of principal transactions.'' \41\ Although the 
Commission has, once again, suggested that intends to narrow the scope 
of soft dollars, its recent history suggests that Congressional action 
is necessary. In any case, the Commission lacks the authority to ban 
soft dollars.
---------------------------------------------------------------------------
     \40\ Commission Guidance on the Scope of Section 28(e) of the 
Exchange Act, Exchange Act Rel. No. 45194 (Dec. 27, 2001).
     \41\ Investment Advisers Act Release No. 1469 (February 14, 1995).
---------------------------------------------------------------------------
    There is no better evidence that the time has come to ban soft 
dollars than the recognition of the insidious nature of this practice 
by members of the fund industry. In addressing the fact that soft 
dollars enable fund managers to use the fund's money to pay for 
research used by the manager, the independent chairman of the Putnam 
Funds has stated that ``[t]he best decisions get made when you buy 
services with your own money.'' \42\ Similarly, MFS' chairman, Robert 
Pozen,
---------------------------------------------------------------------------
     \42\ Id. (quoting John Hill).

        sees the soft-dollar funnel as a lucrative one for brokers, but 
        one that hides the true cost of such services to shareholders. 
        ``It's all camouflaged,'' said Mr. Pozen, a former associate 
        general counsel of the SEC. Now, he added, ``If we want 
        something, if we think it's valuable, we will pay cash.'' \43\
---------------------------------------------------------------------------
     \43\ Id.

    A Fidelity executive has acknowledged the pro-competitive advantage 
of a ban on soft dollars, stating: ``[w]e don't rule out a competitive 
environment through which all research is acquired through cash rather 
than commissions.'' \44\
---------------------------------------------------------------------------
     \44\ Landon Thomas, Jr., Mutual Fund Tells Wall Street It Wants ` 
la Carte Commissions, New York Times (Mar. 16, 2004).
---------------------------------------------------------------------------
    The difficulty for fund firms, however, is that without a statutory 
ban on soft dollars they may suffer a competitive disadvantage MFS has 
estimated that paying for its own research will reduce its advisory 
fees. \45\ Fidelity has estimated that of the $1.1 billion in 
commission it paid in 2003, $275 million paid for soft dollar research. 
\46\ It is unrealistic to expect these fund managers to maintain the 
high road at the expense of reduced advisory fees, while other fund 
managers continue to pay their own research expenses through soft 
dollars rather than out of their own pockets.
---------------------------------------------------------------------------
     \45\ MFS Ends `Soft Dollar' System, supra.
     \46\ Fidelity Wants Trading Costs To Be Broken Down, supra.
---------------------------------------------------------------------------
Fund Names and Investor Expectations
    The recent collapse of the stock market has exposed a significant 
gap in the regulation of mutual fund names. The average investor will 
reasonably assume that funds will invest consistent with their names, 
but mutual fund rules do not require that funds honor these 
expectations.
    To illustrate, one would expect a Target Date 2010 Fund to be 
designed to fit the needs of someone who planned to retire at age 65 in 
2010. Such a fund would invest in mix of stocks and bonds. The 
investment of stocks carries higher risk, but this risk is necessary to 
provide the growth potential needed by someone who may live 30 or more 
years after retirement. The fixed income securities provide stability 
to ensure that assets that will be needed for living expenses in the 
near term are not exposed to risk. There is no definitive asset 
allocation between stocks and fixed income securities in which a Target 
Date 2010 Fund should invest, and one could not argue that under no 
circumstances would it be appropriate for a 65-year-old retiree to have 
an 80 percent stock / 20 percent bond mix, but such a mix would fall 
well outside the generally expected asset allocation of a Target Date 
2010 Fund.
    Mutual fund disclosure rules would allow a Target Date 2010 Fund to 
adopt such an 80 percent / 20 percent asset allocation. Notwithstanding 
that the Fund's name suggests a substantially lower stock allocation, 
the description of the Fund's investment objectives and style in its 
prospectus could correct this misimpression and investors would be 
expected to have read and understood such clarifying disclosure. Under 
current prospectus liability rules, the true nature of the Fund's 
aggressive asset allocation strategy could even be omitted from the 
summary of its investment objectives and style in the summary 
prospectus as long as corrective disclosure appeared elsewhere in the 
full prospectus. (It is likely that some courts would find that even 
corrective disclosure buried in the Fund's Statement of Additional 
Information, which is delivered to investors only upon request, would 
be a sufficient defense for prospectus liability purposes.) Thus, 
investors that expect the stock allocation suggested by the name of the 
Target Date 2010 Fund to be substantially lower than 80 percent and do 
not carefully scrutinize other fund disclosure documents will be 
subject to more risk than they expected. For example, a 45 percent 
decline in the stock market would result in a 36 percent decline in the 
value of their Fund shares, when they might have expected an 18 percent 
or 22.5 percent based on a 40 percent or 50 percent stock allocation. 
\47\
---------------------------------------------------------------------------
     \47\ Tom Laurcella, For Retirement, `One Size' Isn't Always a Good 
Fit, Wall. St. J. (Mar. 2, 2009) available at http://online.wsj.com/
article/SB123549381087960625.html (``A typical fund for an investor 
aiming to retire 20 years from now might have at least 80 percent in 
stocks. By the time the retirement date approaches, most funds 
typically have less than 40 percent in stocks.'').
---------------------------------------------------------------------------
    It is helpful to consider a recent example of this problem. A 
particular Target Date 2010 Fund has been criticized for declining 38 
percent in value, but this decline is consistent with its aggressive 
asset allocation. The fourth page of the fund's prospectus (for the 
relatively assiduous investor) states that each retirement fund:

        is managed to the specific year of planned retirement included 
        in its name (the `retirement date'). The Strategies' asset 
        mixes will become more conservative each year until reaching 
        the year approximately fifteen years after the retirement date 
        (the `target year') at which time the asset allocation mix will 
        become static.

    At this point, the prospectus has only reinforced the expectation 
that the 2010 fund's asset allocation strategy will reflect a stock 
allocation in the range of 40 percent to 50 percent. Under current law, 
this disclosure by no means created an expectation on which investors 
could actionably rely. Indeed the same paragraph includes a state that 
15 years after retirement the static allocation would be: 27 percent 
short-term bonds, 37.5 percent other fixed-income securities, 25 
percent equities and 10 percent real estate investment trusts 
(``REITs''). From this, a very attentive investor could assume that the 
stock allocation at retirement would be fairly aggressive. The fifth 
page of the prospectus includes table that shows an expected allocation 
of approximately 77 percent 30 of the 2010 fund's assets to equities, 
REITS and high-yield debt in the year before retirement.
    The problem is that this fund's allocation is inconsistent with 
what many investors will expect from a Target Date 2010 Fund. There is 
no reason that this fund's sponsor should not be allowed to offer a 
fund for retirees who wish to adopt an aggressive asset allocation. In 
combination with other investments the retiree might hold, the 
retiree's overall asset allocation might fall within the more typical 
40 percent to 50 percent range. But, in the words of a Fidelity 
executive, something called a ``target-date'' fund should follow a 
``one size fits most'' strategy, and this fund fails that test.
    This problem is not limited to target-date funds. In some 529 
plans, there are asset allocations designed for children expected to 
need the funds for college within one or two years that experienced 
substantial losses. These losses were inconsistent with the investment 
performance range one would expect from a conventionally constructed 
portfolio for such a short time horizon. Some of these 529 plans 
invested in bond funds that included ``short-term'' in the fund's name, 
but their investment returns fall well outside of the variance one 
would associate with short-term bond funds. Many ``short-term bond'' 
funds held outside of 529 plans have produced abnormally high losses.
    To reiterate, the problem here is not that some funds have 
experienced substantial losses. To the extent that investors knowingly 
assumed the risk of large losses, criticizing these funds is somewhat 
unfair. For example, actively managed funds that lost 60 percent of 
their value while comparable markets lost only 40 percent provided 
their investors with returns that were within the range of variance 
from market returns that one assumes by accepting active management 
risk. One could criticize such funds for poor stock-picking, but it was 
the shareholder who chose to assume the active management risk that the 
fund would underperform the market. Similarly, the shareholder invested 
in a Target-Date 2050 Fund should expect to experience large losses 
when stock markets experience significant declines. In this case, it 
would be the Target-Date 2050 Fund that invested most of its assets in 
money market instruments that would be contradicting the asset 
allocation implied by its name.
    The SEC has had the opportunity to address the potential of fund 
names to mislead investors. Pursuant to a request from consumer 
advocates, the SEC adopted a misleading fund names rule in 2001. The 
rule fell far short of providing reasonable assurances that fund names 
that strongly implied a particular investment objective or style would 
stick to it. The rule allows ``stock'' funds to invest 100 percent of 
their assets in cash in emergency situations, ``short-term bond'' funds 
to risk substantial losses, ``value'' funds to invest primarily in 
growth stocks, and ``target-date 2010'' funds to invest a more than 75 
percent of their assets in equities. The SEC has taken the position 
that no matter how strongly a particular fund name implies a particular 
investment objective or style, the name's potential to mislead 
investors can be entirely corrected through narrative disclosure that 
is often buried in fund documents. The SEC staff went out of its way to 
reassure fund managers that funds the included the term ``U.S. 
Government'' in its name could nonetheless invest 100 percent of its 
assets in securities issued by Fannie Mae and Freddie Mac. \48\ As I 
testified before this Committee in 2004, the term ``U.S. Government'' 
implies that the fund will invest in government-guaranteed securities, 
which Fannie Mae and Freddie Mac securities are not.
---------------------------------------------------------------------------
     \48\ Letter from Paul F. Roye, Director, SEC Division of 
Investment Management, to Craig Tyle, General Counsel, Investment 
Company Institute (Oct. 17, 2003).
---------------------------------------------------------------------------
    Although investors should read prospectuses carefully before 
investing, I disagree that investors whose investments in a ``target-
date 2010'' fund, a ``shortterm bond'' fund or 529 plan investment 
option for a 16-year-old that declined more than 40 percent in one year 
are entirely to blame for their misfortune. Congress should enact 
legislation that meaningfully regulates fund names. It should require 
the SEC to prohibit the use of fund names that create a common 
expectation among investors regarding a fund's investment objectives 
and style unless the fund invests consistent with that style. The 
precise scope of the rule should be left to the SEC, but there should 
be no question that terms such as ``target-date,'' ``short-term bond,'' 
and ``value'' would be covered. Fund sponsors use these terms in fund 
names precisely to communicate something about the fund to investors. 
They should not be permitted to contradict the fund name's message with 
qualifying disclosure in fund documents.
    Some have criticized this position as requiring that the government 
dictate how funds invest. This argument is a red herring designed to 
divert attention from the real issue. The only restriction that would 
apply would be to the names that funds are permitted to use. The new 
rule would have no effect on any fund that chose a name that did not 
imply a particular investment objective or style. I strongly agree that 
free markets should determine what mutual funds invest in, not 
regulators. Requiring that all mutual funds invest only in a portfolio 
the returns of which will fall within a fairly predictable range would 
be inefficient, impracticable and inconsistent with basic principles of 
individual liberty. There are and should be mutual funds the variance 
of the investment returns of which essentially match the scope of the 
fund manager's investment discretion.
    Requiring that a fund that uses a particular name produce 
predictably variable returns, however, does not implicate these 
concerns. When Magellan Fund manager Jeff Vinik invested a large amount 
of the Fund's assets in fixed income securities prior to a run-up in 
the stock market in the late 1990s, the opportunity lost by its 
shareholders was a risk that they knowingly assumed. There is nothing 
about the name ``Magellan Fund'' that implies that its investment 
returns will reflect the variance that is characteristic of a 
particular market. Indeed, the name ``Magellan'' aptly suits a fund 
that may explore any and all investment opportunities around the globe. 
In contrast, it is misleading that a so-named ``stock'' fund can, 
consistent with its name, invest 100 percent of its assets in cash, or 
that something called a ``short-term bond'' fund could lose 40 percent 
of its value in a single year.
Fund Governance
    As indicated by this testimony, the breadth and depth of investor 
protection issues in the mutual fund industry that have been left 
unattended by regulators calls for new ideas on the most efficient 
structure for mutual fund regulation. The mutual fund scandal of 2003 
also demonstrated the need for more independent boards. As described in 
greater detail in my March 23, 2004, testimony before this Committee, 
Congress should implement the following reforms to strengthen the 
oversight of mutual funds:

    Create a Mutual Fund Oversight Board that would have 
        examination and enforcement authority over funds and fund 
        boards.

    Require that a fund's chairman be independent.

    Require that a fund's board be 75 percent independent.

    Prohibit former directors, officers and employees of the 
        fund manager from serving as independent directors.

    Require that independent directors stand for election at 
        least once every 5 years.

    The Commission does not have the authority to impose any of these 
requirements on an unconditional basis. Each of these proposals 
requires Congressional action.
529 PLANS
    As this Committee is aware, 529 plans have become an increasingly 
popular means for Americans to save for higher education. These plans 
have enjoyed enormous appeal in part because they offer a unique 
combination of federal and state tax benefits, high contribution 
limits, matching state contributions, donor control, automatic 
rebalancing and, in many cases, low costs. However, 529 plans also have 
been subject to criticism on the grounds of excessive and inadequately 
disclosed fees, inconsistent state tax treatment across different 
plans, and questionable sales practices. The following discussion 
briefly sets forth some of the issues relating to 529 plans and 
proposes regulatory reforms. \49\
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     \49\ Many of these issues are discussed in greater detail at: 
Mercer Bullard, The Visible Hand in Government Sponsored Financial 
Services: Why States Should Not Sponsor 529 Plans, 74 U. Cin. L. Rev. 
1265 (2006).
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Regulatory Oversight
    Permitting states to sell and regulate 529 plans has effectively 
added 50 new regulators for tax-deferred mutual fund wrappers (e.g., 
401(k) plans, IRAs, Roth IRAs, and 403(b) plans), which are subject to 
too many different regulators and sets of rules as it is. The 
Commission is responsible for fee disclosure for variable annuities, 
the Department of Labor is responsible for fee disclosure for employee 
benefit plans, and banking regulators and the Internal Revenue Service 
are responsible for fee disclosure for IRAs. Multiple disclosure 
regimes confuse investors and increase the costs of offering investment 
products, as each provider must tailor its program to the particular 
state's requirements. The Committee should take this opportunity to 
explore ways of rationalizing fee disclosure and other regulatory 
aspects of various tax-deferred mutual fund wrappers.
    One option would be to assign exclusive oversight of 529 plans to 
the SEC. The SEC has greater experience and expertise in this area than 
any other government entity, and it would bring greater independence 
and objectivity to the creation and enforcement of 529 plan fee 
disclosure requirements. The states, as the issuers of interests in 529 
plans, lack the independence and objectivity to regulate their own 
plans and to enforce any rules they might devise. Congress should 
consider specifically authorizing the Commission to establish 
comprehensive rules governing the 529 plan fee disclosure, and consider 
expanding this responsibility to all aspects of 529 plans operations.
    In addition, Congress should consider amending the municipal 
securities exemption to exclude 529 plans or permitting private firms 
to offer 529 plans outside of state sponsorship. The municipal 
exemption under which 529 plans operate was not intended for the 
offering of retail financial services, but for the conduct of bona fide 
government activities. There is nothing state-specific about 529 plans 
that could not be accomplished outside of the framework of a money 
management structure.
Fee Disclosure
    Some commentators have criticized 529 plans on the ground that the 
high fees charged by many plans have reduced the potential tax benefits 
of the plans. Indeed, one commentator decried a plan that consumed more 
than 10 percent of participants' balances each year for two years. 
Determining whether a particular fee is too high or too low, based 
solely on the amount of the fee, is a difficult and uncertain exercise. 
In my view, the best way to promote efficient pricing is through 
standardized, transparent disclosure of fees. It is generally accepted 
that standardized, transparent fee disclosure promotes competition and 
reduces prices. The disclosure of 529 plan fees, however, is generally 
incoherent and obscure, and 529 plans would likely be forced to reduce 
their fees if adequate fee disclosure were provided.
    The lack of transparent, prominent, standardized disclosure of 529 
plan fees is exacerbated by factors in the 529 plan context that make 
fee disclosure even more important than in other contexts. In effect, 
certain governmental entities have been granted an exclusive monopoly 
to sell a particular tax-deferred investment product in competition 
with private providers of other tax-deferred investment products. This 
intrusion of the government into the private sector may distort many 
functions of the financial services markets, including the setting of 
fees.
    For example, investors may lower their guard when evaluating 529 
plans on the assumption that a public-minded governmental entity would 
sell only a high quality, low-cost investment product. In fact, states' 
interests may not be aligned with plan participants' interests with 
respect to negotiating fees and choosing investment options, and 
investors' trust in states' motivations and interests may be misplaced. 
States may have incentives to offer plans that charge high fees. States 
may charge high fees as a means of increasing their general revenues, 
or charge higher fees to out-of-state residents as a way to subsidize 
services provided to instate participants. Political considerations 
also may influence the selection of money managers and cause states to 
be less diligent when negotiating fees. For example, states may favor 
in-state money managers or managers that have contributed to the 
election campaigns of state officials. State officials may even use 529 
plan assets for self-promotion.
    Further, participants in 529 plans have limited control over fees. 
Mutual funds can raise advisory and 12b-1 fees only with shareholder 
approval, whereas states generally can raise fees at will without 
notice to participants, thereby making it more important that investors 
understand the fees charged before making an investment decision. When 
a mutual fund that is a 529 plan investment option seeks to raise its 
fees, the state has the right to vote on the fee increase, but, as 
noted above, it may not have the same interests to negotiate low fees 
as plan participants have. Finally, federal law gives mutual fund 
shareholders legal recourse against a fund's directors and manager with 
respect to excessive fees charged by the manager, which may provide 
some restraint on fees. Participants in 529 plans, however, have no 
such rights absent a violation of the antifraud rules under the federal 
securities laws.
    Restrictions on 529 plan investment options, participants' limited 
control over fees and fee increases, the costs and burdens of 
transferring from one plan to another, states' monopoly on state tax 
benefits, limited legal recourse against plan sponsors, and the 
divergence of state and participant interests are some of the special 
factors that make it especially critical that 529 plan fees be fully 
disclosed in an understandable, standardized, accessible format.
    These special factors militate for prompt Congressional action to 
ensure that 529 plans are required to provide standardized, 
transparent, prominent fee disclosure. In short, fee disclosure for 529 
plans, at a minimum, should be:

    Standardized, both in the way in which the fees are 
        calculated and the terms used to describe the fees;

    Prominently disclosed relative to other information about 
        the plan;

    Presented both as a percentage of assets and a dollar 
        amount, and on an illustrative and individualized basis;

    Inclusive of a total expense ratio for each investment 
        option that includes all fees incurred in connection with an 
        investment in the plan, to include, among other things, 
        portfolio transaction costs, distribution costs, operating 
        costs and administrative fees, whether charged by the state, 
        plan manager, investment manager, or other person;

    Inclusive of a pie chart that illustrates the components of 
        the total expense ratio according to standardized categories of 
        fees, such as investment management, administrative services, 
        and marketing and distribution;

    Inclusive of information on fees charged by other 529 plans 
        both in a disclosure document and in an easily accessible 
        format on the Internet; and

    Inclusive of separate disclosure of all payments received 
        by intermediaries for executing the transactions in plan 
        interests, both as a dollar amount and percentage of assets, 
        whether or not the payment is made directly by the participant.

    As discussed above, Congress should ensure that fee disclosure 
requirements for 529 plans are promulgated and enforced by an 
independent, objective government entity.
Disparate State Tax Treatment
    Most states that permit state deductions for 529 plans limit the 
deductions to the in-state plan. This disparate state tax treatment of 
529 plans distorts the marketplace for investment products. Investors 
may opt for a higher-cost, in-state plan specifically in order to 
receive the tax benefits of the in-state plan, or may miss out on the 
in-state tax benefit offered by a low-cost in-state plan because 
brokers recommend out-of-state plans that pay higher compensation to 
the broker.
    The disparate state tax treatment of 529 plans has the effect of 
reducing price competition among 529 plans because in-state plans can 
exploit their monopoly on in-state tax benefits to offset their higher 
fees. This is essentially a kind of bundling, not dissimilar to a 
private company that has a government-granted monopoly over one product 
(state tax deductions) to help it sell another, possibly inferior 
product (the 529 plan). States will inevitably exploit this monopoly to 
the detriment of investors in 529 plans. The unavailability of state 
tax deductions for out-of-state plans may further undermine market 
efficiency and create incentives to charge higher fees, as discussed in 
the next section. A small minority of states have extended their state 
tax deduction to out-of-state 529 plans, but most continue to frustrate 
Congress's intent in creating the plans. Congress should consider 
mandating that any state tax deductions for 529 plan contributions or 
distributions be reciprocal across all qualified 529 plans.
HEDGE FUNDS
Systemic Risk
    There is no question that hedge funds are a potential source of 
systemic risk, that is, the kind and scope of financial risk that is 
systemic in the sense of posing a threat to our political, social and 
economic systems. Systemic risk warrants government oversight because 
our society might not be able to absorb an extreme contraction of free 
financial markets without long-term damage to political, economic and 
social institutions. This concern militates for appropriate prudential 
oversight of hedge funds, such as requirements that they report net 
positions and leverage ratios.
    This does not mean that hedge funds or their advisers should be 
subject to substantive regulation, however. It is important that 
capital be allowed to flow to unregulated intermediaries such as hedge 
funds. Investment in hedge funds is limited to sophisticated investors, 
and these investors are presumed to be in the best position to protect 
their interests without costly governmental oversight. Substantive 
regulation of hedge funds will simply drive sophisticated capital 
offshore and provide little benefit to the financial markets. As 
discussed below, however, the SEC has permitted hedge funds to be sold 
to unsophisticated investors in certain circumstances.
Public Offering of Hedge Funds
    In 2007, the SEC effectively decided to permit hedge funds to 
publicly offer their shares. These hedge funds argued that they 
reflected investments in hedge fund managers, not in the funds, yet the 
value of interests that they sold were predominantly depended on the 
success of their funds. The financial structure of these public 
companies is closer to a hedge fund than to a conventional money 
manager, \50\ and the behavior of the stock prices of public hedge 
funds and conventional money managers over the last two years has 
reflected the significantly greater risks posed by the former. As 
predicted, these publicly held hedge funds are acting like hedge funds, 
not money managers. Much attention is being--and should be--paid to the 
systemic risk posed by hedge funds, but too little has been paid to the 
sale of hedge fund interests to unsophisticated investors. If the SEC 
continues to be unwilling to ensure that hedge funds are sold only to 
sophisticated investors, Congress should prohibit the public offering 
of shares of these entities.
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     \50\ See After Blackstone: Should Small Investors Be Exposed to 
Risks of Hedge Funds? Hearing before the Subcommitee on Domestic 
Policy, Committee on Oversight and Government Reform (July 11, 2007) 
(testimony of Mercer Bullard); Mercer Bullard, Regulating Hedge Fund 
Managers: The Investment Company Act as a Regulatory Screen, 13 
Stanford J. Law, Bus. & Fin. 286 (2008).
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Accredited but Unsophisticated Investors
    Under current law, persons with net worth of $1 million either 
alone or with their spouse qualify to invest in hedge funds. The SEC 
has conceded that this test, which has not been adjusted since 1982, 
has made millions of new investors eligible to invest in hedge funds at 
the same time that ``private pools have become increasingly complex and 
involve risks not generally associated with many other issuers of 
securities.'' The Commission estimated that the minimum net worth 
requirement, if adjusted only for inflation and disregarding the issue 
of increased complexity, would have been $1.9 million as of July 1, 
2006. That year, the Commission issued a modest proposal to increase 
the $1 million minimum to $2.5 million. That minimum would be 
inflation-adjusted again on July 12, 2012, and every 5 years 
thereafter. In 2007, the Commission requested additional comments on 
the proposal, but almost three years after the initial proposal, the 
Commission has yet to take final action.
    The effect of the SEC's position is that a newly retired couple 
with $700,000 investments and a $300,000 home--the SEC continues to 
count a person's personal residence counts toward the $1 million net 
worth minimum while conceding that the ``value of an individual's 
primary residence may have little relevance with regard to the 
individual's need for the protections of Securities Act 
registration''--is sophisticated enough to invest in a hedge fund. With 
$700,000 in investments, a retired couple's typical withdrawal rate 
would be 4 or 5 percent annually, or about $31,000 per year, plus 
Social Security income and, in some cases, a company pension. Even 
assuming additional income of $20,000 per year (which would not be 
needed for the couple to meet the SEC standard), it is self-evident 
that this couple's net worth in no way qualifies them to risk their 
retirement security in a hedge fund. Nearly three years after its 
initial proposal (and 27 years after the $1 million minimum was first 
established), the SEC continues to permit hedge funds to prey on 
unsophisticated investors. Congress should take steps to ensure that 
any individual net worth standard for private offerings bears a 
reasonable relationship to the likely financial sophistication of the 
purchaser.
INVESTMENT ADVISERS
Fiduciary Standard
    It is hard to understand how, after years of regulatory review, the 
simple question of whether those who provide individualized investment 
advice should be subject to a fiduciary standard has not been answered. 
It is accepted that professionals who provide individualized, technical 
advice similar to investment advice--e.g., lawyers and doctors--are 
fiduciaries. They are required to act solely in their clients' best 
interests. They may charge higher fees than other advisers, but their 
fees must be fair. The must disclose all potential conflicts of 
interest to their clients. In many cases, doctors and lawyers are 
prohibited from assuming a conflicted role no matter what amount of 
disclosure they provide.
    The Supreme Court agrees. In the Capital Gains decision, it held 
that investment advisers are subject to a fiduciary duty to their 
clients. Yet the SEC and FINRA have taken the position that when 
brokers provide individualized advisory services to their clients, they 
should not necessarily be subject to a fiduciary duty, even when they 
charge a separate, asset-based fee and advertise themselves as 
``financial consultants,'' ``financial planners,'' and ``wealth 
managers.'' In the narrow circumstances in which the SEC would consider 
a broker to be an adviser, such as when it had provided a variety of 
financial planning services to a client, the SEC still would allow the 
broker to revert to a non-fiduciary role in executing the financial 
plan. As a practical matter, the ``financial consultant'' can provide a 
generic financial plan subject to a fiduciary duty, and then take off 
its fiduciary hat when selling the client mutual funds that pay the 
broker higher distribution fees than other funds without disclosing the 
fees. As long as the funds are suitable, which they generally will be, 
the broker has acted consistent with FINRA's standards of conduct.
    The SEC's approach to this issue has been consistently anti-
investor. Ten years ago, it adopted a rule that expressly eliminated 
Congress's requirement that the broker exclusion apply only if the 
broker receives no special compensation for investment advisory 
services. The rule also read Congress's requirement that the advisory 
services also be ``solely incidental'' so broadly so as to be 
meaningless. The SEC took the position that advice was solely 
incidental if the advisory services were provided ``in connection with 
and reasonably related to'' brokerage services. As stated in an amicus 
brief filed by Fund Democracy and the Consumer Federation, ``[t]he 
Commission's `in connection with and reasonably related to' standard 
sets no limits on the degree of advisory services provided in relation 
to the brokerage services, much less in any way limit the advisory 
services to those that are `minor' or otherwise `incidental.'' ''
    Congress needs to take action to end this debate. For over a 
decade, the SEC has been unable to muster the backbone to defend 
fiduciary standards for investment advisers, and the current SEC 
Chairman and one Commissioner spent years defending FINRA's self-
interested position that a suitability standard is adequate, \51\ 
notwithstanding that, for example, it does not require the disclosure 
of conflicts of interest. Congress should enact legislation that 
imposes a fiduciary duty on any persons who provide individualized 
investment advice or sell products pursuant to their providing of such 
individualized investment advice. Americans who naturally expect those 
providing fiduciary services to act solely in their clients' best 
interests are entitled to nothing less.
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     \51\ See, e.g., Letter from Mary Schapiro, Vice Chairman and 
President, NASD, and Elisse Walter, Executive Vice President, NASD to 
Annette Nazareth, Director, Division of Market Regulation, and Meyer 
Eisenberg, Acting Director, Division of Investment Management, U.S. 
Securities and Exchange Commission (Apr. 4, 2005) available at http://
www.sec.gov/rules/proposed/s72599/nasd040405.pdf
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Madoff Scandal
    It should not be necessary to include the Madoff scandal as a 
separate category in this testimony, but the import of the scandal for 
investment adviser regulation has been so distorted that some 
clarification is necessary. We still don't know exactly how Madoff 
perpetrated his fraud, except that he did so without detection for many 
years. Some have argued that this reflects a failure of investment 
adviser regulation despite the fact that he was exclusively regulated 
as a broker-dealer during most of the period of the fraud. These 
arguments may simply reflect nothing more than a short-sighted 
political strategy to curry favor as the preferred choice as the SRO 
for the adviser industry, but they nonetheless need to be addressed. I 
agree that an SRO for advisers would be appropriate, but if the Madoff 
scandal has revealed anything with respect to this issue, it is that 
some regulators lack a full understanding of the nature of investment 
adviser services and regulation and could not adequately protect 
investors' interests in overseeing the investment adviser industry.
    During most of the period during which Madoff defrauded his 
clients, he was not registered as an investment adviser--he was 
registered as a broker. It appears that he was not registered as an 
investment adviser because the SEC had interpreted the broker exclusion 
from the definition of investment adviser for ``solely incidental'' 
investment advice to be available for discretionary accounts. The SEC 
has since abandoned this ill-advised position, but during most of 
Madoff's illegal activities he was able to rely on the exclusion and 
was regulated solely as a broker. Thus, while FINRA, the SRO 
responsible for broker oversight, has suggested that the Madoff scandal 
illustrates the risk of ``the absence of FINRA-type oversight of the 
investment adviser industry,'' this position is belied by the 
undisputed fact that Madoff was subject only to broker regulation 
during most of the relevant period.
    FINRA's position is understandable and not necessarily a negative 
reflection on its capacity as the broker SRO. Its leadership lacks a 
deep understanding of and experience with investment adviser 
regulation, and it has a close relationship with and is naturally 
protective of the brokerage industry. Its sometimes excessive 
exuberance for extending its jurisdiction over functionally dissimilar 
services is a common, unavoidable symptom of agency politics, 
especially in the inexperienced hands of new leadership. And one would 
expect that a fraud perpetrated by a man who for years served in a 
variety of leadership roles with FINRA's predecessor (the NASD), and 
who used the luster that the NASD gave his reputation to help entice 
unknowing victims, would put FINRA on the defensive and make its 
objective evaluation of the situation difficult. \52\ Indeed, FINRA's 
precipitate response to the Madoff scandal is quite understandable, but 
it is also, unfortunately, evidence that it is not capable of providing 
effective self-regulation of the investment adviser industry.
---------------------------------------------------------------------------
     \52\ See Susan Antilla, Investors happily handed Madoff Billions, 
Business Times (Dec. 17, 2008) (Madoff's ``company Web site describes 
him as 'a major figure in the National Association of Securities 
Dealers', the regulatory agency now known as Finra. He was board 
chairman of the Nasdaq Stock Market; was on the board of governors of 
the NASD; sat on an advisory committee for the Securities and Exchange 
Commission (SEC); and was chairman of the trading committee of Sifma, 
formerly the Securities Industry Association.'').
---------------------------------------------------------------------------
    This is not to say that the Madoff scandal tells us nothing about 
investment adviser regulation. As noted, it demonstrates the problem of 
leaving solely to broker regulation the kinds of advisory activities 
that are clearly in need of investment adviser oversight. The SEC has 
corrected the regulatory gap that allowed brokers who provided 
discretionary advice to avoid advisory regulation. As discussed below, 
the Commission should take steps to ensure that all individualized 
investment advice is subject to advisory regulation.
    In addition, during the last stages of the scandal Madoff was 
registered as an investment adviser. His registration statement 
indicated that he had custody of $17 billion in assets under 
management. The Investment Advisers Act generally requires that an 
investment adviser maintain custody of client assets with a broker 
dealer or a bank, and in doing so relies on FINRA and banking 
regulators to ensure that the custodied assets actually exist. In view 
of reports that much of the Madoff related losses will be covered by 
SIPC, it appears that the failed custody arrangement was with a broker. 
It is unclear why, if the stolen assets were custodied by a broker, 
regular broker examinations by Madoff's SRO did not uncover the fraud. 
As discussed below, such prudential oversight should be assigned to a 
prudential regulator, not to a regulator such as FINRA with concurrent 
investor protection jurisdiction. A regulator such as FINRA should 
focus solely on what it knows and does best: regulating the sales 
activities of brokers.
    A final word is necessary regarding the argument made by some that 
the Madoff scandal demonstrates the weakness of a fiduciary standard. A 
fiduciary duty is not designed to nor could it protect investors from 
those who are willing to steal their money outright. The Madoff scandal 
is no more a reflection on the fiduciary standard (or FINRA's lower 
suitability standard) than would be a bank robbery. What would have 
detected Madoff's fraud is adviser registration triggered by the 
providing of individualized investment advice and competent 
examinations of his custody arrangements.
Principal Trading Exemption
    One of the primary reasons that brokers seek to avoid triggering 
investment adviser regulation is the principal trading prohibition. 
Section 206(3) of the Investment Advisers Act requires that investment 
advisers obtain written notice and consent from their clients prior to 
completion of the transaction in which the adviser acts in a principal 
capacity. Brokers chafe under the requirement to obtain client consent 
prior to every principal trade, and they hoped to be relieved of this 
restriction by the SEC's proposed rule excluding virtually all brokers 
managing nondiscretionary accounts from the definition of investment 
adviser (known as the ``Merrill Rule''). When the Merrill Rule was 
vacated by the Court of Appeals, the SEC quickly sought to accommodate 
brokers' concerns by adopting an interim rule that exempted virtually 
all trades not conducted in a discretionary account from section 
206(3).
    Before considering this interim rule, some history on the SEC's 
ill-advised Merrill Rule is in order. As with the principal trading 
exemption, the SEC effectively adopted the Merrill Rule without prior 
notice and consent. The SEC took a no-action position with respect to 
activity conducted within the proposal's purview, thereby circumventing 
Administrative Procedures Act requirements. Those who opposed the rule 
were left in limbo waiting for the Commission to adopt a final rule so 
that it could be challenged in court. Almost five years later, the 
Commission had yet take final action on the rule and the Financial 
Planning Association sued to force a final resolution of the issue. The 
SEC reproposed the rule in 2004, and then again in 2005. It finally 
adopted the rule in 2005, after it had been in operation for almost six 
years, and the Court of Appeals vacated the rule in its entirety in 
2007.
    Even before the Court's order went into effect, the SEC embarked on 
the same path of adopting effectively final rules without prior notice 
and comment. It scheduled its ``interim'' exemption from section 206(3) 
to expire more than two years after its adoption. The SEC's repeated 
abuse of notice and comment procedures undermines faith in the rule of 
law and the administrative process, especially when it abuses its 
authority by enacting broad exemptions from carefully crafted laws 
enacted by Congress specifically to protect investors against abusive 
transactions.
    In this instance, the interim rule has created significant investor 
protection gaps that continue to remain unaddressed. For example, the 
rule does not expressly require firms to develop policies and 
procedures that are specifically designed to detect, deter and prevent 
disadvantageous principal transactions. Such procedures are necessary 
to ensure that the fairness of the price at which the principal trade 
is effected can be objectively verified. The market's current 
difficulty in valuing certain fixed income securities that previously 
were considered relatively liquid and easily valued illustrates the 
potential risk. Securities that are difficult to value often are more 
likely to be securities that an adviser may be attempting to dump on 
its clients. The incentive to engage in the abuses that section 206(3) 
is designed to prevent rises with the difficulty of determining whether 
the transaction was fair. Congress should insist that the SEC take 
prompt action to address this and other concerns relating to the 
principal trading exemption. \53\
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     \53\ See Letter from Mercer Bullard, President and Founder, Fund 
Democracy and Barbara Roper,Director of Investor Protection, Consumer 
Federation of America to Nancy Morris, Secretary, U.S. Securities and 
Exchange Commission (Nov. 30, 2007) available at http://
www.funddemocracy.com/principal%20trading%20ltr%2011.30.07.pdf
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Pay-To-Play Ban
    In August 1999, the SEC proposed to prohibit money managers from 
engaging in pay-to-play. The Commission had thoroughly documented the 
practice among public pension officials of awarding investment 
management business to large political donors. \54\ The retirement 
accounts of millions of our nation's schoolteachers, fire fighters, 
police officers and other public servants were being invested by money 
managers who qualify for the job not by earning it, but by financing 
the political campaigns of public pension fund officials. The SEC's 
proposal was elegantly simple. It would have required that money 
managers give up any compensation they received for managing public 
money for two years after the firm, its executives or agents made a 
campaign contribution to an elected official or candidate who could 
have influenced the selection of the money manager.
---------------------------------------------------------------------------
     \54\ These findings in a series of articles published in 2001, see 
Mercer Bullard, PaytoPlay in America, TheStreet.com (Apr. 26-30, 2001), 
available at http://www.thestreet.com/funds/mercerbullard/1406251.html, 
and a state-by-state guide to pay-to-play practices uncovered by the 
SEC is posted on Fund Democracy's Web site. See http://
www.funddemocracy.com/Pay-to-Play%20Page.htm
---------------------------------------------------------------------------
    The pay-to-play proposal was modeled on Rule G-37, which prohibits 
municipal bond underwriters from contributing to the campaigns of 
elected officials who may influence the award of bond underwriting 
contracts. The rule is widely credited with cleaning up the municipal 
bond industry. An unfortunate byproduct of Rule G-37 has been its 
incidental effect on pay-to-play in the money manager arena. State 
treasurers and other elected fiduciaries of municipal pension funds saw 
campaign contributions from municipal underwriters dry up, so they 
turned to money managers and lawyers doing business for the pension 
funds to make up the difference.
    Pay-to-play practices continue to plague the awarding of money 
management business by public pension funds at the same time that 
public pension underfunding has reached crisis proportions. It is 
imperative that managers tasked with restoring financial stability to 
public pension plans are not selected on the basis of political favor, 
but on the basis of their expertise and experience. This will not 
happen as long as the SEC allows investment advisers to pay-to-play in 
the public money management arena. Congress should strongly encourage 
the SEC to repropose the pay-to-play rule and see it through to final 
adoption.


                  PREPARED STATEMENT OF ROBERT PICKEL
            Executive Director and Chief Executive Officer,
            International Swaps and Derivatives Association
                             March 10, 2009
    Mr. Chairman and Members of the Committee, thank you very much for 
allowing ISDA to testify at this hearing. We are grateful to the 
Committee for the opportunity to discuss the privately negotiated 
derivatives business and more specifically, the credit default swaps 
market. This business is an important source of innovation for our 
financial system--it is one that employs tens of thousands of 
individuals in the United States and benefits thousands of American 
companies across a broad range of industries.
About ISDA
    ISDA, which represents participants in the privately negotiated 
derivatives industry, is the largest global financial trade 
association, by number of member firms. ISDA was chartered in 1985, and 
today has over 850 member institutions from 56 countries on six 
continents. These members include most of the world's major 
institutions that deal in privately negotiated derivatives, as well as 
many of the businesses, governmental entities and other end users that 
rely on over-the-counter derivatives to manage efficiently the 
financial market risks inherent in their core economic activities.
    Since its inception, ISDA has pioneered efforts to identify and 
reduce the sources of risk in the derivatives and risk management 
business. Among its most notable accomplishments are: developing the 
ISDA Master Agreement; publishing a wide range of related documentation 
materials and instruments covering a variety of transaction types; 
producing legal opinions on the enforceability of netting and 
collateral arrangements; securing recognition of the risk-reducing 
effects of netting in determining capital requirements; promoting sound 
risk management practices; and advancing the understanding and 
treatment of derivatives and risk management from public policy and 
regulatory capital perspectives.
    In my remarks today, I would briefly like to:

    Describe how CDS contracts works and the benefits they 
        provide;

    Clarify the level of exposure in the CDS business;

    Discuss the robust infrastructure that industry 
        participants have developed to support the CDS business;

    Review the role of CDS in today's financial crisis; and

    Outline my views on the evolution of the regulatory 
        framework for privately negotiated derivatives.

    As I cover these topics, I hope to clarify some key misperceptions 
regarding the CDS business:

    The first is that, even in the face of a significant 
        increase in defaults and the collapse of major financial 
        institutions, the CDS business has continued to function. 
        Credit derivatives have remained available as a means to manage 
        risk in today's financial markets;

    Second, as recent events have proven out, the risks related 
        to the CDS business have been widely misunderstood;

    Third, the CDS business operates within a robust 
        infrastructure that incorporates time-tested standards, 
        practices and principles;

    Fourth, CDS are not responsible for today's financial 
        crisis; and

    Finally, the CDS industry continues to work with 
        policymakers to improve and evolve how we do business.
How Credit Default Swaps Work
    Credit default swaps are simple financial transactions negotiated 
between two counterparties. They enable firms to transfer and more 
effectively manage risk.
    In the real world, CDS play an important role in the growth and 
functioning of our nation's economy:

    CDS facilitate the flow of credit to American businesses;

    CDS lower borrowing costs for American companies; and

    CDS provide vital information to the market about the 
        creditworthiness of borrowers.

    OTC derivatives exist to serve the risk management and investment 
needs of end-users such as the businesses that are the backbone of our 
economy and the investors that provide funds to those businesses. The 
development of OTC derivatives has followed the development of the 
American economy. For centuries, foreign exchange transaction have 
facilitated trade and helped American businesses expand; they were one 
of the original banking powers recognized in the National Bank Act of 
1863. The first OTC derivative linked to interest rates was transacted 
in the early 1980s between IBM and the World Bank, helping IBM raise 
funds on more favorable terms. Today, over 90 percent of the Fortune 
500, 50 percent of mid-sized companies and thousands of other smaller 
American companies, use OTC currency and interest rate derivatives. 
Credit derivatives first appeared in the mid-1990s as a tool to help 
banks diversify the credit risk in their loan portfolio, and they have 
grown into a vital risk management and diversification tool. In each 
case the need for these products was driven by the needs of end-users, 
and their growth was a direct function of their utility to end-users. 
If end-users did not want these products, they would not exist.
    It might be helpful to provide an example of the needs that credit 
derivatives address. Imagine a bank that wants to lend more to American 
companies in a particular sector of the economy, or a particular 
geographic region, but that does not have relationships with those 
companies. That bank could enter into a credit derivative transaction 
with a bank that does have loans to those companies, whereby the first 
bank would sell protection to the second bank on those companies, 
taking on some of the second bank's credit exposure to those companies 
in exchange for periodic payments. This transaction benefits both 
banks: the first bank diversifies its loan portfolio and earns income 
and the second bank is able to lend more money to those companies and 
deepen its relationship with them. Equally importantly, this 
transaction also benefits the companies themselves. It expands their 
funding sources and thus allows them to get better rates on their 
borrowings.
    CDS can also be used to hedge against other risks related to the 
potential default of a borrower. For instance, an auto parts company 
that is heavily reliant on one auto manufacturer as its primary 
customer might seek to protect itself against the risk that 
manufacturer will go out of business by purchasing protection in the 
form of a CDS on that company.
    These credit derivatives, so-called single-name credit default 
swaps because they provide default protection on a single entity, were 
the foundation of the credit derivatives market and still constitute 
the vast majority of the market. These trades help American companies 
raise money more cheaply, and they help American investors diversify 
risk and seek out attractive investment opportunities. To that end, 
Warren Buffett wrote this year in his letter to Berkshire Hathaway 
shareholders that he has started to use single name CDS to sell 
protection and that he would like to enter into more such transactions. 
The utility of such credit derivatives to investors and to companies is 
what makes them so valuable to the American economy.
Growth and Size of the CDS Business
    Because of the important role they play in enabling firms to more 
precisely manage risk, the CDS business has grown significantly in a 
relatively short period of time. The most common measurement of the 
size of the CDS business is notional amount. For CDS, this represents 
the face value of the bonds and loans on which participants have 
written protection.
    While using notional amount as a measurement tool for the size of 
the privately negotiated derivatives business has its benefits, it also 
has a major drawback. Notional amount greatly overstates the actual 
exposure represented by the CDS business. One reason for this is 
because a seller of protection often seeks to hedge its risk by 
entering into offsetting transactions. Using the example above, if the 
counterparty that sold $10 million of protection wished to hedge its 
risk and buy protection, it too would enter into a $10 million CDS 
contract. Thus, there are now two CDS contracts outstanding with a 
total notional amount of $20 million. The reality is, however, that 
only $10 million is at risk.
    The Depository Trust and Clearing Corporation recently began 
publishing market data based on information compiled for their Trade 
Information Warehouse. According to DTCC, the net notional amount 
outstanding--which represents the maximum possible net funds transfer 
between net sellers and net buyers of protection that could be required 
upon the occurrence of a credit event--is $2.6 trillion.
    This may seem like a large number, and it is. But consider what it 
represents: the sum total of payouts if all reference entities were to 
default. This is, to say the least, unlikely. What's more, the average 
of the net notional amount across the reference entities in the DTCC 
warehouse is $2.6 billion. And this actually overstates the potential 
losses, because it excludes any recovery value that sellers of 
protection might receive. The point here is that the net payout on an 
individual reference entity basis is manageable. This was aptly 
demonstrated by the Lehman default, where the amounts paid on 
settlement were handled with no disruption to the system.
    One additional point regarding the size and risks of the CDS 
business bears mentioning. CDS do not create new risks. They enable 
firms to transfer risk that already exists. This risk-shifting process 
is a zero-sum arrangement; what the buyer potentially gains by buying 
protection, the seller potentially loses by selling protection. The 
amount that the seller of protection loses is identical to the risk 
that the buyer originally held.
CDS Infrastructure
    Privately negotiated derivatives are often referred to as ``OTC 
derivatives,'' with the implication being that this is an unregulated 
business with no structure, standards or principles governing it. As 
someone who has been involved in building a robust infrastructure for 
privately negotiated derivatives for virtually my entire professional 
career, this misperception is perhaps the most frustrating among those 
that characterize the CDS business.
    The truth is, there is a robust infrastructure for CDS and other 
swaps that has been developed over the past 25 years by ISDA, industry 
participants and policymakers around the world. The growth, strength, 
and success of the business could not have been achieved without it.
    A case in point: some believe that, in the OTC derivatives 
business, all kinds of firms can enter into all types of CDS contracts 
with each other. This is simply not the case. The fact is, banks are 
the primary market makers in the CDS business, and firms wishing to 
trade CDS need to have credit lines with them. Of the trades in the 
DTCC warehouse, virtually all involve at least one dealer and 86 
percent are between two dealers. These dealer banks, in turn, impose a 
variety of requirements on their counterparties (and vice versa) in 
terms of the maximum exposure they will take, the imposition of 
collateral requirements, and so on. Virtually all of the exposure in 
the CDS business originates within the heavily regulated banking 
system.
    Another example of the industry's infrastructure at work: at the 
core of every CDS transaction is a contract negotiated and entered into 
between two firms. The specific terms of the contract--its amount, the 
premium payment, its duration, etc.--are determined by the 
counterparties and are codified in a confirmation agreement between 
them.
    Underlying the confirmation is the widely used ISDA Master 
Agreement, which includes standardized language on definitions and 
other contract terms. The ISDA Master is widely recognized as a 
groundbreaking document that has enabled the growth of the risk 
management industry by enhancing legal certainty and reducing credit 
risk. It establishes key international contractual standards, and its 
importance to the global financial community has been described as ``no 
less than the creation of global law by contractual consensus.'' 
Reflecting its wide acceptance, the vast majority of derivatives 
transactions executed annually are documented under the ISDA Master.
    In addition to the standardized legal architecture governing 
privately negotiated derivatives, the industry has also worked to 
develop sound practices in other areas. These include risk management, 
the use and management of collateral, and the incorporation of 
technology into the derivatives business.
    The industry's work to further strengthen and improve the 
infrastructure and platform upon which it operates is never-ending. The 
industry has, for example, greatly improved transparency through the 
publication of information in DTCC's trade information warehouse, and 
significant progress has been made to reduce operational risk in the 
confirming, settling, and clearing of CDS.
The Role of CDS in Today's Financial Crisis: Bear, Lehman, AIG
    Over the past year, CDS have received a significant amount of 
attention because of concerns about their role in the current financial 
crisis. More specifically, issues have been raised regarding whether 
CDS created the financial crisis and/or played a significant part in 
the Bear Stearns, Lehman Brothers, and AIG situations.
    It is by now clear that the roots of the current financial crisis 
lie in imprudent lending decisions, particularly with respect to 
residential housing, but also extending to other areas including 
consumer receivables, auto finance and commercial development. These 
imprudent decisions were in part the result of an ``easy money'' 
environment and a mispricing of risk. They were in turn exacerbated by 
distortions in ratings models that underestimated both the risk of 
individual securities as well as how closely correlated the risks of 
those securities were within portfolios.
    If CDS did not cause the crisis, did they make it worse? Some 
industry observers cite the Bear Stearns situation in answering this 
question. While it may seem far longer, it was only a year ago that 
Bear Stearns suffered a liquidity crisis that led to its eventual 
purchase by JPMorgan Chase. As this drama unfolded, there were 
widespread concerns that Bear's failure as a derivatives counterparty 
would have systemic implications. The theory was the CDS and other 
privately negotiated derivatives supposedly created an interlinking web 
in which a shock from one participant could capsize others.
    The fact is, Bear's problems were primarily related to a lack of 
confidence from its lenders and its resulting inability to secure 
institutional funding to run its business. It was a classic liquidity 
squeeze for an institution that apparently relied too much on short-
term funding. The role of swaps in this situation was at best cursory.
    As for the systemic risk fears related to Bear's role as a swaps 
counterparty, subsequent events have proven this supposition to be 
groundless. Lehman was larger than Bear Stearns--a bigger institution 
with a bigger derivatives portfolio--and its bankruptcy created no 
system fissures.
    In fact, by the time of the Lehman default in September, the focus 
had shifted. No longer were market observers especially worried about 
the failure of a large derivatives counterparty. Concerns centered on 
the implications of a failure of a reference entity upon which a 
significant level of credit protection had been sold.
    Here, too, however, the fears were overblown. Contrary to rumors, 
the actual payout on CDS contracts in which Lehman was a reference 
entity was about $5 billion--far less than some industry critics 
initially thought. By all accounts, the Lehman bankruptcy and default 
was processed well by the industry, testifying to its strength and 
resilience.
    Moving now to AIG: Last week, this Committee heard testimony on the 
regulatory failures that contributed to the terrible situation at AIG. 
We also heard Chairman Bernanke express his frustration with AIG, 
stating that it acted like an unregulated hedge fund.
    The truth, however, is far worse. First, it's clear that AIG was in 
fact regulated. Its supervisors apparently knew how much mortgage risk 
it was taking on in its credit protection and securities lending 
business. They also knew that AIG included ratings triggers and 
collateral requirements in its contracts in order to gain additional 
counterparty capacity.
    In addition, a hedge fund would not have been allowed to build up 
such a large, uncollateralized positions with so many counterparties. 
In fact AIG Financial Products operated far more recklessly than most 
hedge funds or, for that matter, other businesses engaged in similar 
activities. It is worth noting these practices were contrary to the 
generally accepted practices advanced by ISDA for the last 20 years.
    In short, the causes of the AIG situation are clear. First, AIG's 
Financial Products subsidiary took on too much exposure to subprime 
mortgage debt. As the ratings on that debt were downgraded, the 
company's own ratings came under pressure. Under agreements with its 
counterparties and customers, AIG was then forced to post ever 
increasing amounts of collateral with them. In short, AIG took on too 
much exposure to subprime debt, and failed to appropriately manage its 
collateral and liquidity. It was a collective risk, liquidity, and 
collateral management failure, facilitated by poor supervision and an 
overreliance on rating agency models.
The Continued Evolution of the CDS Business
    As noted previously, the CDS industry is committed to further 
strengthening and improving how we do business. This includes working 
with policymakers to address areas of mutual concern.
    On November 14 the PWG announced a series of policy objectives for 
the privately negotiated derivatives industry. The PWG broke their 
recommendations into four broad categories: (1) improve the 
transparency and integrity of the credit default swaps market; (2) 
enhance risk management of OTC derivatives; (3) further strengthen the 
OTC derivatives market infrastructure; and (4) strengthen cooperation 
among regulatory authorities.
    ISDA agrees with these four objectives, and believes that 
continuing to pursue the improvements industry and regulators have 
worked on over the last several years is key to ensuring the OTC 
derivatives industry in the United States remains healthy and 
competitive.
    Within those four broader objectives the PWG lists a number of 
specific recommendations. These can be separated into:

    Recommendations for policymakers (e.g., ``Regulators should 
        establish consistent policy standards and risk management 
        expectations for CCPs or other systemically important 
        derivatives market infrastructures and apply those standards 
        consistently'');

    Recommendations for industry (e.g., ``Market participants 
        should adopt best practices with respect to risk management for 
        OTC derivatives activities, including public reporting, 
        liquidity management, senior management oversight and 
        counterparty credit risk management'');

    Recommendations of an operational nature (e.g., ``Details 
        of all credit default swaps that are not cleared through a CCP 
        should be retained in a central contract repository'').

    These recommendations provide a helpful framework for policymakers 
and industry alike to discuss while reviewing and reforming the current 
regulatory structure. Of particular importance from ISDA's perspective 
is the PWG's statement acknowledging the continued need for bi-lateral, 
custom tailored risk management contracts. As the PWG states: 
``Participants should also be able to bilaterally negotiate customized 
contracts where there are benefits in doing so, subject to continued 
oversight by their prudential supervisors.'' While some have posited 
that all OTC derivatives contracts should be made to trade on-exchange, 
as the PWG notes there will continue to be the need for customized OTC 
transactions.
    On the same day the PWG announced its policy objectives, it also 
released a Memorandum of Understanding among the Federal Reserve, the 
Commodities Futures Trading Commission and the Securities and Exchange 
Commission related to regulation of central counterparties. This 
Memorandum is an important step in ensuring that regulators do not work 
at cross-purposes while working to facilitate the creation of a central 
clearinghouse. It would be unfortunate were the creation of a CDS 
clearinghouse to be unnecessarily delayed because of a lack of 
agreement among federal regulators.
Conclusion
    Both the role and effects of CDS in the current market turmoil have 
been greatly exaggerated. CDS were not the cause, or even a large 
contributor, to this turmoil. There is little dispute that ill advised 
mortgage lending, coupled with improperly understood securities backed 
by those loans, are the root cause of the present financial problems. 
These risk management problems have in some instances been exacerbated 
by a failure to appropriately manage collateral and liquidity.
    CDS are valuable risk management tools. They facilitate lending and 
corporate finance and provide an important price discovery function 
that is useful not only within the CDS business itself but across a 
much broader spectrum. The business has remained open and liquid 
throughout the financial crisis, demonstrating its resiliency.
    It is ISDA's hope that the facts surrounding privately negotiated 
derivatives, including CDS, will highlight the benefit of these risk-
transfer tools and the robust, sound infrastructure that has developed 
around them.
    At the same time, recent market events clearly demonstrate that the 
regulatory structure for financial services has failed. Laws and 
regulations written in the 20th century, in many cases designed to 
address markets which existed in the 18th century, need to be changed 
to account for 21st century markets and products. An in-depth 
examination of the U.S. regulatory structure is self-evidently 
warranted.
    In summary, privately negotiated derivatives have continued to 
perform well during a greater period of stress than the world financial 
system has witnessed in decades. In the wake of failures of major 
market participants, both counterparties and issuers of debt, CDS 
participants have settled trades in an orderly way precisely according 
to the rules and procedures established by Congress and market 
participants. In this respect CDS activity has been a tremendous 
success. We are confident that policymakers and market participants 
alike will find their prudent efforts in helping build the 
infrastructure for derivatives over the last 25 years have been 
rewarded.
                                 ______
                                 
                 PREPARED STATEMENT OF DAMON A. SILVERS
                       Associate General Counsel,
                                AFL-CIO
                             March 10, 2009
    Good morning, Chairman Dodd and Senator Shelby. My name is Damon 
Silvers, I am an Associate General Counsel of the AFL-CIO, and I am the 
Deputy Chair of the Congressional Oversight Panel created under the 
Emergency Economic Stabilization Act of 2008 to oversee the TARP. While 
I will describe the Congressional Oversight Panel's report on 
regulatory reform, my testimony reflects my views and the views of the 
AFL-CIO unless otherwise noted, and is not on behalf of the Panel, its 
staff or its chair, Elizabeth Warren.
    The vast majority of American investors participate in the markets 
as a means to secure a comfortable retirement and to send their 
children to college. Most investors' goals are long term, and most 
investors rely on others to manage their money. While the boom and bust 
cycles of the last decade generated fees for Wall Street--in many cases 
astounding fees--they have turned out to have been a disaster for most 
investors. The 10-year nominal rate of return on the S&P 500 is now 
negative, and returns for most other asset classes have turned out to 
be more correlated with U.S. equity markets than anyone would have 
imagined a decade ago.
    While the spectacular frauds like the Madoff ponzi scheme have 
generated a great deal of publicity, the bigger questions are (1) how 
did our financial system as a whole become so weak how did our system 
of corporate governance, securities regulation, and disclosure-based 
market discipline fail to prevent trillions of dollars from being 
invested in value-destroying activities--ranging from subprime 
mortgages and credit cards, to the stocks and bonds of financial 
institutions, to the credit default swaps pegged to those debt 
instruments; and (2) what changes must be made to make our financial 
system a more reasonable place to invest the hard earned savings of 
America's working families?
    My testimony today will seek to answer the second question at three 
levels:

  1  How should Congress strengthen the regulatory architecture to 
        better protect investors;

  2.  How should Congress think about designing regulatory jurisdiction 
        to better protect investors; and

  3.  What are some specific substantive steps Congress and the 
        regulators should take to shore up our system of investor 
        protections?

    Finally, I will briefly address how to understand the challenge of 
investor protection in globalized markets.
Regulatory Architecture
    While there has been much discussion of the need for better 
systemic risk regulation, the Congressional Oversight Panel, in its 
Special Report on Regulatory Reform issued on January 29, 2009, 
observed that addressing issues of systemic risk cannot be a substitute 
for a robust, comprehensive system of routine financial regulation. \1\ 
There are broadly three types of routine regulation in the financial 
markets--(1) safety and soundness regulation for insured institutions 
like banks and insurance companies; (2) disclosure and fiduciary duty 
regulation for issuers and money managers in the public securities 
markets; and (3) substantive consumer protection regulation in areas 
like mortgages, credit cards, and insurance. These are distinct 
regulatory missions in significant tension with each other.
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     \1\ Congressional Oversight Panel, Special Report on Regulatory 
Reform, at 3 (Jan. 29, 2009), available at http://cop.senate.gov/
documents/cop-012909-report-regulatoryreform.pdf
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    Investors, people who seek to put money at risk for the prospect of 
gains, really are interested in transparency, enforcement of fiduciary 
duties, and corporate governance. This is the investor protection 
mission. It is often in tension with the equally legitimate regulatory 
mission of protecting the safety and soundness of insured financial 
institutions. A safety and soundness regulator is likely to be much 
more sympathetic to regulated entities that want to sidestep telling 
the investing public bad news. At the same time, investor protection is 
not the same thing as consumer protection--the consumer looking for 
home insurance or a mortgage is seeking to purchase a financial service 
with minimal risk, not to take a risk in the hope of a profit.
    Because these functions should not be combined, investor protection 
should be the focus of a single agency within the broader regulatory 
framework. That agency needs to have the stature and independence to 
protect the principles of full disclosure by market participants and 
compliance with fiduciary duties among market intermediaries. Any 
solution to the problem of systemic risk prevention should involve the 
agency charged with investor protection, and not supersede it.
    Since the New Deal, the primary body charged with enforcing 
investor protections has been the Securities and Exchange Commission. 
Although the Commission has suffered in recent years from diminished 
jurisdiction and leadership failure, it remains an extraordinary 
government agency, whose human capital and market expertise needs to be 
built upon as part of a comprehensive strategy for effective 
reregulation of the capital markets.
    While I have a great deal of respect for former Treasury Secretary 
Paulson, there is no question that his blueprint for financial 
regulatory reform was profoundly deregulatory in respect to the 
Securities and Exchange Commission. \2\ He and others, like the self-
described Committee on Capital Markets Regulation led by Harvard 
Professor Hal Scott, sought to dismantle the Commission's culture of 
arms length, enforcement-oriented regulation and to replace it with 
something frankly more captive to the businesses it regulated. \3\ 
While these deregulatory approaches have fortunately yet to be enacted, 
they contributed to an environment that weakened the Commission 
politically and demoralized its staff.
---------------------------------------------------------------------------
     \2\ Department of the Treasury, Blueprint for a Modernized 
Financial Regulatory Structure, at 11-13, 106-126 (Mar. 2008), 
available at http://www.treas.gov/press/releases/reports/Blueprint.pdf
     \3\ Committee on Capital Markets Regulation, Interim Report (Nov. 
30, 2006), available at http://www.capmktsreg.org/pdfs/
11.30Committee_Interim_ReportREV2.pdf; Committee on Capital Markets 
Regulation, The Competitive Position of the U.S. Public Equity Market 
(Dec. 4, 2007), available at http://www.capmktsreg.org/pdfs/
The_Competitive_Position_of_the_US_Public_Equity_Market.pdf
---------------------------------------------------------------------------
    While there has been a great deal of attention paid to the 
Commission's failure to spot the Madoff ponzi scheme, there has been 
insufficient attention to the Commission's performance in relation to 
the public debt markets, where the SEC regulates more than $438.3 
billion in outstanding securities related to home equity loans and 
manufactured housing loans, among the riskiest types of mortgages. 
Similarly, little attention has been paid to the oversight of 
disclosures by the financial and homebuilding firms investing in and 
trading in those securities, and perhaps most importantly, the lack of 
action by the Commission once the financial crisis began. \4\
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     \4\ Securities Industry and Financial Markets Association, Market 
Sector Statistics: Asset Backed Securities--Outstanding By Major Types 
of Credit.
---------------------------------------------------------------------------
    But elections have consequences, and one of those consequences 
should be a renewed commitment by both Congress and the new 
Administration to revitalizing the Commission and to rebuilding the 
Commission's historic investor protection oriented culture and mission. 
The President's budget reflects that type of approach in the funding it 
seeks for the Commission, and the new Chair of the Commission Mary 
Schapiro has appeared to be focused on just this task in her recent 
statements. \5\
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     \5\ See, e.g., Speech by SEC Chairman: Address to Practising Law 
Institute's ``SEC Speaks in 2009'' Program available at http://sec.gov/
news/speech/2009/spch020609mls.htm
---------------------------------------------------------------------------
    A key issue the Commission faces is how to strengthen its staff. 
Much of what needs to be done is in the hands of the Commission itself, 
where the Chair and the Commissioners set the tone for better or for 
worse. When Commissioners place procedural roadblocks in the way of 
enforcing the law, good people leave the Commission and weak staff are 
not held accountable. When the Chair sets a tone of vigorous 
enforcement of the laws and demands a genuine dedication to investor 
protection, the Commission both attracts and retains quality people.
    Congress should work with the Commission to determine if changes 
are needed to personnel rules to enable the Commission to attract and 
retain key personnel. The Commission should look at more intensive 
recruiting efforts aimed at more experienced private sector lawyers who 
may be looking for public service opportunities--perhaps through a 
special fellows program. On the other hand, Congress should work with 
the Commission to restrict the revolving door--ideally by adopting the 
rule that currently applies to senior bank examiners for senior 
Commission staff--no employment with any firm whose matters the staffer 
worked on within 12 months.
Regulating the Shadow Markets and the Problem of Jurisdiction
    The financial crisis is directly connected to the degeneration of 
the New Deal system of comprehensive financial regulation into a Swiss 
cheese regulatory system, where the holes, the shadow markets, grew to 
dominate the regulated markets. If we are going to lessen future 
financial boom and bust cycles, Congress must give the regulators the 
tools and the jurisdiction to regulate the shadow markets. In our 
report of January 29, the Congressional Oversight Panel specifically 
observed that we needed to regulate financial products and 
institutions, in the words of President Obama, ``for what they do, not 
what they are.'' \6\ We further noted in that report that shadow market 
products and institutions are nothing more than new names and new legal 
structures for very old activities like insurance (read credit default 
swaps) and money management (read hedge funds and private equity/lbo 
funds). \7\
---------------------------------------------------------------------------
     \6\ Senator Barack Obama, Renewing the American Economy, Speech at 
Cooper Union in New York (Mar. 27, 2008) (transcript available at 
http://www.nytimes.com/2008/03/27/us/politics/27text-
obama.html?pagewanted=all); Congressional Oversight Panel, Special 
Report on Regulatory Reform, at 29.
     \7\ Congressional Oversight Panel, Special Report on Regulatory 
Reform, at 29.
---------------------------------------------------------------------------
    The Congressional Oversight Panel's report stated that shadow 
institutions should be regulated by the same regulators who currently 
have jurisdiction over their regulated counterparts. \8\ So, for 
example, the SEC should have jurisdiction over derivatives that are 
written using public debt or equity securities as their underlying 
asset. The Congressional Oversight Panel stated that at a minimum, 
hedge funds should also be regulated by the SEC in their roles as money 
managers by being required to register as investment advisors and being 
subject to clear fiduciary duties, the substantive jurisdiction of U.S. 
law, and periodic SEC inspections. \9\ To the extent a hedge fund or 
anyone else engages in writing insurance contracts or issuing credit, 
however, it should be regulated by the bodies charged with regulating 
that type of economic activity.
---------------------------------------------------------------------------
     \8\ Id.
     \9\ Id.
---------------------------------------------------------------------------
    Some have suggested having such shadow market financial products as 
derivatives and hedge funds simply regulated by a systemic regulator. 
This would be a terrible mistake. Shadow market products and 
institutions need to be brought under the same routine regulatory 
umbrella as other financial actors. To take a specific case, while it 
is a good idea to have public clearinghouses for derivatives trading, 
that reform by itself is insufficient without capital requirements for 
the issuers of derivatives and without disclosure and the application 
of securities law principles, generally, to derivatives based on public 
securities regulations. So, for example, the SEC should require the 
same disclosure of short positions in public equities that it requires 
of long positions in equities, whether those positions are created 
through the securities themselves or synthetically through derivatives 
or futures.
    The historic distinctions between broker-dealers and investment 
advisors have been eroding in the markets for years. In 2007, the 
Federal Appeals Court for the District of Columbia issued an opinion 
overturning Commission regulations seeking to better define the 
boundary between the two. \10\ The Commission should look at merging 
the regulation of the categories while ensuring that the new regulatory 
framework preserves clear fiduciary duties to investors. As part of a 
larger examination of the duties owed by both broker-dealers and 
investment advisors to investors, the Commission ought to examine the 
fairness and the efficacy of the use of arbitration as a form of 
dispute resolution by broker-dealers. Finally, part of what must be 
done in this area is to determine whether the proper regulatory 
approach will require Congressional action in light of the D.C. Circuit 
opinion.
---------------------------------------------------------------------------
     \10\ Fin. Planning Ass'n v. SEC, 482 F.3d 481 (D.C. Cir. 2007).
---------------------------------------------------------------------------
    But there is a larger point here. Financial reregulation will be 
utterly ineffective if it turns into a series of rifle shots at the 
particular mechanisms used to evade regulatory structures in earlier 
boom and bust cycles. What is needed is a return to the jurisdictional 
philosophy that was embodied in the founding statutes of federal 
securities regulation--very broad, flexible jurisdiction that allowed 
the SEC to follow the activities. By this principle, the SEC should 
have jurisdiction over anyone over a certain size who manages public 
securities, and over any contract written that references publicly 
traded securities. Applying this principle would require at least 
shifting the CFTC's jurisdiction over financial futures to the SEC, if 
not merging the two agencies under the SEC's leadership.
    Much regulatory thinking over the last couple of decades has been 
shaped by the idea that sophisticated parties should be allowed to act 
in financial markets without regulatory oversight. Candidly, some 
investors have been able to participate in a number of relatively 
lightly regulated markets based on this idea. But this idea is wrong. 
Big, reckless sophisticated parties have done a lot of damage to our 
financial system and to our economy. I do not mean to say that 
sophisticated parties in the business of risk taking should be 
regulated in the same way as auto insurers selling to the general 
public. But there has to be a level of transparency, accountability, 
and mandated risk management across the financial markets.
    Finally, while it is not technically a shadow market, the 
underregulation of the credit rating agencies has turned out to have 
devastating consequences. The Congressional Oversight Panel called 
particular attention to the dysfunctional nature of the issuer pays 
model, and recommended a set of options for needed structural change--
from the creation of PCAOB-type oversight body to the creation of a 
public or non-profit NRSRO. \11\
---------------------------------------------------------------------------
     \11\ Id. at 40-44.
---------------------------------------------------------------------------
Substantive Reforms
    Beyond regulating the shadow markets, the Congress and the 
Securities and Exchange Commission need to act to shape a corporate 
governance and investor protection regime that is favorable to long 
term investors and to the channeling of capital to productive purposes. 
There is no way to look at the wreckage surrounding us today in the 
financial markets and not conclude we have had a regulatory regime 
that, intentionally or not, facilitated grotesquely short-term thinking 
and led to capital flowing in unheard of proportions to pointless or 
destructive ends.
    This is a large task, and I will simply point out some of the most 
important steps that need to be taken in three areas--governance, 
executive pay, and litigation.
    First, in the area of governance, once again the weakness of 
corporate boards, particularly in the financial sector, appears to be a 
central theme in the financial scandal. The AFL-CIO has interviewed the 
audit committees of a number of the major banks to better understand 
what happened. We found in general very weak board oversight of risk--
evidenced in audit committee leadership who did not understand their 
companies' risk profiles, and in boards that tolerated the weakening of 
internal risk management.
    Strong boards require meaningful accountability to investors. 
Short-term, leveraged investors have been the most powerful voices in 
corporate governance in recent years, with destructive results. The 
AFL-CIO urges Congress to work with the SEC to ensure that there are 
meaningful, useable ways for long-term investors to nominate and elect 
psychologically independent directors to public company boards through 
access to the corporate proxy. I put the stress here on long-term--
there must be meaningful holding time requirements for exercising this 
right. Recent statements by SEC Chair Mary Schapiro suggest she is 
focused on this area, and we urge the Congress to support her efforts. 
\12\
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     \12\ Rachelle Younglai, SEC developing proxy access plans: 
sources, REUTERS, Mar. 6, 2009, at http://www.reuters.com/article/
bernardMadoff/idUSTRE52609820090307
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    Second, effective investor protection requires a comprehensive 
approach to reform in the area of executive pay. Proxy access is an 
important first step in this area, but we should learn from the 
financial crisis how destructive short-term oriented, asymmetric 
executive pay can be for long-term investors and for our economy. The 
focus of the Congressional Oversight Panel's recommendations in the 
area of executive pay were on ending these practices in financial 
institutions. \13\ Here Chairman Dodd's leadership has been very 
helpful in the context of the TARP.
---------------------------------------------------------------------------
     \13\ Congressional Oversight Panel, Special Report on Regulatory 
Reform, at 37-40.
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    But Congress and the Administration should pursue a comprehensive 
approach to executive pay reform around two concepts--equity linked pay 
should be held beyond retirement, and pay packages as a whole should 
reflect a rough equality of exposure to downside risk as to upside 
gain. Orienting policy in this direction requires coordination between 
securities regulation and tax policy. But we could begin to address 
what has gone wrong in executive pay incentives by (1) developing 
measurements for both the time horizon and the symmetry of risk and 
reward of pay packages that could be included in pay disclosure; (2) 
looking more closely at mutual fund proxy voting behavior to see if it 
reflects the time horizons of the funds; (3) focusing FINRA inspections 
of broker dealer pay policies on these two issues; and (4) providing 
for advisory shareholder votes on pay packages. With respect to say on 
pay, any procedural approaches that strengthened the hand of long term 
investors in the process of setting executive compensation would be 
beneficial.
    Finally, Congress needs to address the glaring hole in the fabric 
of investor protection created by the Central Bank of Denver and 
Stoneridge cases. \14\ These cases effectively granted immunity from 
civil liability to investors for parties such as investment banks and 
law firms that are co-conspirators in securities frauds. It appeared 
for a time after Enron that the courts were going to restore some 
sanity in this area of the law on their own, by finding a private right 
of action when service providers were actually not just aiders and 
abetters of a fraud, but actual co-conspirators. In the Stoneridge 
decision, with the Enron case looming over them, the Supreme Court made 
clear Congress would have to act. The issue here of course is not 
merely fairness to the investors defrauded in a particular case--it is 
the incentives for financial institutions to police their own conduct. 
We seem to have had a shortage of such incentives in recent years.
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     \14\ Central Bank of Denver, N.A. v. First Interstate Bank of 
Denver, N.A., 511 U.S. 164 (1994); Stoneridge Investment Partners, LLC 
v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008).
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The International Context
    The Bush Administration fundamentally saw the internationalization 
of financial markets as a pretext for weakening U.S. investor 
protections. That approach has been discredited. It needs to be 
replaced by a commitment on the part of the Obama Administration to 
building a strong global regulatory floor in coordination with the 
world's other major economies. This effort is vital not only for 
protecting U.S. investors in global markets, but for protecting our 
financial sector from the consequences of a global regulatory race to 
the bottom that will inevitably end in the kind of financially driven 
economic crisis that we are living through today. Congress can play a 
part by seeking to strengthen its relationships with its counterpart 
legislative bodies in the major world markets, and should look for 
opportunities to coordinate setting regulatory standards on a global 
basis. The Administration needs to make this effort a priority, and to 
understand that it needs to extend beyond the narrow confines of 
systemic risk and the banking system to issues of transparency and 
investor protection.
    However, Congress must not allow the need for global coordination 
to be an impediment or a prerequisite to vigorous action to reregulate 
U.S. financial markets and institutions. That task is urgent and must 
be addressed if the U.S. is to recover from the blow this financial 
crisis has delivered to our private capital markets' reputation as the 
gold standard for transparency and accountability.
Conclusion
    The task of protecting investors by reregulating our financial 
system and restoring vitality to our regulators is a large one. This 
testimony simply sketches the outline of an approach, and notes some 
key substantive steps Congress and the Administration need to take. 
This Committee has already taken a leadership role in a number of these 
areas, but there is much more to be done. Even in areas where the 
primary responsibility must lie with regulators, there is a much needed 
role for Congress to oversee, encourage, and support the efforts of the 
Administration.
    While I do not speak for the Congressional Oversight Panel, I think 
I am safe in saying that the Panel is honored to have been asked to 
assist Congress in this effort, and is prepared to assist this 
Committee in any manner the Committee finds useful. I can certainly 
make that offer on behalf of the AFL-CIO. Thank you.
SUPPLEMENT--March 10, 2009
    The challenge of addressing systemic risk in the future is one, but 
by no means the only one, of the challenges facing Congress as Congress 
considers how to reregulate U.S. financial markets following the 
extraordinary events of the last 18 months.
    Systemic crises in financial markets harm working people. Damaged 
credit systems destroy jobs rather than create them. Pension funds with 
investments in panicked markets see their assets deteriorate. And the 
resulting instability undermines business' ability to plan and obtain 
financing for new investments--undermining the long term growth and 
competitiveness of employers and setting the stage for future job 
losses. The AFL-CIO has urged Congress since 2006 to act to reregulate 
shadow financial markets, and the AFL-CIO supports addressing systemic 
risk, but in a manner that does not substitute for strengthening the 
ongoing day to day regulatory framework, and that recognizes addressing 
systemic risk both requires regulatory powers and financial resources 
that can really only be wielded by a fully public body.
    The concept of systemic risk is that financial market actors can 
create risk not just that their institutions or portfolios will fail, 
but risk that the failure of their enterprises will cause a broader 
failure of other financial institutions, and that such a chain of 
broader failures can jeopardize the functioning of financial markets as 
a whole. The mechanisms by which this broader failure can occur involve 
a loss of confidence in information, or a loss of confidence in market 
actors ability to understand the meaning of information, which leads to 
the withdrawal of liquidity from markets and market institutions. 
Because the failure of large financial institutions can have these 
consequence, systemic risk management generally is seen to both be 
about how to determine what to do when a systemically significant 
institution faces failure, and about how to regulated such institutions 
in advance to minimize the chances of systemic crises.
    Historically, the United States has had three approaches to 
systemic risk. The first was prior to the founding of the Federal 
Reserve system, when there was a reluctance at the Federal level to 
intervene in any respect in the workings of credit markets in 
particular and financial markets in general. The Federal Reserve 
system, created after the financial collapse of 1907, ushered in an era 
where the Federal Government's role in addressing systemic risk largely 
consisted of sponsoring through the Federal Reserve system, a means of 
providing liquidity to member banks, and thus hopefully preventing the 
ultimate liquidity shortage that results from market participants 
losing confidence in the financial system as a whole.
    But then, after the Crash of 1929 and the 4 years of Depression 
that followed, Congress and the Roosevelt Administration adopted a 
regulatory regime whose purpose was in a variety of ways to 
substantively regulate financial markets in an ongoing way. This new 
approach arose out of a sense among policymakers that the systemic 
financial crisis associated with the Great Depression resulted from the 
interaction of weakly regulated banks with largely unregulated 
securities markets, and that exposing depositors to these risks was a 
systemic problem in and of itself. Such centerpieces of our regulatory 
landscape as the Securities and Exchange Commission's disclosure based 
system of securities regulation and the Federal Deposit Insurance 
Corporation came into being not just as systems for protecting the 
economic interests of depositors or investors, but as mechanisms for 
ensuring systemic stability by, respectively, walling off bank 
depositors from broader market risks, and ensuring investors in 
securities markets had the information necessary to make it possible 
for market actors to police firm risk taking and to monitor the risks 
embedded in particular financial products.
    In recent years, financial activity has moved away from regulated 
and transparent markets and institutions and into the so-called shadow 
markets. Regulatory barriers like the Glass-Steagall Act that once 
walled off less risky from more risky parts of the financial system 
have been weakened or dismantled. So we entered the recent period of 
extreme financial instability with an approach to systemic risk that 
looked a lot like that of the period following the creation of the 
Federal Reserve Board but prior to the New Deal era. And so we saw the 
policy response to the initial phases of the current financial crisis 
primarily take the form of increasing liquidity into credit markets 
through interest rate reductions and increasingly liberal provision of 
credit to banks and then to non-bank financial institutions.
    However, with the collapse of Lehman Brothers and the Federal 
rescues of AIG, FNMA, and the FHLMC, the federal response to the 
perception of systemic risk turned toward much more aggressive 
interventions in an effort to ensure that after the collapse of Lehman 
Brothers, there would be no more defaults by large financial 
institutions. This approach was made somewhat more explicit with the 
passage of the Emergency Economic Stabilization Act of 2008 and the 
commencement of the TARP program. The reality was though that the TARP 
program was the creature of certain very broad passages in the bill, 
which generally was written with the view that the federal government 
would be embarking on the purchase of troubled assets, a very different 
approach than the direct infusions of equity capital that began with 
the Capital Purchase Program in October of 2008.
    We can now learn some lessons from this experience for the 
management of systemic risk in the financial system.
    First, our government and other governments around the world will 
step in when major financial institutions face bankruptcy. We do not 
live in a world of free market discipline when it comes to large 
financial institutions, and it seems unlikely we ever will. If two 
administrations as different as the Bush Administration and the Obama 
Administration agree that the Federal Government must act when major 
financial institutions fail, it is hard to imagine the administration 
that would do differently. Since the beginning of 2008, we have used 
Federal dollars in various ways to rescue either the debt or the equity 
holders or both at the following companies--Bear Stearns, Indymac, 
Washington Mutual, AIG, Merrill Lynch, Fannie Mae, Freddie Mac, 
Citigroup, and Bank of America. But we have no clear governmental 
entity charged with making the decision over which company to rescue 
and which to let fail, no clear criteria for how to make such 
decisions, and no clear set of tools to use in stabilizing those that 
must be stabilized.
    Second, we appear to be hopelessly confused as to what it means to 
stabilize a troubled financial institution to avoid systemic harm. We 
have a longstanding system of protecting small depositors in FDIC 
insured banks, and by the way policyholders in insurance companies 
through the state guarantee funds. The FDIC has a process for dealing 
with banks that fail--a process that does not always result in 100 
percent recoveries for uninsured creditors. Then we have the steps 
taken by the Treasury Department and the Federal Reserve since Bear 
Stearns collapsed. At some companies, like Fannie Mae and Freddie Mac, 
those steps have guaranteed all creditors, but wiped out the equity 
holders. At other companies, like Bear Stearns, AIG, and Wachovia, 
while the equity holders survive, they have been massively diluted one 
way or another. At others, like Citigroup and Bank of America, the 
equity has been only modestly diluted when looked at on an upside 
basis. It is hard to understand exactly what has happened with the 
government's interaction with Morgan Stanley and Goldman Sachs, but 
again there has been very little equity dilution. And then there is 
poor Lehman Brothers, apparently the only non-systemic financial 
institution, where everybody lost. In crafting a systematic approach to 
systemically significant institutions, we should begin with the 
understanding that while a given financial institution may be 
systemically significant, not every layer of its capital structure 
should be necessarily propped up with taxpayer funds.
    Third, much regulatory thinking over the last couple of decades has 
been shaped by the idea that sophisticated parties should be allowed to 
act in financial markets without regulatory oversight. But this idea is 
wrong. Big, reckless sophisticated parties have done a lot of damage to 
our financial system and to our economy. This is not to say that 
sophisticated parties in the business of risk taking should be 
regulated in the same way as auto insurers selling to the general 
public. But there has to be a level of transparency, accountability, 
and mandated risk management across the financial markets.
    Fourth, financial markets are global now. Norwegian villages invest 
in U.S. mortgage backed securities. British bankruptcy laws govern the 
fate of U.S. clients of Lehman Brothers, an institution that appeared 
to be a U.S. institution. AIG, our largest insurance company, collapsed 
because of a London office that employed 300 of AIG's 500,000 
employees. Chinese industrial workers riot when U.S. real estate prices 
fall. We increasingly live in a world where the least common 
denominator in financial regulation rules.
    So what lessons should we take away for how to manage systemic risk 
in our financial system?
    The Congressional Oversight Panel, in its report to Congress made 
the following points about addressing systemic risk:

  1.  There should be a body charged with monitoring sources of 
        systemic risk in the financial system, but it could either be a 
        new body, an existing agency, or a group of existing agencies;

  2.  The body charged with systemic risk managements should be fully 
        accountable and transparent to the public in a manner that 
        exceeds the general accountability mechanisms present in self-
        regulatory organizations;

  3.  We should not identify specific institutions in advance as too 
        big to fail, but rather have a regulatory framework in which 
        institutions have higher capital requirements and pay more on 
        insurance funds on a percentage basis than smaller institutions 
        which are less likely to be rescued as being too systemic to 
        fail.

  4.  Systemic risk regulation cannot be a substitute for routine 
        disclosure, accountability, safety and soundness, and consumer 
        protection regulation of financial institutions and financial 
        markets.

  5.  Ironically, effective protection against systemic risk requires 
        that the shadow capital markets--institutions like hedge funds 
        and products like credit derivatives--must not only be subject 
        to systemic risk oriented oversight but must also be brought 
        within a framework of routine capital market regulation by 
        agencies like the Securities and Exchange Commisson.

  6.  There are some specific problems in the regulation of financial 
        markets, such as the issue of the incentives built into 
        executive compensation plans and the conflict of interest 
        inherent in the credit rating agencies' business model of 
        issuer pays, that need to be addressed to have a larger market 
        environment where systemic risk is well managed.

  7.  Finally, there will not be effective reregulation of the 
        financial markets without a global regulatory floor.

    I would like to explain some of these principles and at least the 
thinking I brought to them. First, on the issue of a systemic risk 
monitor, while the Panel made no recommendation, I have come to believe 
that the best approach is a body with its own staff and a board made up 
of the key regulators, perhaps chaired by the Chairman of the Board of 
Governors of the Federal Reserve. There are several reasons for this 
conclusion. First, this body must have as much access as possible to 
all information extant about the condition of the financial markets--
including not just bank credit markets, but securities and commodities, 
and futures markets, and consumer credit markets. As long as we have 
the fragmented bank regulatory system we now have, this body would need 
access to information about the state of all deposit taking 
institutions. The reality of the interagency environment is that for 
information to flow freely, all the agencies involved need some level 
of involvement with the agency seeking the information. Connected with 
the information sharing issue is expertise. It is unlikely a systemic 
risk regulator would develop deep enough expertise on its own in all 
the possible relevant areas of financial activity. To be effective it 
would need to cooperate in the most serious way possible with all the 
routine regulators where the relevant expertise would be resident.
    Second, this coordinating body must be fully public. While many 
have argued the need for this body to be fully public in the hope that 
would make for a more effective regulatory culture, the TARP experience 
highlights a much more bright line problem. An effective systemic risk 
regulator must have the power to bail out institutions, and the 
experience of the last year is that liquidity provision is simply not 
enough in a real crisis. An organization that has the power to expend 
public funds to rescue private institutions must be a public 
organization--though it should be insulated from politics much as our 
other financial regulatory bodies are by independent agency structures.
    Here is where the question of the role of the Federal Reserve comes 
in. A number of commentators and Fed officials have pointed out that 
the Fed has to be involved in any body with rescue powers because any 
rescue would be mounted with the Fed's money. However, the TARP 
experience suggests this is a serious oversimplification. While the Fed 
can offer liquidity, many actual bailouts require equity infusions, 
which the Fed cannot currently make, nor should it be able to, as long 
as the Fed continues to seek to exist as a not entirely public 
institution. In particular, the very bank holding companies the Fed 
regulates are involved in the governance of the regional Federal 
Reserve Banks that are responsible for carrying out the regulatory 
mission of the Fed, and would if the current structure were untouched, 
be involved in deciding which member banks or bank holding companies 
would receive taxpayer funds in a crisis.
    These considerations also point out the tensions that exist between 
the Board of Governors of the Federal Reserve System's role as central 
banker, and the great importance of distance from the political 
process, and the necessity of political accountability and oversight 
once a body is charged with dispersing the public's money to private 
companies that are in trouble. That function must be executed publicly, 
and with clear oversight, or else there will be inevitable suspicions 
of favoritism that will be harmful to the political underpinnings of 
any stabilization effort. One benefit of a more collective approach to 
systemic risk monitoring is that the Federal Reserve Board could 
participate in such a body while having to do much less restructuring 
that would likely be problematic in terms of its monetary policy 
activity.
    On the issue of whether to identify and separately regulate 
systemically significant firms, another lesson of the last eighteen 
months is that the decision as to whether some or all of the investors 
and creditors of a financial firm must be rescued cannot be made in 
advance. In markets that are weak or panicked, a firm that was 
otherwise seen as not presenting a threat of systemic contagion might 
be seen as doing just that. Conversely, in a calm market environment, 
it maybe the better course of action to let a troubled firm go bankrupt 
even if it is fairly large. Identifying firms (ITAL)ex ante as 
systemically significant also makes the moral hazard problems much more 
intense.
    An area the Congressional Oversight Panel did not address 
explicitly is whether effective systemic risk management in a world of 
diversified institutions would require some type of universal systemic 
risk insurance program or tax. Such a program would appear to be 
necessary to the extent the federal government is accepting it may be 
in a position of rescuing financial institutions in the future. Such a 
program would be necessary both to cover the costs of such 
interventions and to balance the moral hazard issues associated with 
systemic risk management. However, there are practical problems 
defining what such a program would look like, who would be covered and 
how to set premiums. One approach would be to use a financial 
transactions tax as an approximation. The global labor movement has 
indicated its interest in such a tax on a global basis, in part to help 
fund global reregulation of financial markets.
    More broadly, these issues return us to the question of whether the 
dismantling of the approach to systemic risk embodied in the Glass-
Steagall Act was a mistake. We would appear now to be in a position 
where we cannot wall off more risky activities from less risky 
liabilities like demand deposits or commercial paper that we wish to 
ensure. On the other hand, it seems mistaken to try and make large 
securities firms behave as if they were commercial banks. Those who 
want to maintain the current dominance of integrated bank holding 
companies in the securities business should have some burden of 
explaining how their securities businesses plan to act now that they 
have an implicit government guaranty.
    Finally, the AFL-CIO believes very strongly that the regulation of 
the shadow markets, and of the capital markets as a whole cannot be 
shoved into the category labeled ``systemic risk regulation,'' and then 
have that category be effectively a sort of night watchman effort. The 
lesson of the failure of the Federal Reserve to use its consumer 
protection powers to address the rampant abuses in the mortgage 
industry earlier in this decade is just one of several examples going 
to the point that without effective routine regulation of financial 
markets, efforts to minimize the risk of further systemic breakdowns 
are unlikely to succeed. We even more particularly oppose this type of 
formulation that then hands responsibility in the area of systemic risk 
regulation over to self-regulatory bodies.
    As Congress moves forward to address systemic risk management, one 
area that we believe deserves careful consideration is how much power 
to give to a body charged with systemic risk management to intervene in 
routine regulatory policies and practices. We strongly agree with 
Professor Coffee's testimony that a systemic risk regulator should not 
have the power to override investor or consumer protections. However, 
there are a range of options, ranging from power so broad it would 
amount to creating a single financial services superregulator, e.g., 
vesting such power in staff or a board chairman acting in an executive 
capacity, to arrangements requiring votes or supermajorities, to a 
system where the systemic risk regulator is more of scout than a real 
regulator, limited in its power to making recommendations to the larger 
regulatory community. The AFL-CIO would tend to favor a choice 
somewhere more in the middle of that continuum, but we think this is an 
area where further study might help policymakers formulate a well-
founded approach.
    Finally, with respect to the jurisdiction and the reach of a 
systemic risk regulator, we believe it must not be confined to 
institutions per se, or products or markets, but must extend to all 
financial activity.
    In conclusion, the Congressional Oversight Panel's report lays out 
some basic principles that as a Panel member I hope will be of use to 
this Committee and to Congress in thinking through the challenges 
involved in rebuilding a more comprehensive approach to systemic risk. 
The AFL-CIO is very concerned that as Congress approaches the issue of 
systemic risk it does so in a way that bolsters a broader reregulation 
of our financial markets, and does not become an excuse for not 
engaging in that needed broader reregulation.
AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009
Bank Bailouts
    There has been a dramatic concentration of banking power since the 
Gramm-Leach-Bliley Act repealed New Deal bank regulation. More than 43 
percent of U.S. bank assets are held by just four institutions: 
Citigroup, Bank of America, Wells Fargo and JPMorgan Chase. When these 
institutions are paralyzed, our whole economy suffers. When banks 
appear on the brink of collapse, as several have repeatedly since 
September, government steps in. The free market rules that workers live 
by do not apply to these banks.
    Since Congress passed financial bailout legislation in October, 
working people have seen our tax dollars spent in increasingly 
secretive ways to prop up banks that we are told are healthy, until 
they need an urgent bailout. In some instances, institutions that were 
bailed out need another lifeline soon after. The Congressional 
Oversight Panel, charged with overseeing the bailout, recently found 
that the Federal Government overpaid by $78 billion in acquiring bank 
stock.
    The AFL-CIO believes government must intervene when systemically 
significant financial institutions are on the brink of collapse. 
However, government interventions must be structured to protect the 
public interest, and not merely rescue executives or wealthy investors. 
This is an issue of both fairness and our national interest. It makes 
no sense for the public to borrow trillions of dollars to rescue 
investors who can afford the losses associated with failed banks.
    The most important goal of government support must be to get banks 
lending again by ensuring they are properly capitalized. This requires 
forcing banks to acknowledge their real losses. By feeding the banks 
public money in fits and starts, and asking little or nothing in the 
way of sacrifice, we are going down the path Japan took in the 1990s--a 
path that leads to ``zombie banks'' and long-term economic stagnation.
    The AFL-CIO calls on the Obama administration to get fair value for 
any more public money put into the banks. In the case of distressed 
banks, this means the government will end up with a controlling share 
of common stock. The government should use that stake to force a 
cleanup of the banks' balance sheets. The result should be banks that 
can either be turned over to bondholders in exchange for bondholder 
concessions or sold back into the public markets. We believe the debate 
over nationalization is delaying the inevitable bank restructuring, 
which is something our economy cannot afford.
    A government conservatorship of the banks has been endorsed by 
leading economists, including Nouriel Roubini, Joseph Stiglitz, and 
Paul Krugman. Even Alan Greenspan has stated it will probably be 
necessary.
    The consequences of crippled megabanks are extraordinarily serious. 
The resulting credit paralysis affects every segment of our economy and 
society and destroys jobs. We urge President Obama and his team to 
bring the same bold leadership to bear on this problem as they have to 
the problems of economic stimulus and the mortgage crisis.
AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009
Financial Regulation
    Deregulated financial markets have taken a terrible toll on 
America's working families. Whether measured in lost jobs and homes, 
lower earnings, eroding retirement security, or devastated communities, 
workers have paid the price for Wall Street's greed. But in reality, 
the cost of deregulation and financial alchemy are far higher. The 
lasting damage is in missed opportunities and investments not made in 
the real economy. While money poured into exotic mortgage-backed 
securities and hedge funds, our pressing need for investments in clean 
energy, infrastructure, education, and health care went unmet.
    So the challenge of reregulating our financial markets, like the 
challenge of restoring workers' rights in the workplace, is central to 
securing the economic future of our country and the world. In 2006, 
while the Bush administration was in the midst of plans for further 
deregulation, the AFL-CIO warned of the dangers of unregulated, 
leveraged finance. That call went unheeded as the financial catastrophe 
gathered momentum in 2007 and 2008, and now a different day is upon us. 
The costs of the deregulation illusion have become clear to all but a 
handful of unrepentant ideologues, and the public cast its votes in 
November for candidates who promised to end the era of rampant 
financial speculation and deregulation.
    In October, when Congress authorized the $700 billion financial 
bailout, it also established an Oversight Panel to both monitor the 
bailout and make recommendations on financial regulatory reform. The 
panel's report lays the foundation for what Congress and the Obama 
administration must do.
    First, we must recognize that financial regulation has three 
distinct purposes: (1) ensuring the safety and soundness of insured, 
regulated institutions; (2) promoting transparency in financial 
markets; and (3) guaranteeing fair dealing in financial markets, so 
investors and consumers are not exploited. In short, no gambling with 
public money, no lying and no stealing.
    To achieve these goals, we need regulatory agencies with focused 
missions. We must have a revitalized Securities and Exchange Commission 
(SEC), with the jurisdiction to regulate hedge funds, derivatives, 
private equity, and any new investment vehicles that are developed. The 
Commodity Futures Trading Commission should be merged with the SEC to 
end regulatory arbitrage in investor protection.
    Second, we must have an agency focused on protecting consumers of 
financial services, such as mortgages and credit cards. We have paid a 
terrible price for treating consumer protection as an afterthought in 
bank regulation.
    Third, we need to reduce regulatory arbitrage in bank regulation. 
At a minimum, the Office of Thrift Supervision, the regulator of choice 
for bankrupt subprime lenders such as Washington Mutual and IndyMac, 
should be consolidated with other federal bank regulators.
    Fourth, financial stability must be a critical goal of financial 
regulation. This is what is meant by creating a systemic risk 
regulator. Such a regulator must be a fully public agency, and it must 
be able to draw upon the information and expertise of the entire 
regulatory system. While the Federal Reserve Board of Governors must be 
involved in this process, it cannot undertake it on its own.
    We must have routine regulation of the shadow capital markets. 
Hedge funds, derivatives, and private equity are nothing new--they are 
just devices for managing money, selling insurance and securities, and 
engaging in the credit markets without being subject to regulation. As 
President Obama said during the campaign, ``We need to regulate 
institutions for what they do, not what they are.'' Shadow market 
institutions and products must be subject to transparency and capital 
requirements and fiduciary duties befitting what they are actually 
doing.
    Reform also is required in the incentives governing key market 
actors around executive pay and credit rating agencies. There must be 
accountability for this disaster in the form of clawbacks for pay 
awarded during the bubble. According to Bloomberg, the five largest 
investment banks handed out $145 billion in bonuses in the 5 years 
preceding the crash, a larger amount than the GDP of Pakistan and 
Egypt.
    Congress and the administration must make real President Obama's 
commitment to end short-termism and pay without regard to risk in 
financial institutions. The AFL-CIO recently joined with the Chamber of 
Commerce and the Business Roundtable in endorsing the Aspen Principles 
on Long-Term Value Creation that call for executives to hold stock-
based pay until after retirement. Those principles must be embodied in 
the regulation of financial institutions. We strongly support the new 
SEC chair's effort to address the role played by weak boards and CEO 
compensation in the financial collapse. With regard to credit rating 
agencies, Congress must end the model where the issuer pays.
    Financial reregulation must be global to address the continuing 
fallout from deregulation. The AFL-CIO urges the Obama administration 
to make a strong and enforceable global regulatory floor a diplomatic 
priority, beginning with the G-20 meeting in April. The AFL-CIO has 
worked closely with the European Trade Union Congress and the 
International Trade Union Confederation in ensuring that workers are 
represented in this process. We commend President Obama for convening 
the President's Economic Recovery Advisory Board, chaired by former 
Federal Reserve Chair Paul Volcker, author of the G-30 report on global 
financial regulation, and we look forward to working with Chairman 
Volcker in this vital area.
    Reregulation requires statutory change, regulatory change, 
institutional reconstruction and diplomatic efforts. The challenge is 
great, but it must be addressed, even as we move forward to restore 
workers' rights and revive the economy more broadly.
                                 ______
                                 
                    PREPARED STATEMENT OF THOMAS DOE
                        Chief Executive Officer,
                       Municipal Market Advisors
                             March 10, 2009
Introduction
    Chairman Dodd, Senator Shelby and Committee Members: It is a 
distinct pleasure that I come before you today to share my perspective 
on the U.S. municipal bond industry. I am Thomas Doe, founder and CEO 
of Municipal Market Advisors, that for the past 15 years has been the 
leading independent research and data provider to the industry.
    In addition from 2003 to 2005, I served as a public member of the 
Municipal Securities Rulemaking Board (MSRB), the selfregulatory 
organization (SRO) of the industry established by Congress in 1975.
The Market
    There are nearly 65,000 issuers in the municipal market that are 
predominantly states and local governments. Recent figures identify an 
estimated $2.7 trillion in outstanding municipal debt. This is debt 
that aids our communities in meeting budgets and financing society's 
essential needs, whether it is building a hospital, constructing a 
school, ensuring clean drinking water, or sustaining the safety of 
America's infrastructure. A distinctive characteristic of the municipal 
market is that many of those who borrow funds, rural counties and small 
towns, are only infrequently engaged in the capital markets.
    As a result, there are many issuers of debt who are inexperienced 
when entering a transaction, and unable to monitor deals that may 
involve the movement of interest rates or the value of derivative 
products.
The Growth
    According to the The Bond Buyer, the industry's trade newspaper, 
annual municipal bond issuance was $29B in 1975 whereas in 2007 
issuance peaked at $430B. In the past 10 years derivatives have 
proliferated as a standard liability management tool for many local 
governments. However, because derivatives are not regulated it is 
exceptionally difficult, if not impossible, to identify the degree of 
systemic, as well as specific, risk to small towns and counties that 
have engaged in complex swaps and derivative transactions.
Systemic Risk Emerges
    Municipal issuers themselves sought to reduce their borrowing costs 
by selling bonds with a floating rate of interest, such as auction-rate 
securities. Because state and local governments do not themselves have 
revenues that vary greatly with interest rates, these issuers employed 
interest rate swaps to hedge their risk. Issuers used the instruments 
to transform their floating risk for a fixed-rate obligation.
    A key factor in the growth of the leverage and derivative 
structures was the prolific use of bond insurance.
The Penal Rating Scale
    Municipal issuers are rated along a conservative ratings scale, 
resulting in much lower ratings for school districts and states than 
for private sector financial or insurance companies. Although most 
state and local governments represent very little default risk to the 
investor, the penal ratings scale encouraged the use of insurance for 
both cash and derivatives to distribute products to investors and 
facilitate issuer borrowing.
    So instead of requiring more accurate ratings, the municipal 
industry chose to use bond insurance to enhance an issuer's lower 
credit rating to that of the higher insurance company's rating.
    The last 18 months have exposed the risks of this choice when 
insurance company downgrades, and auction-rate security failures, 
forced numerous leveraged investors to unwind massive amounts of debt 
into an illiquid secondary market. The consequence was that issuers of 
new debt were forced to pay extremely high interest rates and investors 
were confused by volatile evaluations of their investments.
Steps To Improve the Regulatory Context
    The 34-year era of the municipal industry's self regulation must 
come to an end. Today, the market would be in a much better place if: 
First, the regulator were independent of the financial institutions 
that create the products and facilitate issuers' borrowing.
    Second, the regulator were integrated into the national regime of 
regulation.
    Third, the regulator's reach and authority were extended to all 
financial tools and participants of the municipal transaction: ratings 
agencies, insurers, evaluators, and investment and legal advisors for 
both the cash and swaps transactions.
    Fourth, the regulator were charged with more aggressively 
monitoring market data with consumers' interests in mind, both 
investors and issuers.
    The good news is that this new era of regulatory oversight can be 
funded by the MSRB's annual revenue $20-plus million, collected from 
bond transactions, and can be staffed by the current MSRB policy and 
administrative infrastructure.
Caution
    I should be clear. The innovations of derivatives and swaps have a 
useful application and have been beneficial for those for which they 
are appropriate. However, it is also important that these instruments 
become transparent and regulated with the same care as the 
corresponding cash market.
Get This Done
    It is critical to get this right. There is too much at stake.
    Thank you for asking me to testify today, and I welcome your 
questions during this session.
Municipal Market Advisors
    Founded in 1995, MMA is the leading independent strategy, research 
and advisory firm in the municipal bond industry. MMA's intelligent 
approach to timely issues and analysis of market events has proven 
invaluable to a wide range of clients. As conditions have become more 
complex and difficult, MMA's recognized ability to concisely comment on 
the key issues of the market is of critical importance and value. The 
firm's independent research, data, market coverage and insight educate 
and inform without bias or product agenda.
    Our Clients: Investors, Dealers, Financial Advisors, Issuers and 
Individuals: MMA's business has been predominantly portfolio managers 
and dealer firms (with a focus on sales, trading and underwriting). 
However, in 2007, demand for our services expanded to include issuers, 
financial advisors, individuals and public finance professionals who 
have recognized the increased value of accurate and insightful coverage 
of current historical market conditions. MMA does not advocate on 
behalf of its clients, we educate on behalf of the market.
    Washington, DC--Educating and Working With Decision-Makers: MMA's 
Washington DC office has enabled our firm to provide more direct 
information to policy makers, regulators, trade associations and the 
Federal Reserve. MMA's role is that of an educator to provide immediate 
uncompromised assistance to entities that are actively engaged in 
working on issues pertaining to the municipal industry.
    Informing the Media: In 2008, more than 200 publications and media 
outlets have sought MMA's expertise for definitive comment on the 
issues confronting the industry. At no other time has accurate market 
coverage been more valued, and trusted resources considered 
indispensable. Unbiased information is important for correct 
representation of market conditions, policy decisions and management of 
portfolios.
    Thomas G. Doe, Founder and CEO: Mr. Doe has been an analyst in the 
municipal industry for 25 years with a consistent focus on pricing data 
and information flows, investor and issuer behavior, and contextual 
investing. He has addressed all of the leading groups in the municipal 
industry, as Mr. Doe's insight, candor and historical context is sought 
to establish a clear perspective of current conditions affecting 
investors and issuers in the municipal cash and derivative markets. He 
has been a featured speaker at numerous industry conferences and has 
been frequently quoted in industry and national media. Mr. Doe's 
leadership was recognized when he was named to a 3-year term with the 
Municipal Securities Rulemaking Board, (MSRB) the regulatory entity of 
the municipal securities industry in 2002. Mr. Doe received an 
undergraduate degree from Colgate University in 1980 and a Masters 
degree from Harvard University in 1984.
Background on How the Credit Crisis Has Affected the Municipal Market
    The municipal market has suffered repeated shocks from the credit 
crisis since August 2007. In a very primary sense, our sector was, and 
in many ways continues to be, exposed to the same systemic risks that 
collapsed the housing and securitization markets and undermined our 
nation's banks. The deep interconnectedness of the municipal market 
with the global financial and interest rate markets was unforeseen by 
most municipal regulators, issuers, investors, advisors, lawyers, and 
dealer banks; their surprise at, and misunderstanding of, the systemic 
risks at work has consistently exacerbated problems over the last two 
years. Further, there is little provision being made at present to 
create a more resilient and stable market in the future.
    The initiation of the credit crisis in municipals, as it was 
elsewhere, began in 2001 and 2002, with the integration of leverage 
into municipal bond buying strategies. Leveraged investment vehicles, 
called Tender Option Bond (TOB) programs, borrowed low interest 
(floating-rate) cash from the tax-exempt money market funds to invest 
in higher yielding (fixed-rate) municipals. Not only does this strategy 
capture the simple difference between the high long and low short 
interest rates (the carry), but also TOB sponsors--which included hedge 
funds, dealer banks, mutual funds, liquidity providers, and many 
others--are placing bets on the tax-exempt market's outperformance of 
carefully selected taxable bonds or swaps via interest rate hedging.
    However, one of the key conditions for the safe operation of a TOB 
was not implicit in the municipal market: liquidity. Because TOBs are 
subject to mark-to-market accounting, margin calls, and periodic 
adjustments of their leverage, they benefit from a well-traded and 
accurately priced bond market. A TOB invested in securities with 
unpredictable or volatile prices will itself provide unpredictable and 
volatile returns. The municipal bond market, as we have detailed 
elsewhere in this report, comprises 65,000 potential bond issuers and 
1.5 million individual securities, most of which are rated along an 
overly cautious rating scale that intentionally exaggerates the risks 
and differences between individual issuers and bonds. Further, 
municipal issuers have long sold bonds in serial maturities, with a 
variety of interest rate coupons, call structures, security pledges, 
etc. And finally, the bulk of municipal investors are households, who 
either directly or indirectly though a manager, prefer to buy and hold 
small pieces of multiple bond offerings: these are not active 
securities trading operations.
    This context was not conducive for TOBs, but, because their use of 
leverage they were permitted to purchase municipal bonds at 
substantially higher prices than other investors were willing to pay, 
so the primary market rapidly adjusted to their needs. This entailed 
the pervasive use of AAA-rated bond insurance and bank guaranties 
(creating the appearance of safe homogeneity) and the facilitation of 
very large, governmental-oriented bond sales carrying a standardized 5 
percent coupon. For the period between 2002 and 2007, these adjustments 
permitted the near doubling of annual bond issuance (from about $200Bn 
to about $400Bn), and the amount of par volume municipal bonds 
outstanding swelled 77 percent from $1.5T in 2001 to $2.7T today. 
What's more, the rapid growth of TOB (and related strategy) 
investment--along with a large increase in demand from property 
casualty insurance companies riding post-9/11 waves of premiums and 
profitability--allowed municipals to be priced more and more 
aggressively, fulfilling the TOB investor's aim of outperformance of 
the taxable bond market and encouraging ever larger allocations to this 
strategy.
    At the same time, the interest rates that tax-exempt money market 
funds were receiving from the TOBs were better than an investor could 
receive in a regular savings account, and aggressive TOB creation meant 
a surfeit of product in which the money funds could invest. This 
attracted more money fund deposits which, along with monetary policy, 
kept short-term interest rates low. Municipal issuers themselves sought 
to reduce their borrowing costs by selling long maturity, AAA-insured 
bonds with a floating rate of interest, including variable-rate demand 
obligations (VRDOs), which can be purchased by the money market funds, 
and auction-rate securities, which were largely bought by individuals 
and corporate cash managers. However, because state and local 
governments do not themselves receive much revenue that floats with 
short-term interest rates, these issuers also employed interest rate 
swaps with these floating-rate bonds in an attempt to exchange their 
floating-rate liability for a fixed one (but with the addition of 
increased counterparty exposure to both a bank and the a bond insurer).
    By these means, issuer interest rate swaps and derivatives became a 
fundamental, but unregulated part of the municipal industry's standard 
machinery, and systemic exposure to the financial sector, the bond 
insurers, and, more importantly, the rating agencies' opinions of the 
financial sector, and the bond insurers grew rapidly. In addition, our 
market had become substantially vulnerable to fluctuations in the value 
of taxable securities: remember that much if not all of the massive 
investment by TOBs (estimated to have peaked near $500Bn although 
little was done by the municipal regulators to even tabulate this 
exposure) was hedged against the performance of Treasuries, LIBOR 
swaps, or other slightly more muni-centric derivatives.
    The problems with this arrangement were exposed in August 2007 with 
the first surge of flight-to-safety buying of Treasury securities on 
news of worsening damage to the housing sector. Stronger Treasury (and 
LIBOR) prices created losses in TOB hedges, forcing margin calls that 
rapidly consumed available cash. In addition, sharp increases in the 
overnight lending rates pushed floating-rate product credit spreads 
wider: the source of TOB leverage, loans from the money funds, grew 
much more expensive, to the point where the money funds were demanding 
almost as much (or more) interest than the TOBs were receiving from 
their long-term, fixed-rate municipal position. Some TOBs thus began to 
liquidate their positions, forcing sales of their fixed-rate bonds into 
a municipal secondary market that quickly became oversupplied and 
illiquid. Keep in mind that, up until that point, the TOBs had been 
purchasing bonds at (and driving market clearing prices and statement 
evaluations to) higher levels than traditional institutional investors 
were reasonably willing to pay. Thus, when the TOBs needed to quickly 
sell their bonds to these same traditional buyers, large price 
concessions were required. Dealer banks helped soften the effects by 
acquiring bonds into their own trading inventories, but ultimately 
market pressures forced municipal bond yields sharply higher (while 
Treasury yields were moving sharply lower). Higher yields attracted 
enough demand to stabilize the market by the end of the month, but, 
through the end of the year, nervous investors repeated this pattern of 
fast selling/recovery, heightening volatility in prices, and 
encouraging a steady reduction in TOB investment. For substantially 
more detail on the daily and weekly evolution of our the market, please 
see the complete catalog of published MMA research, available to 
subscribers on our Web site and to Congressional staffs on request.
    Importantly, market participants had by this time also become 
increasingly concerned about the future of the bond insurers, who had 
guaranteed subprime residential mortgage securitizations. Research 
firms such as MMA and private investors amplified former warnings about 
these companies. In particular, more cautious corporate cash managers 
began selling auction-rate securities that had been marketed to them, 
in part, based on the apparent safety of AAA-rated bond insurance. Once 
again, dealer banks managing auction-rate programs provided liquidity 
in the absence of incremental investor demand, but in December 2007, 
the rating agencies sounded formal warnings about the bond insurers. 
This precipitated vast selling pressure among auction-rate investors 
that, in January, overwhelmed dealers' risk tolerances for buying back 
additional auction paper, and auctions began to fail (please see 
Auction Rate Securities, below).
    Auction-rate securities paying high penalty rates attracted 
investors away from other fixed- and floating-rate products, forcing 
both fixed and floating rates up sharply. At the end of February 2008, 
TOB programs were once again forced to sell bonds to pay margin calls, 
to unwind their leverage that had grown too expensive, and to afford 
investor redemptions. Extreme selling and uncertainty led to widely 
divergent pricing decisions across the industry; liquidity was almost 
completely interrupted, and state and local issuers were temporarily 
shut out of the capital markets.
    Once again, high yields galvanized demand in March, and from that 
point until December 2008, the municipal market continued to face boom 
and bust pricing cycles of sometimes extraordinary depth. In general, 
these entailed yield-fueled, or media-driven demand bubbles that were 
ultimately pricked by yet another bond insurer downgrade that renewed 
fears and sometimes forced selling by leveraged bondholders. The worst 
of these cycles began in September, when the collapse of Lehman 
Brothers, plus concerns over other broker-dealer counterparties were 
realized in investor redemptions from municipal money markets, which 
put large numbers of variable rate obligations back to dealers. The 
flow of bonds initially overwhelmed dealer balance sheets, forcing the 
unwind of some proprietary positions, but was ultimately managed 
through dramatically higher floating rates (the municipal industry's 7-
day floating rate reset from about 2 percent to 8 percent and credit 
spreads to that rate widened sharply, in particular for TOBs because of 
their reliance on multiple layers of bank support) and the temporary 
withdrawal of a large number of floaters from active markets onto 
liquidity provider balance sheets. Still, higher floating rates forced 
many tender option bond programs to unwind their trades for perhaps the 
final time, as investors now began demanding their money back in 
earnest.
    The excess supply created by forced TOB selling in September to 
November, along with downgrades to the bond insurers, pushed municipal 
yields sharply higher, prices lower. Institutional buyers retreated 
from the public markets until the end of the year (although many large 
buyers were able to buy portfolios of highly discounted bonds in the 
evenings and weekends, muffling the implications of these very cheap 
trades on broader market pricing), causing credit spreads to widen 
dramatically. Spread widening and price declines hurt tax-exempt mutual 
fund net asset values, giving the appearance of undue credit risk to 
their investors and initiating perhaps the largest sequence of mutual 
fund investor outflows (and thus forced selling of related holdings by 
the funds) on record. And, as was well covered by the media, with 
fixed-rate yields having risen to extraordinary heights, many state and 
local issuers chose to table the majority of their planned primary 
market loans, waiting for conditions to improve. Indeed, smaller, 
lower-rated, and riskier credit issuers may have at least temporarily 
been unable to access capital at all, but large states and cities were 
always able to raise money; their decisions were based on price. MMA 
estimates that, in 2008, more than $100Bn of planned new-money 
infrastructure projects were delayed, the majority of that occurring in 
the fourth quarter.
    Persistent institutional demand has not yet returned to the 
municipal market, but since the start of 2009, municipal fund managers 
and brokerages have been highly successful attracting retail investment 
on the back of both flight-to-safety allocations (out of equities) and, 
more importantly, on speculation that the stimulus will ultimately 
drive up municipal bond prices. In fact, yields on the kind of bonds 
favored by retail investors touched two-decade lows in mid-January, 
although they have since begun to retreat again. Lower-rated, risky 
credit issuers (like hospitals) still face difficulty finding cost-
effective market access and even highly rated state and local 
governments are commonly required to downsize new bond issues or risk 
pushing market yields higher.
Summary of Regulation Issues
Introduction
    The Municipal Securities Rule-making Board (MSRB) is a self-
regulatory organization (SRO) and was formulated by Congressional 
statute in 1975. Please see the attached National Federation of 
Municipal Analysts White Paper``Federal Securities Law Relating to 
Municipal Securities,'' for background and more detail.
    During Thomas Doe's tenure as a Board member from 2003 to 2005, 
there was rarely a Board meeting where the subject of derivatives was 
not discussed and the risks to the industry and investors were not 
addressed. However, the outdated statute limited the Board's regulatory 
purview to municipal cash securities and to activities of dealers and 
dealer banks. Proactive action was inhibited for three reasons: (1) it 
was exceptionally difficult, however well intended, for Board members 
representing security firms to advocate for change that would reduce 
the revenue of its firm; (2) the volunteer nature of the Board resulted 
in a consistent deferral of strategy, tactics and policy to staff; (3) 
the Chairman of the Board served only one year and dictated the Board's 
focus, which, in our opinion, was to sustain the status quo and could 
again be heavily influence by staff. Since staff, especially the 
Executive Director, worked for the Board, it appeared to be 
exceptionally difficult for innovation and proactive regulation to 
occur.
    To be fair, there is now new leadership of the MSRB's staff. 
However, the negative characteristics of a: (1) short-tenured Chairman; 
(2) volunteer Board; and (3) the tremendous challenge to advocate for 
the investor or issuer interest, which could hurt an employer's revenue 
stream, are still present. These conditions can be inhibitive toward 
regulation in the best interest of the consumer--both issuers and 
investors.
Opportunity
    In 2009, led by the catalysts of curtailed institutional demand, 
limited issuer access to the capital markets and the allegations 
revolving around municipal finance practices in New Mexico, the MSRB 
has suggested a review of the Congressional regulatory statute created 
34 years ago. Specifically the Board has suggested an expansion of 
entities to be regulated swap advisors. The willingness of the Board to 
advocate change is applauded however, the action falls short.
Necessary Change
    More entities should not alone be regulated, but rather legislative 
language should be expanded to be inclusive of all practices and 
products in which financial institutions would be involved related to 
municipal finance. By regulating the products, all entities involved 
with municipal finance--from creation to distribution--would be 
governed by transparency and regulations, which would advance and 
define a context for transactions in the municipal industry for the 
protection of issuer, dealer and investor. Only in this manner can 
responsibility and integrity be promoted and transparency ensured. The 
byproduct of such attention to derivatives would accomplish the 
disclosure required by issuers to both inform investors and those who 
choose to provide capital to public entities.
Action Items
  1.  End the MSRB as an SRO.

  2.  Integrate the MSRB formally and directly into a larger entity, 
        possibly the Securities Exchange Commission, Treasury or 
        Federal Reserve.

  3.  Congress expand the regulatory purview of municipal regulation to 
        include all participants in municipal finance and all financial 
        tools involved in a municipal finance transaction--this would 
        include derivatives and swaps in addition to the cash market. 
        Along with dealers: advisors, ratings agencies, and evaluation 
        services would be included in the new regulatory scheme.

  4.  Ensure that the regulatory statue was adaptable and flexible to 
        allow regulation to be proactive and timely.

  5.  Include the municipal industry within an organization, where its 
        regulatory framework, data and action can be more easily 
        coordinated with larger markets. (Too often critical regulation 
        may not have been enacted or suggested as the industry is small 
        relative to equities and taxable fixed-income. One might argue 
        that the vulnerability of the eclectic resources of the 65,000 
        municipal issuers/borrowers of the industry demands more 
        vigilant protection because of the critical importance of the 
        financings to essential services and projects for town, 
        counties and states in the US.)

  6.  Mandate better regulatory coordination with its consumers--
        specifically issuers and investors--not simply the dealer 
        community.

  7.  Demand greater financial forensics to mine the vast municipal 
        transaction data created by the Real-Time Transaction Reporting 
        System in order to better indentify market behavior that can 
        adversely impact (i.e., volatility) issuer pricing and investor 
        evaluations. In addition, better data analysis can better 
        define conditions of market liquidity to assist market 
        participants in risk management strategies and investors to 
        better use performance data measurements, specifically indices 
        of price performance and returns. This report highlights 
        significant areas where more robust data collection would have 
        helped manage and avert systemic risks exposed in the credit 
        crisis.
Conclusion
    The municipal industry has evolved outside of a confined regulatory 
context that is outdated and biased, and been consistently challenged 
by the temptation to regulate in its self-interest. The evolution 
resulted in detrimental practices and products that have proved penal 
to investors, issuers and the financial institutions. The opportunity 
to broaden the current regulatory framework has presented itself and in 
acting to take steps to protect the public entities, which require 
access to capital for infrastructure, the new broad regulation of the 
municipal industry with specific attention to both derivatives and cash 
financial products will provide precedence for global regulatory reform 
of all derivatives.
    The best news is that the MSRB's current major funding mechanism, 
fees from municipal transactions (more than $20 million in 2008), 
provides a revenue stream to fund expansion and transition of the 
regulatory purview. In addition, the existing organizational 
infrastructure of the MSRB allows for experienced personnel, technology 
and data to be powerfully integrated in a revitalized context.
    The municipal regulatory entity must be independent of those it 
regulates and integrated within a regular Federal entity where the 
industry can be included and coordinated with regulation of the larger 
markets.
Disclosure and Investor Protection
    For a background on municipal disclosure, MMA here quotes from the 
National Federation of Municipal Analysts March 2008 ``White Paper on 
Federal Securities Law Relating to Municipal Securities.'' The full 
paper is attached at the end of this report.

        The SEC promulgated Rule 15c2-12 (the ``Rule'' or ``Rule 15c2-
        12'') in 1989 and amended the Rule in 1994 to include 
        continuing disclosure requirements. . . . Direct regulation of 
        issuers would have required repeal of the Tower Amendments, so 
        the Rule instead applies to municipal broker-dealers and 
        generally applies to financings where the principal amount 
        offered is $1 million or greater. The Rule applies indirectly 
        to issuers, effectively denying their access to the market 
        unless the Rule's requirements are satisfied. The Rule contains 
        primary disclosure requirements and continuing disclosure 
        requirements. With respect to continuing disclosure, the Rule 
        prohibits the purchase and sale of municipal securities by an 
        underwriter in a public offering unless the issuer or an 
        ``obligated person'' undertakes to provide continuing 
        disclosure. Continuing disclosure obligations include both 
        periodic reporting of financial and operating information and 
        disclosure of the occurrence of any of a specified list of 11 
        events, if material. The annual information is required to 
        include audited financial statements when available and 
        material financial information and operating data of the type 
        included in the official statement for the securities. . . . 
        Independent of contractual undertakings made by issuers and 
        conduit borrowers and continuing disclosure obligations under 
        Rule 15c2-12, the SEC maintains that issuers of municipal 
        securities and conduit borrowers have continuing disclosure 
        responsibilities under Section 10(b) of the Exchange Act and 
        Rule 10b-5. While issuers and conduit borrowers have no 
        affirmative duty to disclose information (unless they are 
        engaged in the offering, purchase or sale of securities or 
        unless disclosure is required under a continuing disclosure 
        undertaking), if an issuer or conduit borrower chooses to 
        disclose information to the market it is prohibited from 
        disclosing information that is materially untrue or misleading, 
        or that contains a material omission, ``in light of the 
        circumstances'' in which such information is disclosed. There 
        are no other limits on the issuer's or the conduit borrower's 
        disclosure.

    We also reference DPC Data's report, ``The Consequences of Poor 
Disclosure Enforcement in the Municipal Securities Market'' that 
provides more information on how disclosure is disseminated. Currently 
disclosure occurs through a regime of several repositories (Nationally 
Recognized Municipal Securities Information Repositories, or NRMSIRs), 
but, with recent change in law, a single repository will exist: the 
Municipal Securities Rulemaking Board. In MMA's opinion, the state of 
disclosure in the municipal sector should be regarded as poor, and 
recent changes in the law are unlikely to make much difference here. 
Issuers, as detailed by DPC data's important (and accurate) study on 
the topic, regularly fall out of compliance with stated disclosure 
requirements, undermining liquidity in selected bonds and hurting 
smaller investors (those without credit analysts trained to track down, 
or mitigate the impact of, absent financial and operating data) who buy 
bonds, in part, based on statements in the prospectus that regular 
information will be disclosed.
    In MMA's opinion, disclosure gaps occur because: (1) many issuer 
representatives are not capital markets professionals and lose track of 
their responsibilities, and (2) there is little penalty to be suffered 
by the industry for not policing compliance. A specific failing of SEC 
Rule 15c2-12 is its leaving the decision on whether an issuer is in 
disclosure compliance to the individual participants trading the 
issuer's securities. In our experience, firms have generally ignored 
this requirement and continued to trade likely safe, but disclosure-
gapped bonds, albeit at a slight discount. Further, we note a pattern 
of smaller issuers falling out of compliance almost immediately after a 
new offering, remaining out of compliance for several years until, just 
prior to another new primary market loan, the issuer will send its past 
due financial information to the information repositories.
    Again, MMA believes a solution to municipal disclosure problems is 
available:

  1.  We believe Congress should require that the SEC act as arbiter to 
        determine whether each issuer is in compliance with their 
        stated disclosure requirements. This would be a very large 
        undertaking, potentially requiring a large staff increase by 
        the SEC. Should the SEC subsume the MSRB, the MSRB's funds 
        could offset at least a portion of the cost.

  2.  Bonds found to be not in compliance would be flagged, and 
        registered firms would be prohibited in trading in such until 
        either the issue's original underwriter or any other investor 
        can succeed in getting the issuer to remedy the gap. We are 
        reluctant to advise that the SEC be able to compel disclosure 
        directly from the issuers for fear of abridging state autonomy.

  3.  The SEC would keep a database to track, for every Cusip and 
        borrower, the number and percent of days it has been out of 
        compliance on all of its outstanding bond issues. This 
        statistic would be vitally important for potential buyers 
        evaluating new purchases of the borrower's securities.

  4.  Additionally, all firms trading municipal bonds, regardless of 
        their status, would need to track how many trades, and the 
        volume of par traded, that firm had made with disclosure-
        flagged municipals Cusips. Again, this could be very important 
        data for investors evaluating with which firm to invest their 
        money.

  5.  MMA also believes that all tax-relevant calculations and 
        investigations should be included in required disclosure 
        topics. These include how tax-exempt bond proceeds are being 
        spent, on a weekly basis, the precise formula by which bond 
        counsel determines that a bond issue is tax exempt, and the 
        presence and status of any SEC investigations.
The Undisclosed Risk of Bank Bonds and Swaps
    MMA's principal concern for the municipal sector in 2009 is that 
variable-rate related problems will set off a wave of downgrades and 
even defaults among risky sector credits (such as hospitals and private 
universities), creating incremental economic loss and threatening more 
investor aversion to municipal bonds generally. But the risks in 
variable-rate demand obligations are not exclusive to hospitals; many 
state and local governments also issued these securities and face very 
similar credit challenges.
    VRDOs are long maturity bonds where the interest rate is 
periodically (weekly, daily, etc.) reset by a remarketing agent--
usually a dealer bank--who also attempts to make proprietary markets in 
these securities among a universe of the firm's clients with a strong 
focus on tax-exempt money market funds. VRDOs also entail some form of 
liquidity support (structured via a letter of credit or standby 
purchase agreement) from a highly rated bank. In other words, a bank is 
contractually obligated to become the immediate buyer of last resort 
for a VRDO, giving money market funds confidence in the liquidity of a 
VRDO investment. MMA estimates that there are about $500Bn of 
outstanding VRDOs at present; this number has likely increased from 
$400Bn since the start of 2008 reflecting numerous post-collapse ARS 
restructurings into VRDOs.
    Yet today's financial markets entail substantially more investor 
caution among banks and between credits generally, and large numbers of 
VRDOs have been rejected by the money funds because of their reliance 
on a damaged or downgraded liquidity provider (most notably DEPFA and 
Dexia) or connection to a downgraded bond insurer. In the absence of 
other investors or remarketing agents' inability to bring yet more 
bonds onto their own balance sheets, many of these rejected bonds have 
triggered their liquidity features, requiring the liquidity providers 
to buy these securities directly. Provider-purchased VRDOs are referred 
to as ``bank bonds,'' which the liquidity providers hold as available 
for sale for a period of time (for example, 90 days), but then convert 
to accelerated maturity term loans between the liquidity provider and 
the issuer. It is unclear whether any municipal bank bonds have 
actually yet converted to term loans, but their acceleration of 
principal and penalty interest rate would reasonably require either an 
immediate restructuring or a default forbearance agreement between 
provider and issuer. Because there is little hope for market interest 
in Dexia or DEPFA to improve, at some point, issuer defaults may become 
public. MMA estimates, based on our polling of industry sources, that 
there have been as many as $50Bn of rejected floaters, with perhaps 
$50Bn more being kept away from liquidity providers through special--
and thus potentially temporary--intervention by securities dealers. MMA 
believes that the amount of bank bonds has fallen in 2009, as issuers 
are actively restructuring their bank bond obligations, although we 
underscore that we are unaware of any information being collected by 
any regulator or data provider on this topic.
    Interestingly, the rejection of many VRDOs by the money funds has 
worsened problems elsewhere in the municipal floating-rate markets. 
First, it has required liquidity providers to become more cautious in 
writing new policies, increasing the scarcity and cost of same for 
municipal issuers. Second, by removing large swathes of floaters from 
money fund ``approved'' lists, and noting: (1) the near complete 
absence of TOB-related lending by the money funds (see ``Background'' 
section above), and (2) large, fear driven investor inflows into the 
money funds, has created a severe supply/demand imbalance. Approved and 
available securities are scarce and--because the funds' alternative is 
not investing their funds at all--are being bid up to extremely low 
yields (weekly interest rates have been close to, or well below 1 
percent since November). Low benchmark floating rates, along with very 
strong demand for long-maturity LIBOR swap rates, an unwinding of 
arbitrageurs' interest rate hedges, and a dearth of new municipal 
issuer derivative activity, has pushed the related long-maturity 
municipal swap rates to very low levels. And this movement in swap 
rates has greatly increased issuers' cost of terminating any 
outstanding swap, complicating the restructuring of any distressed VRDO 
position. Further, higher issuer swap termination costs have produced 
substantial cash drains away from issuers via requirements that the 
issuers collateralize their potential termination liability to their 
counterparty. (Many issuers had purchased bond insurance AAAs to ward 
off credit- or rate-driven collateralization requirements. But with the 
insurers' losing their ratings, many issuers are no longer shielded, 
sometimes removing cash to the detriment of normal operations.) As not-
for-profit hospitals have been particularly large users of this debt 
structure, and as these same hospitals also face lower private pay 
revenues and strained governmental reimbursements, defaults are likely 
in the near term. Because swap positions are only dimly disclosed, even 
sophisticated municipal investors remain largely without information on 
their own portfolios' related risks.
    Once again, these municipal issuer exposures to systemic risks were 
accreted with little public disclosure or regulatory insight. Further, 
MMA is unaware of any municipal regulator or information provider 
systematically collecting information on the size and scope of this 
problem. This not only inhibits better projection of potential losses, 
but also prevents a more robust response from national regulators 
(e.g., Treasury, the Federal Reserve, the SEC) who are struggling to 
grasp the depth of the problem and coordinate their response with those 
in other asset classes. Solutions are well within Federal abilities. 
MMA recommends that Treasury extend subsidized loans to municipal 
issuers to terminate difficult swap positions, with the cost of those 
loans recouped by Treasury via a surcharge on all future issuer swap 
activity. This would allow issuers to restructure their obligations 
into fixed rate bonds, relieving liquidity provider balance sheets of 
troubled exposures, and potentially encouraging future policy writing.
Auction-Rate Securities and Unchecked Systemic Risks
    Auction-Rate Securities (ARS) are long maturity bonds where the 
interest rate is periodically reset by auction among potential 
investors, or failing that, set manually by a bank pursuant to an index 
or (typically very high) fixed rate. Because they are valued at par, 
ARS were typically purchased by individual investors as a higher-
yielding alternative to cash deposits. However, higher yields reflected 
the fact that an ARS holder cannot sell their bond without an 
identified buyer: a sharp distinction from other ``cash like'' 
instruments that required dealer banks to periodically step in as a 
buyer to prevent auctions from failing. In part because of this 
reliance on bank intervention, ARS programs were (and still are) set up 
as proprietary trading exchanges by individual dealers, inhibiting the 
easy flow of capital and information from program to program.
    The implications of the ARS structure, in the context of the 
municipal industry's systemic exposure to the bond insurers and the 
financial counterparties were little understood by issuers, investors, 
or the dealer banks themselves prior to 2007. It was the collapse of 
the bond insurers in 2007 that undermined investor confidence in ARS 
issuers and precipitated vast selling. (Remember that individual 
investors had long been sold on the AAA virtues of bond insurance; this 
myth was not so easy to dispel when bond insurer downgrades began). 
Banks were initially able to use their own cash to buy back securities, 
but in January 2008, bank risk tolerances prevented further purchases, 
and ARS auctions began to fail. Thus, current holders were left without 
a means to get out of their positions, and issuers were forced to pay 
sometimes highly punitive fixed interest rates. Since that time, MMA 
estimates that about two thirds of ARS issuers have restructured or 
refinanced their securities, although many remain unable to do so as: 
(1) refinances with liquidity-supported floating-rate debt require the 
purchase of a liquidity policy from a highly rated bank--these policies 
have become both scarce and expensive as U.S. banks have reduced 
lending; and (2) refinances with fixed-rate debt are prevented not only 
by the high fixed rates many lower-rated issuers must now pay, but also 
the sometimes staggering cost of terminating the interest rate swap 
most municipal issuers have connected to their bond sales (please see 
bank bonds section, above).
    Thus, many investors still remain stuck with highly illiquid 
securities that are paying well-below-market, index-linked interest 
rates. At issue is an unwillingness to allow ARS to trade at a discount 
to entice potential buyers, because of the increase in potential 
liability and because sub-par pricing of these holdings could result in 
additional waves of mark-to-market losses for the already stressed 
banks. Although private trading venues have emerged to provide 
emergency assistance to distressed clients needing to liquidate their 
holdings at any price, we are unaware of any broker dealer making sub-
par markets in any ARS. On the other hand, several of the large banks 
have, on the intervention of state securities regulators, settled with 
their individual and small institutional investors, in effect buying 
ARS securities back at par. Indeed, the largest current holders of ARS 
are likely the dealer firms themselves that are still carrying their 
swollen inventories from 2008 and now the bonds purchased via 
settlement.
    ARS shows another breakdown in the municipal regulatory framework. 
While there are initiatives to improve ARS price discovery, no market 
participant (including investors, dealer banks, nor the regulators 
themselves) knows precisely how many ARS are outstanding (MMA's 
estimate was about $200Bn municipal ARS at the market's peak), how many 
bonds were being placed through each dealer program, how many ARS 
issuers were reliant on bond insurance for their marketing to 
investors, the extent and means by which these issuers were leveraging 
counterparty credit through interest rate derivatives, and how much 
dealer support was being directly extended to the market. The 
implications for systemic risk management, as now being discovered in 
the credit crisis, are clear in these questions, which can (and should) 
be extended to the still healthy, but periodically threatened, 
municipal VRDO market.
Municipal Bond Ratings and Bond Insurance
    Most municipal bonds are rated on a different, more conservative 
rating scale than corporate bonds. Moody's and Standard & Poor's have 
shown that triple-A U.S. corporate bonds have up to 10 times the 
historical default rate of single-A municipals. In MMA's opinion, 
neither municipal issuers, nor the individual investors who own the 
large majority of outstanding paper or fund shares, understands this 
point. But instead of requiring more accurate ratings, the municipal 
industry (i.e., issuers, investors, and underwriters) has instead 
chosen to make bonds appear safer and more similar through bond 
insurance (the insurers are rated along the more generous corporate 
rating scale; much of the bond insurance model distills to simple 
arbitrage between the two rating scales). At its peak, the municipal 
bond insurance industry entailed just nine companies whose ratings were 
applied to more than 50 percent of annual municipal bond sales. And 
this invited massive systemic exposure into the municipal industry as 
the bond insurers carried in the risk of subprime mortgage-backed 
securities, the insurers' and the financial sectors' leverage of 
ratings on securitized debt, and failed rating agency models.
    Attached, please find our January 2008 report, ``MMA on Corporate 
Equivalent Ratings,'' and our April 2008 report, ``Second Research Note 
on Moody's,'' for more detail on the problem with how municipal bonds 
have been rated. In the last year, both Moody's and Fitch ratings 
strongly considered reforming their muni rating processes, but both 
have tabled these initiatives because of the recession. Standard and 
Poor's continues to deny the existence of separate rating scales for 
municipals and corporate bonds, but that agency has embarked on a plan 
of sweeping upgrades to selected municipal sectors. Finally, the U.S. 
House of Representatives considered the ``Municipal Bond Ratings 
Fairness Act of 2008,'' which MMA believes would, for little cost to 
taxpayers, successfully remediate much of the rating problem in our 
sector. We strongly recommend that Congress adopt this legislation in 
its current form. MMA has been a leader on the topic of ratings and the 
municipal sector's use of bond insurance; we welcome any opportunities 
to continue to educate Congress and its agents on these topics.
Pricing and Evaluation Issues
    The events of the past 18 months have amplified the risks and 
challenges associated with illiquidity and limited price discovery for 
municipal bond investors and issuers.
    The municipal bond industry has been challenged with a troublesome 
irony. While municipal bonds have favorable low historical default 
risks, the securities can be illiquid. How can a safe investment not 
have liquidity? Inconsistency of primary market pricing, the eclectic 
composition and multitude of issuing entities, the penal and overly 
granular ratings scale, reduced number of liquidity providers, the 
diminished number of AAA bond insurers and the inability to manage 
interest rate and credit risk have contributed to the challenges for 
the markets transactions to provide evaluation services with sufficient 
price discovery. The result is that evaluations that represent the 
price that investors receive on their investment firm statements or the 
prices that comprise the net asset value of a mutual fund share may 
bear little resemblance to an execution price should an investor choose 
to buy or sell. In addition, the periodic illiquid market conditions 
and limited price can result in sharp volatility that can be 
misinterpreted as credit or default risk, either of which may not be 
valid. In this manner the data can misinform an investor and 
potentially prompt emotional and inappropriate investment decisions. 
These same characteristics can also increase the difficulty for 
municipal issuers to assess market conditions and accurately predict 
market demand to give context for the pricing of their primary market 
deal.
    An aggressive, investigative and knowledgeable regulator with 
access to all transactions and who conducted each transaction, can 
assist consumers--both the investor and borrower--with providing a 
context to ensure that the data is relied upon by consumers inspires 
confidence and provides an objective context in which investors and 
issuers can make decisions from the prices of their securities.
Schedule of Additional Attachments
    MMA has attached the following documents, under separate Acrobat 
file, in support of the arguments made herein.

    NFMA White Paper ``Federal Securities Law Relating to 
        Municipal Securities'' March 2008

    DPC Data ``The Consequences of Poor Disclosure Enforcement 
        in The Municipal Securities Market'' January 2009

    Municipal Market Advisors ``Corporate Ratings for Munis'' 
        January 2008

    Municipal Market Advisors ``Second Research Note on 
        Moody's'' April 2008
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
                  PREPARED STATEMENT OF LYNN E. TURNER
                        Former Chief Accountant,
                   Securities and Exchange Commission
                             March 10, 2009
    Thank you Chairman Dodd and Ranking Member Shelby for holding this 
hearing on an issue important to not only investors in America's 
capital markets, but to all who are being impacted by the current 
economic devastation.
    Before I start with my personal perspective on the issues 
surrounding the current economic crisis and securities regulation, it 
might be worthwhile to provide some background on my experience. I 
serve as a trustee of a mutual fund and a public pension fund. I have 
served as an executive of an international semiconductor manufacturer 
as well as on the board of directors of both Fortune 500 and small cap 
public companies. In the past, I served as chief accountant of the U.S. 
Securities and Exchange Commission (SEC) and as a partner in one of the 
major international auditing firms, where I was involved with audits 
and restructurings of troubled or failed institutions. I also was the 
managing director of research at a financial and proxy advisory firm. 
In addition, I have also been a professor of accounting at a major U.S. 
public university and an investor representative on the Public 
Companies Accounting Oversight Board (PCAOB) Standards Advisory Group 
and the Financial Accounting Standards Board's (FASB) Investor 
Technical Advisory Committee (ITAC).
The Crisis--Bad Loans, Bad Gatekeepers, and Bad Regulation
    The economic crisis of 2007-2009 has three root causes; the making 
of bad loans with other peoples money, gatekeepers who sold out, and a 
lack of regulation. In order to prevent a repeat of this debacle it is 
of paramount importance that policy makers understand what will cure 
the ``disease'' before they remedy the cause. To that end, I would urge 
the committee to take the same approach it did some seven decades ago 
when the Senate Banking Committee, with experienced investigators using 
its subpoena powers, investigated the banking and security markets, 
stock exchanges, and conduct of their participants. A similar approach 
in the midst of the current crisis would give Americans and investors 
hope and confidence that their interests will be served, and adequate 
protections restored. Unfortunately, if the public perceives the remedy 
is off target, as it has with other recent legislation, I fear the 
markets will continue their downward spiral resulting in a lengthening 
of the recession, or potentially worse outcome.
    From my perspective, those most responsible for the current crisis 
are the banks, mortgage bankers, and finance companies who took money 
from depositors and investors and loaned it out to people who simply 
could not, or did not repay it. In some instances predatory practices 
occurred. In other instances, people borrowed more than they should 
have as Americans in general ``leveraged'' their personal and corporate 
balance sheets to the max. Speculators also took out loans expecting 
that real estate values would continue to rise, allowing them to profit 
from flipping their investments. But who can dispute that when 
``liar,'' ``no doc,'' and ``Ninja loans'' are being made while banking 
regulators are watching, there is something seriously wrong.
    In addition to the financiers, a second problem was the 
gatekeepers--the credit rating agencies and underwriters--who are 
suppose to protect investors. They did anything but that. Instead they 
became the facilitators of this fraud on the American public, rather 
than holding up a stop sign and putting the brakes on what was 
occurring. They became blinded by the dollars they were billing rather 
than providing insight to the public into the perfect storm that was 
forming. Recent testimony before the House of Representatives that the 
rating agencies knew their models did not work, but did not fix them 
was stunning. But perhaps not as stunning as the report of the SEC in 
which employees of an agency stated they would rate a product even if 
it had been created by a cow.
    And while lenders were making bad loans in exchange for up-front 
fees, and gatekeepers were falling down on the job, Federal Government 
agencies were failing to supervise or regulate those under their 
oversight, as well as failing to enforce laws. It is a huge public 
concern that a systemic failure of financial and securities market 
regulation in this country occurred. Some of this was due to the lack 
of regulation of new products and institutions, such as credit default 
swaps and hedge funds, but more importantly, the fundamental problem 
was the lack of Federal Government regulators doing their jobs, or 
lacking the resources to do so.
    For example, for 13 years, as abuses of subprime lending occurred, 
the Federal Reserve refused to issue regulations as mandated by the 
Homeownership Equity Protection Act of 1994 (HOPEA). That legislation 
specifically stated:

        PROHIBITIONS--The Board, by regulation or order, shall prohibit 
        acts or practices in connection with-- ``(A) mortgage loans 
        that the Board finds to be unfair, deceptive, or designed to 
        evade the provisions of this section; and (B) refinancing of 
        mortgage loans that the Board finds to be associated with 
        abusive lending practices, or that are otherwise not in the 
        interest of the borrower.''.

        Not less than once during the 3-year period beginning on the 
        date of enactment of this Act , and regularly thereafter, the 
        Board of Governors of the Federal Reserve System, in 
        consultation with the Consumer Advisory Council of the Board, 
        shall conduct a public hearing to examine the home equity loan 
        market and the adequacy of existing regulatory and legislative 
        provisions and the provisions of this subtitle in protecting 
        the interests of consumers, and low-income consumers in 
        particular . . .

    Yet the Federal Reserve Board (Federal Reserve or Fed), which had 
examiners in the very banks who were making mortgage loans, did 
nothing. Had the Federal Reserve acted, much of the subprime disaster 
might have been averted. Instead, ignoring the clarion calls of one of 
its own Governors for action, the late Edward Gramlich, it was not 
until 2007 that the Federal Reserve acted. But by then, much of the 
damage to the American economy and capital markets had been done.
    Indeed, even the Comptroller of the Currency spoke in 2006 of 3 
years of lowering of lending standards. In a press release in 2006, the 
Comptroller stated:

        ``What the Underwriting Survey says this year should give us 
        pause,'' Mr. Dugan said. ``Loan standards have now eased for 
        three consecutive years.'' The Comptroller reported 
        ``slippage'' in commercial lending involving leverage lending 
        and large corporate loans as well as in retail lending with 
        significant easing in residential mortgage lending standards 
        including home equity loans. [Emphasis supplied]

    Unfortunately, armed with this information and legislative 
authority to fix the problem, the Comptroller of the Currency (OCC) 
failed to act in earlier years. Rather than reining in these abusive 
practices, the OCC permitted them to continue, with the most toxic of 
the subprime loans being originated in 2006 or 2007. And today, we have 
Inspector General reports that have cited the lack of action by the OCC 
and Office of Thrift Supervision, leaving taxpayers and investors 
exposed to losses totaling trillions of dollars.
    What is equally troubling about this lack of action by the banking 
regulators, is that it comes after similar problems occurred with the 
crisis in the savings and loan and banking industries in the 1980s and 
early 1990s. I was at the SEC at that time and watched as the Federal 
Reserve who had oversight over an undercapitalized CitiBank, worked to 
keep it afloat. It seems that we are seeing a repeat performance of 
this situation and rather than having learned from history, we are 
again repeating it. After having two swings at the bat, I wonder why 
some want to make the same regulators the risk regulator for the entire 
financial system in the United States. These are regulators who all too 
often have been captured by the regulated.
    Once again, as with Enron, a lack of transparency has also been a 
contributing factor to the current crisis. Investors have time and time 
again--from Bear Stearns to Lehman to Wachovia to Citigroup and Bank of 
America--questioned the validity of the financial numbers they are 
being provided. The prices of their stocks have reflected this lack of 
credibility driven by transactions hidden off the balance sheets and 
values of investments and loans that fail to reflect their real values.
    Unfortunately, millions of bad loans were made that are not going 
to be repaid. While financial institutions argue they will hold the 
loans to maturity and be repaid, that just isn't true for loans subject 
to foreclosures or short sales. And for many mortgages, they prepay and 
once again are not held to maturity. At the same time, collateral 
values of the underlying assets securing the loans have taken a 
tremendous tumble in values. Almost 5 million Americans have lost their 
jobs since this recession began impacting their ability to make their 
mortgage payments. There is a years worth of inventory of unsold homes 
on the market even further depressing home prices. Asset backed 
securities are being sold in actual transactions at pennies on the 
dollar. Yet the financial institutions continue to act like an ostrich 
with their head in the sand and ignore these facts when valuing their 
assets. At the same time however, the markets are looking through these 
numbers and revaluing the stocks in what is an inefficient approach, 
driving stocks of some of the largest financial institutions in this 
country to a price that is lower than what you can buy a Happy Meal for 
at McDonalds.
    In 1991 the General Accounting Office (GAO) published a report 
titled ``Failed Banks--Accounting and Auditing Reforms Urgently 
Needed.'' In their report, the GAO noted how during the savings and 
loan crisis, the failure of banks and savings and loans to promptly 
reflect their loans and assets at their market values drove up the cost 
to the taxpayer. I hope Congress will not allow this mistake to be 
repeated by allowing banks to avoid marking their assets to market.
    Managing the assets held by a financial institution and the 
positions taken has also been lacking. One large institution that was 
failing and required a bailout through a buyer did not even have a 
chief risk officer in place as the risks that caused their demise were 
entered into. This could have been avoided in if the recommendations of 
the 2001 Shipley Working Group on Public Disclosure had been adopted by 
the banking and securities regulators that had convened the group. 
Instead, consistent with a deregulatory approach, the type of risk 
disclosures the group called remained nonexistent, hiding the buildup 
of risks in the financial system.
    There has also been a lack of regulation of new products and 
institutions. Credit rating agencies were not subject to regulation by 
the SEC until after many of the subprime loans had been made. Credit 
default swaps and derivatives were specifically exempted by Congress 
from regulation, despite a plea for regulation from the CFTC chairman, 
creating grave systemic risks for the financial system. These markets 
grew to over $60 trillion, a multiple of many times the actual debt 
subject to these swaps. In essence, a betting system had been 
established whereby people were wagering on whether others would pay 
their debt. But while we regulate betting in Las Vegas, congress chose 
to specifically not regulate such weapons of mass destruction in the 
capital markets. This has directly led to the more than $160 billion 
bailout of the bets AIG placed, and those to whom it is indebted on 
those on those bets.
    Likewise, there has been a rise in a shadow banking system that 
includes hedge funds and private equity firms. These funds have under 
management money from many public sources, such as public pension funds 
and their members and the endowments of colleges and universities. Yet 
they remain largely opaque and these unregulated entities have been 
allowed to co-exist alongside the regulated firms as a push was made 
for less regulation. That push was advanced by an argument the markets 
can regulate themselves, a perspective that has been proven to totally 
lack any credibility during this decade of one scandal after another. 
Others said that without regulation, these unregulated entities could 
innovate and create great wealth. Unfortunately, their innovation has 
not always created wealth and in other instances has been quite 
destructive.
    The subprime crisis, and our economic free fall, is the showcase 
for what can happen without adequate regulation and enforcement. Those 
who made the loans including mortgage bankers, the credit rating 
agencies who put their stamp of approval on the Ninja, no doc and liar 
loans, and the investment bankers who packaged them up and sold them to 
an unsuspecting public were all unregulated or regulated only in a 
token fashion.
    Unfortunately, the deregulation of the U.S. capital markets that 
many not so long ago called for, has not resulted in increased 
competitiveness of the markets. Rather it has left the preeminence and 
credibility of our capital markets shattered. Instead of making the 
allocation of capital more efficient, it has resulted in a lack of 
transparency and mispricing and misallocation of capital. Investors 
have watched as over ten trillion in wealth has disappeared. And 
instead of fueling a growth in our economy, we have seen it fall into a 
decline the likes that haven't been seen since the great depression. 
Indeed, some have now called our situation the ``Not So Great 
Depression'' and one commentator, Stephen Roach of Morgan Stanley has 
warned of a Japanese style economy that continues to this day to 
sputter along.
Reforms--The Long Road Back
    On a bipartisan basis, we have dug the hole we find ourselves in 
over an extended period of time. During much of that time we have 
enjoyed economic prosperity that in recent years contributed to the 
``suspended disbelief'' that the good times would never end. All too 
often people spoke of the ``New Economy'' and those who doubted it or 
warned of dangers were treated as outcasts. But as with many a bubble 
in the past, this one too has burst.
    The capital markets have always been the crown jewel of our 
economy--the engine that powered it. And it can once again achieve that 
status, firing on all cylinders, but only if care is taken in 
structuring reforms that protect the investing public.
Basic Principles
    In creating regulator reform, I believe there are some critical 
fundamental principles that should be established. They include:

  1.  Independence

  2.  Transparency

  3.  Accountability

  4.  Enforcement of the law

  5.  Adequate Resources
Independence
    Those responsible for oversight, including regulators and 
gatekeepers, must be independent and free of conflicts and bias when 
doing their jobs. And it is not just enough that they are independent 
on paper, they must be perceived by investors to be free of conflicts 
avoiding arrangements that cause investors to question their 
independence. They need to be free of political pressures that unduly 
influence their ability to carry out their mandates to protect the 
American consumer and investor. They must avoid capture by the 
regulated. And their ability to get resources should not be contingent 
on whether they reach a favorable decision for one special interest 
group or political affiliation.
    This is especially true of regulators such as the SEC and CFTC. 
These agencies must avoid becoming political footballs thrown between 
opposing benches. Unfortunately, that has not always been the case as 
we saw recently at the SEC or with the CFTC when it asked for 
regulation of credit derivatives.
    Similarly, the credit rating agencies have suffered from some of 
the same lack of independence the auditors did before Enron, WorldCom, 
and the enactment of the Sarbanes-Oxley Act of 2002 (SOX). They became 
captured by the desire to increase revenues at just about any cost, 
while ignoring their gatekeeper role.
    Independence also means there is a lack of conflicts that can 
impact one's independent thinking. For example, when a bank originates 
a subprime loan it may will ask its investment banking arm to 
securitize it. But if it is a no doc, liar loan or Ninja loan, will the 
investment banker perform sufficient due diligence and ensure full and 
fair disclosure is made to the investors clearly delineating in plain 
English what they are being sold? I doubt that has really occurred.
    Unfortunately, when the Gramm-Leach-Bliley Act was passed, allowing 
the creation of giant financial supermarkets, it failed to legislate 
and adequately address such conflicts. In fact, it did not address them 
at all leaving us with huge conflicts that have now given rise to 
investments that are not suitable for the vast majority of investors. 
Given this Act gave an implicit blessing to the creation of 
institutions that are ``Too Big To Fail'' and knowing that after the 
failure of Long Term Capital management the creation of such 
institutions brings with it the backing of taxpayers money, this 
serious deficiency in the laws governing regulation of conflicts of 
interests in these institutions needs to be addressed in a robust 
fashion.
Transparency
    Transparency is the life blood of the markets. Investors allocate 
their capital to those markets where they get higher returns. Investors 
need the best possible financial information on which to base their 
decisions as to which capital markets they will invest in, and which 
companies, in order to generate the maximum possible returns. 
Maximizing those returns is critical to investors, and institutions who 
manage their investments, as it determines how much they will have for 
retirement, or spending.
    Investors will allocate their capital to those markets where 
returns are maximized. While economic growth in a particular country 
has a significant impact on returns for a capital market, the quality 
of the information provided to those who allocate capital also 
significant impacts it. In general, the better the information, the 
better the decisions made, and the more efficiently capital is 
allocated and returns maximized.
    The U.S. capital markets have maintained their lead in 
transparency, albeit our pride in that respect has been tarnished by 
off balance sheeting financings, a lack of disclosures regarding the 
quality of securities being sold, and credit ratings that were at best 
poorly done, if not outright misleading. Nonetheless, even in today's 
markets, the U.S. markets have continued to outperform foreign markets.
Accountability
    Accountability clearly places the responsibility for decisions made 
and actions taken. People act differently when they know they will be 
held accountable. When people know there is a state trooper ahead on 
the highway, they typically drive accordingly. When they know there is 
no trooper, a portion of the population will hit the accelerator and 
speed ahead.
    There needs to be greater accountability built into the system. The 
executives and boards of directors of the financial institutions that 
have made the bad loans bringing our economy to its knees, causing 
Americans to lose their jobs, students to have to forgo their 
education, all at a great cost to the taxpayer should be held 
accountable. The American public will demand nothing less.
    The banking, insurance, commodities and securities regulators all 
need to have greater accountability. We need to know that we have a 
real cop on the beat, not just one in uniform standing on a corner.
    Likewise, gatekeepers must be held accountable for the product they 
provide the capital markets. Their product is critical to ensuring the 
credibility of financial information needed for capital allocation.
Enforcement
    We are a Nation of laws. The laws governing the capital markets and 
banking in this country have been developed to provide protections for 
investors and consumers alike. They provide confidence that the money 
they have worked hard for, when invested, is safe from abusive, 
misleading and fraudulent practices. Without such laws, people would be 
much more reluctant to provide capital to banks and public companies 
that can be put to work creating new plants and products and jobs.
    But laws aren't worth the paper they are written on if they are not 
properly enforced. An unleveled playing field in the markets brought on 
by a lack of enforcement of laws providing consumer and investor 
protections can have the devastating effect we are now seeing. For 
example, the Financial Accounting Standards Board Chairman has written 
members of this committee citing how some institutions were not 
properly following the standards hiding transactions off balance sheet. 
Yet to date, enforcement agencies have not brought any cases in that 
regard.
    And laws are not just enforced by the law enforcement agencies, but 
also through private rights of actions of investors and consumers. This 
is critically important as law enforcement agencies have lacked the 
adequate resources to get the job done alone.
    Unfortunately, in recent years we have seen an erosion of investor 
and consumer rights to enforce the laws. Court cases setting up huge 
hurdles to these attempts to enforce the laws have made it much more 
costly taking significant time and resources to get justice. For 
example, one such court decision has now made it in essence legal for 
someone to knowingly aid another party in the commission of a fraud on 
investors, yet be protected by the courts from legal liability. It is 
akin to saying that if one drives a getaway car for a bank robber, they 
can go to jail. But if one wears a white collar and provides assistance 
to such a fraud in the securities market, they get a pass. Something is 
just simply wrong when that is allowed to occur in our Nation. Congress 
needs to remedy this promptly with legislation Senator Shelby 
introduced 7 years ago in 2002.
    Likewise we have seen passage of laws such as the Commodities 
Modernization Act of 2000 which also put handcuffs on our enforcement 
and regulatory agencies. This Act passed in the waning moments of that 
Congress at the requests of special interests. Supported by government 
officials, the Act specifically prevented the SEC and CFTC from 
regulating the derivatives market now totaling hundreds of trillions of 
dollars. These handcuffs need to be promptly removed. The securities 
and commodities laws need to be clarified to give the CFTC the 
authority to regulate commodities and any derivative thereof such as 
carbon trading, and the SEC the authority to regulate securities and 
any derivative thereof such as credit derivatives.
Adequate Resources
    No one can do their job if they are not provided the proper tools, 
sufficient staffing and other resources necessary for the job. This 
includes being provided the necessary authority through legislation to 
do the job. It means Congress has to provide a budget to these agencies 
to hire sufficient number of staff. But it is not just the numbers that 
count, the agencies must also be given enough money to hire staff with 
sufficient experience. For example, while I was at the SEC, the budget 
you provided to the agency did not give the Office of Compliance 
Inspections and Examination a sufficient number of staff. And it 
certainly did not provide the office with enough money to hire senior 
experienced examiners who had the type of depth and breadth of 
expertise in the industry that was necessary to do the job right. Whose 
fault is it then when that agency fails to detects frauds through their 
examinations? I would say a good part of the blame lies at the feet of 
Congress.
    I would urge you to take a look at how these agencies that are so 
critical to the proper functioning of our markets are funded. In the 
case of the SEC, it collects sufficient fees to pay for an adequate 
budget. Yet each year it must go hat in hand to ask for a portion of 
those fees in an amount that has not met its needs. Instead, the SEC 
should be removed from the annual budget process and established as an 
independently funded agency; free to keep the fees it collects to fund 
its budgets.
Necessary Reforms
    Once again, before legislating reforms, I would urge this committee 
to undertake ``Pecora'' hearings to ensure it gets the job done right. 
Some of the reforms that I believe are necessary, and which could be 
examined in such hearings include the following;
    Regulatory Structure: Arbitrage among banking regulators should be 
eliminated, and accountability for examination and regulation of banks 
centralized in one agency. To accomplish that, Congress should once 
again consider the legislation offered in 1994 by the former Chairman 
of this Committee, Donald Reigle. That legislation would combine the 
examination function into one new agency, while having the FDIC remain 
in its role as an insurer and the Federal Reserve as the central 
banker. Careful consideration needs to be given to the conflicts that 
arise when the central banker both sets monetary policy, such as when 
it created low interest rates earlier this decade, and then regulates 
the very banks such as Citigroup and Country Wide that exploit that 
policy, and at the same time fails to put in place safeguards as the 
Fed had been asked to do by Congress in 1994. And the mission of the 
new agency, as well as the missions of the FDIC and Fed with respect to 
consumer and investor protection needs to be made much more explicit. 
All too often these regulators have been captured by industry, much to 
the detriment of consumers and investors and in the name of safety and 
soundness. Yet we have learned that what is good for consumers and 
investors alike, is also good for safety and soundness, but not 
necessarily the reverse.
    I believe the roles of the CFTC and SEC should be clarified. I do 
not support the merger of the two agencies as I don't believe the 
synergies some believe exist will be achieved. I also believe 
commodities and securities are fundamentally two different markets, 
with significantly differing risks, and the regulator needs 
significantly differing skill sets to regulate them. Accordingly, as I 
have previously mentioned, I would clarify the roles of these two 
agencies by giving all commodities and derivatives thereof to the CFTC 
to regulate, and all securities and derivatives thereof to the SEC.
    Some have argued for the creation of new agencies. To date; I have 
yet to see the need for that. For example, some have argued that a 
separate investor and consumer protection agency should be created. 
However, when it comes to the securities markets, I believe the SEC 
should continue in that role, and given the resources to do so.
    Over the years, the SEC has shown it can be a strong investor 
protection agency. It has only been in recent years, when quite frankly 
people who did not believe in regulation were appointed to the 
Commission, that it fell down on the job. By appointing investor minded 
individuals to the Commission, who have a demonstrated track record of 
serving and protecting the public, this problem can be fixed. Likewise 
however, if a separate agency is created, but the wrong people put in 
place to run it, we will see a repeat performance of what has occurred 
at the SEC.
    Gaps in Regulation: There are certain gaps in regulation that are 
in need of fixing. Credit derivatives should become subject to 
regulation by the SEC as former SEC Chairman Cox urged this committee 
to do some time ago. While the establishment of a clearing house is a 
positive development, in and of itself it is insufficient.
    I understand the securities laws generally exclude over-the-counter 
swaps from SEC regulation. This improperly limits the SEC's ability to 
provide for appropriate investor protection and market quality. The OTC 
derivatives market is enormous, and proper regulation is in the public 
interest. The SEC would be in a better position to provide that 
regulation if the following changes were made:

    Repeal the exclusion of security-based swap agreements from 
        the definition of ``security'' under the Securities Act of 1933 
        and Securities Exchange Act of 1934.

    Include within the definition of ``security'' financial 
        products that are economic derivatives for securities. It is 
        important to consolidate the regulatory authority at the SEC 
        because of its investor protection and capital markets mandate. 
        While the SEC has a mandate to protect investors and consumers, 
        other regulators may lose sight of that mission. Based on my 
        business and agricultural background, I have found derivatives 
        in agriculture and other physical commodities have a different 
        purpose than financial derivatives as they permit risk 
        management and secure supplies for users and producers of 
        goods.

    Require all transactions in securities to be executed on a 
        registered securities exchange and cleared through a registered 
        clearing agency.

    There needs to be much greater transparency for this market. The 
recent reluctance of the FED to disclose the counter parties receiving 
the bailout in connection with AIG is alarming but not surprising. Even 
the current Fed Chairman has stated this is an agency that has been all 
too opaque in the past.
    There needs to be greater disclosure to the public of the trading, 
pricing and positions of these arrangements. There also needs to be 
disclosure identifying the counterparties when the impact of the 
contracts could have a material effect on their operations, performance 
or liquidity. Given the deficiencies that have existed in some 
contracts, there also needs to be more transparency provided around the 
nature, terms, and amounts of such contracts when they are material.
    There is also a legitimate question as to whether one party should 
be able to bet on whether another party will pay their debt, when the 
bettor has no underlying direct interest in the debt. Certainly as we 
have seen at AIG and elsewhere, these contracts can have devastating 
effect. Quite frankly, they do not serve a useful purpose for investors 
as a whole in the capital markets. As such, I would like to see them 
prohibited.
    There is also a gap in regulation of the municipal securities 
market as a result of what is known as the Tower Amendment. Recent SEC 
enforcement actions such as with the City of San Diego, the problems in 
the auction rate securities, and the lurking problems with pension 
obligation bonds, all cry out for greater regulation and transparency 
in these markets. These token regulated municipal market now amount to 
trillions of dollars and poses very real and significant risks. 
Accordingly, as former Chairman Cox recommended, I believe Section 
15B(d)--Issuance of Municipal Securities--of the Securities Act of 1934 
should be deleted.
    The SEC should be given authority to regulate hedge and private 
equity funds that directly or indirectly take public capital including 
from retail investors. They should be subject to the same type of 
regulation as their counter parts in the mutual fund market. This 
regulation should give the SEC the (i) authority to require the funds 
to register with the SEC, (ii) give the SEC the authority to inspect 
these firms, (iii) require greater transparency through public 
quarterly filings of their positions and their financial statements and 
(iv) give the SEC appropriate enforcement capabilities when their 
conduct causes damage to investors or the financial markets and system.
    As testimony before this committee in the past has demonstrated, 
the SEC has insufficient authority over the credit ratings agencies 
despite the roles those firms played in Enron and now the subprime 
crisis. This deficiency needs to be remedied by giving the SEC the 
authority to inspect credit ratings, just as Congress gave the PCAOB 
the ability to inspect independent audits. In addition, the SEC should 
be given the authority to fine the agencies or their employees who fail 
to adequately protect investors. Greater transparency should be 
provided to credit ratings themselves. And disclosure should be 
required, similar to that for independent auditors of potential 
conflicts of interests.
    The SEC, CFTC and Banking Regulators should also be given powers to 
regulate new financial products issued by those whom they regulate. 
This should be accomplished through disclosure. The agencies should 
have to make a determination that adequate disclosures have been made 
to consumers and investors regarding the risks, terms conditions of new 
products before they can be marketed. If a new product is determined by 
an agency to present great risk to the financial system or investors, 
the regulating agency should be empowered to prevent it from coming to 
market, just as is done with new drugs.
    In addition, there needs to be greater regulation of mortgage 
brokers. Some States have already made progress in this regards. 
However, the Federal banking regulators should be given power to 
provide consumers necessary protections, if they find that state 
regulators have failed to do so.
    Greater Accountability Through Improved Governance and Investor 
Rights: Legislation equivalent to an investor's Bill of Rights should 
be adopted. Investors own the company and should have some basic 
fundamental rights with respect to their ownership and investments. It 
is well known that investors in the U.S. lack some of the fundamental 
rights they have in foreign countries such as the United Kingdom, the 
Netherlands and Australia. Yet while some argue for regulation and 
regulators similar to those in foreign countries, these very same 
people often oppose importing investor rights from those same countries 
into our system of governance.
    The excesses of executive compensation have been well documented 
and need no further discussion. Some have argued investors have an 
ability to directly address this by voting for or against directors on 
the compensation committee of corporate boards. But that is a fallacy. 
First of all, investors can only vote for, not against a director in 
the system we have today. Second, some institutional investors have 
direct conflicts when voting as a result of receiving fees for managing 
corporate pension funds of the management they are voting on. At times 
this seems to unduly and improperly influence their votes.
    To remedy these shortcomings, Congress should move to adopt 
legislation that would:

    Require majority voting for directors and those who can't 
        get a majority of the votes of investors they are to represent 
        should be required to step down.

    Require public issuers to annually submit their 
        compensation arrangements to a vote of their investors--
        commonly referred to as ``say on pay.''

    Give investors who own 3 to 4 percent of the company, the 
        same equal access to the proxy as management currently has. 
        While some argue this will give special interests an ability to 
        railroad corporate elections, that simply has proven not to be 
        the case. When special interests have tried to mobilize votes 
        based on their interests and not those of investors, they have 
        ALWAYS failed miserably.

    Investors who own 5 percent or more of the stock of a 
        company should be permitted, as they are in other countries, to 
        call for a special meeting of all investors. They should also 
        be given the right to do so to call for a vote on 
        reincorporation when management and corporate boards unduly use 
        state laws detrimental to shareholder interests to entrench 
        themselves further.

    Strengthen the fiduciary requirements of institutional 
        investors when voting on behalf of those whose money they 
        manage. This should extend to all such institutional investors 
        including mutual funds, hedge funds, public and corporate 
        pension funds as well as the labor pension funds.

    Since voting is an integral part of and critically important to 
governance, greater oversight should be put in place with respect to 
those entities who advise institutions on how they should vote. 
Recently a paper from the Milstein Center for Governance and 
Performance at Yale has made recommendations in this regard as well. As 
a former managing director of one such entity, I would support 
legislation that would:

    Require these entities to register with the SEC as 
        investment advisors, subject to inspection by the SEC. While 
        some have registered, others have chosen not to.

    Require these entities to improve their transparency by 
        disclosing their voting recommendations within a reasonable 
        time period after the vote.

    Require all institutional investors, including public, 
        corporate, hedge and labor pension funds to disclose their 
        votes, just as mutual funds are currently required to disclose 
        their votes.

    Require that only the legal owner of a share of stock can 
        vote it, prohibiting those who borrow stock to unduly influence 
        an election by voting borrowed stock they don't even own, and 
        eliminating broker votes.

    It should also be made explicit that the SEC has authority to set 
governance standards for the mutual funds. For example, the SEC should 
have the authority, and act on that authority, to require a majority of 
independent directors for mutual funds, as well as an independent 
chair.
    Investor's rights of private actions have also been seriously 
eroded in the past decade. Certainly we should not return to the abuses 
of the court system that existed before the Private Securities Law 
Reform Act (PSLRA) was passed. But at the same time, investors should 
not have to suffer the type of conduct that contributed to Enron and 
other scandals. And the SEC does not, and will not have the resources 
to enforce the securities laws in all instances.
    The SEC should continue to be supportive of investors' private 
right of action. The SEC should also continue to support court rulings 
that permit private investors to bring suits in the event of aiding and 
abetting and scheme liability. In 2004, the SEC filed an amicus brief 
in Simpson v. Homestore.com, Inc., upholding liability against an 
individual regardless of whether or not the person made false or 
misleading statements. In 2007, a request from SEC Commissioners to the 
Solicitor General to submit a brief in favor of upholding scheme 
liability in the case of Stoneridge v. Scientific-Atlanta was denied by 
the White House, despite the urging of Senate Banking Committee 
Chairman Christopher Dodd (D-CT) and House Financial Services Committee 
Chairman Barney Frank (D-MA). The SEC needs to reclaim the SEC's role 
of providing strong support for the right of investors to seek a 
private remedy.
    Investors in securities fraud cases have always had the burden of 
proving that defendants' fraud caused the investors' losses. Congress 
continued this policy in PSLRA. However, recent lower-court 
interpretations of a 2005 Supreme Court case have improperly 
transformed loss causation into an almost impossible barrier for 
investors in serious cases of fraud. Congress, with the support of the 
SEC, should act to fix the law in this area.
    Taking advantage of the loophole in the law the courts have now 
created, public companies have begun gaming the system. Specifically, 
corporations may now simultaneously disclose other information--
positive and negative--in order to make their adverse disclosures 
``noisy,'' so that attorneys representing shareholders will find it 
more difficult, if not impossible, to satisfy loss causation 
requirements. Other corporations may leak information related to the 
fraud, so that the share price declines at an early date, before they 
formally reveal the adverse news.
    In sum, narrow lower-court standards of loss causation are allowing 
dishonest conduct to avoid liability for fraudulent statements by 
disclosing that the corporation's financial results have deteriorated 
without specifically disclosing the truth about their prior 
misrepresentations that caused the disappointing results. Insisting on 
a ``fact-for-fact'' ``corrective disclosure'' allows fraudsters to 
escape liability simply by not confessing.
    Transparency: The lack of credible financial information has done 
great damage to the capital markets. This has ranged from a lack of 
information on off balance sheet transactions as was the case with 
Enron, to a lack of information on the quality of assets on the balance 
sheets of financial institutions, to a lack of information on risk 
management at public entities, to a lack of transparency at regulators.
    The lack of transparency begins with accounting standards that yet 
again have failed to provide the markets and investors with timely, 
comparable and relevant information. The off balance sheet transactions 
that expose great risk to the markets, have once again been permitted 
to be hid from view by the accounting standard setters. What is more 
disturbing about this is that the standard setters were aware of these 
risks and failed to act.
    To remedy this serious shortcoming, and ensure the standard setters 
provide a quality product to investors and the markets, I believe 
Section 108 of SOX should be amended. It should require that before the 
SEC recognizes an accounting standard setter for the capital markets, 
either from the U.S. or internationally, that its board of trustees and 
voting board members must have preferably a majority of representatives 
from the investor community and certainly no less than 40 percent of 
their membership should be investors with adequate skills and a 
demonstrated ability to serve the public. In addition, any standard 
setter should be required to have an independent funding source before 
their standards are used. And finally, each standard setter should be 
required to periodically reevaluate the standards they have issued, and 
publicly report on the quality of their implementation. For too long 
accounting standard setters have disavowed any responsibility for their 
standards once they have been issued, a practice that should come to an 
immediate halt.
    The SEC also needs to closely monitor the current efforts of the 
FASB and International Accounting Standards Board (IASB) to ensure 
appropriate transactions are brought on balance sheet when a sponsoring 
company controls, or effectively controls the economics of the 
transaction. I fear based on developments to date, these efforts may 
yet once again fail investors.
    Transparency of the regulators needs to be enhanced as well so as 
to establish greater accountability. For example, the regulators should 
be required in their annual reports to Congress to:

    Identify key risks that could affect the financial markets 
        and participants they regulate, and discuss the actions they 
        are taking to mitigate those risks. For example, the OCC and 
        SEC have had risk management offices for some time, yet their 
        reports have failed to adequately alert Congress to the 
        impending disaster that has now occurred. Unfortunately the SEC 
        risk management office was reduced to a staff of one.

    They should have to provide greater detail as to their 
        enforcement actions including the aggregate number and nature 
        of the actions initiated, the number of actions in the pipeline 
        and average age of those cases, the number and nature of the 
        cases resolved and how those cases were resolved (e.g., 
        litigation, settlement, case dismissed).

    Banking and securities regulators should be required to 
        make public their examination reports. The public should be 
        able to see in a transparent fashion what the regulator has 
        found. Regulators who have found problems have all too often 
        failed to disclose their findings of problems to the 
        unsuspecting public or Congress. In some instances, the 
        problems identified have not been promptly addressed by the 
        regulator and have resulted in the need for taxpayer bailouts 
        amounting to hundreds of billions of dollars. That simply 
        should not be allowed to occur. And while some in the industry 
        and banking regulators have indicated such disclosure could 
        harm a financial institution, I believe any such harm is 
        questionable and certainly of much less significance than the 
        damage now being wrought on our economy and society.

    The securities and banking regulators should also be required to 
adopt greater disclosures of risks that can impact the liquidity and 
capital of financial institutions. The Shipley Working Group encouraged 
such disclosures. These disclosures should include greater information 
regarding the internal ratings, risks and delinquencies with respect to 
loans held by financial institutions. In addition, greater disclosures 
should be required regarding how a company identifies and manages risk, 
and changing trends in those risks, with an eye to the future.
    Improve Independence and Oversight of Self Regulatory 
Organizations: FINRA has been a useful participant in the capital 
markets. It has provided resources that otherwise would not have been 
available to regulate and police the markets. Yet serious questions 
have arisen that need to be considered when improving the effectiveness 
and efficiency of self regulation.
    Currently the Board of FINRA includes representatives from those 
who are being regulated. This is an inherent conflict and raises the 
question of whose interest the Board of FINRA serves. To address this 
concern, consideration should be given to establishing an independent 
board, much like what Congress did when it established the PCAOB.
    In addition, the arbitration system at FINRA has been shown to 
favor the industry, much to the detriment of investors. While 
arbitration in some instances can be a benefit, in other situations it 
has been shown to be costly, time consuming, and biased towards those 
who are constantly involved with it. Accordingly, FINRA's system of 
arbitration should be made optional, and investors given the 
opportunity to pursue their case in a court of law if they so desire to 
do so.
    Finally careful consideration should be given to whether or not 
FINRA should be given expanded powers over investment advisors as well 
as broker dealers. FINRA's drop in fines and penalties in recent years, 
and lack of transparency in their annual report to the public, raises 
questions about its effectiveness as an enforcement agency and 
regulator. And with broker dealers involved in providing investment 
advice, it is important that all who do so are governed by the same set 
of regulations, ensuring adequate protection for the investing public.
    Enforcement: With respect to enforcement of the securities laws, 
there are a number of steps Congress should take. After all, if laws 
are not adequately enforced, then in effect there is no law.
    Enforcement by the SEC would be enhanced if it were granted the 
power to bring civil and administrative proceedings for violations of 
18 U.S.C. 1001, and seek civil money penalties therein. 18 U.S.C. 1001 
is a criminal statute that provides, in pertinent part:

        in any matter within the jurisdiction of the executive, 
        legislative, or judicial branch of the Government of the United 
        States, knowingly and willfully--(1) falsifies, conceals, or 
        covers up by any trick, scheme, or device a material fact; (2) 
        makes any materially false, fictitious, or fraudulent statement 
        or representation; or (3) makes or uses any false writing or 
        document knowing the same to contain any materially false, 
        fictitious, or fraudulent statement or entry;

        shall be fined under this title, imprisoned not more than 5 
        years or, if the offense involves international or domestic 
        terrorism (as defined in section 2331), imprisoned not more 
        than 8 years, or both.

    The SEC should be authorized to prosecute criminal violations of 
the Federal securities laws where the Department of Justice declines to 
bring an action. When I was at the Commission, it made a number of 
criminal referrals, including such cases as the Sunbeam matter, which 
DOJ declined to advance because of resource constraints. Finally the 
SEC should be provided an ability to take actions for aiding and 
abetting liability under the Securities Act of 1933. The Commission can 
bring actions for aiding and abetting violations under the Securities 
Exchange Act of 1934.
    The SEC has been chronically underfunded. A dedicated, independent 
financing arrangement, such as that enjoyed by the Federal Reserve, 
would be useful, and is long overdue.
    Finally, we have seen serious problems arise for those who have 
blown the whistle on corporate fraud. Despite the provisions of SOX 
designed to protect such individuals, regulatory interpretations of 
that law have rendered it meaningless all too often. Congress should 
fix these shortcomings, in part by giving jurisdiction over the law as 
it is applicable to the securities markets, to the SEC rather than the 
Department of Labor.
Conclusion
    Improvements to the securities laws and regulations that will once 
again ensure investors can have confidence they are playing on a level 
playing field are critical to recovery of our capital markets and 
economy. Such legislative changes are necessary if a recovery is to 
occur, but it is equally important that when they are made, they are 
changes and improvements investors perceive as being credible and 
worthwhile.
    Thank you and I would be happy to answer any questions.
         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                    FROM JOHN C. COFFEE, JR.

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets?
    Also, would you recommend more transparency for investors:

  1.  By publicly held banks and other financial firms of off-
        balance sheet liabilities or other data?

  2.  By credit rating agencies of their ratings methodologies 
        or other matters?

  3.  By municipal issuers of their periodic financial 
        statements or other data?

  4.  By publicly held banks, securities firms and GSEs of 
        their risk management policies and practices, with 
        specificity and timeliness?

A.1. Very simply, my answer is yes. In the case of financial 
institutions, recent experience has shown that, despite the 
Enron-era reforms, the major banks underwriting asset-backed 
securitizations entered into ``liquidity puts'' with preferred 
customers under which they agreed to repurchase those offerings 
if liquidity was lost in the secondary market--and they did not 
disclose these obligations on the face of their balance sheets. 
This was the same use of off balance sheet financing as Enron 
employed--all over again. Accounting regulators acquiesced to 
pressure from banks, and once again the result endangered the 
financial well being of the entire economy.
    Credit rating agencies should disclose their methodologies 
and assumptions (more or less as Senator Reed's bill (S. 1073) 
would require).
    In general, financial institutions do need to provide 
better and more timely disclosure of risk management practices 
on a continuing basis. Here, rather than listing specific 
disclosures that should be made, I would suggest that Congress 
instruct the SEC to study the recent failures and tighten its 
disclosure requirements in light of such study.

Q.2. Conflicts of Interest: Concerns about the impact of 
conflicts of interest that are not properly managed have been 
frequently raised in many contexts--regarding accountants, 
compensation consultants, credit rating agencies, and others. 
For example, Mr. Turner pointed to the conflict of the board of 
FINRA including representatives of firms that it regulates. The 
Millstein Center for Corporate Governance and Performance at 
the Yale School of Management in New Haven, Connecticut on 
March 2 proposed an industry-wide code of professional conduct 
for proxy services that includes a ban on a vote advisor 
performing consulting work for a company about which it 
provides recommendations.
    In what ways do you see conflicts of interest affecting the 
integrity of the markets or investor protection? Are there 
conflicts affecting the securities markets and its participants 
that Congress should seek to limit or prohibit?

A.2. In particular, conflicts of interest have affected the 
practices of the credit rating agencies, as they both 
``consult'' with issuers and rate them, and only a thin (and 
possibly permeable) Chinese Wall separates the two functions 
and staffs. In addition, there is the problem of forum-
shopping, as the issuer pays an initial fee to several 
agencies, but only uses the higher or highest ratings (after 
paying a second fee).
    Proxy advisors (including Risk Metrics) are similarly 
subject to the same conflicts of interest, as they also advise 
both their client base of institutional investors and issuers 
who specially hire them. At a minimum, such conflicts should be 
disclosed to investors along with all fees received by the 
proxy advisor from the issuer.

Q.3. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the nation's economy. Please summarize your 
recommendations on the best way to oversee these instruments.

A.3. The best response is to mandate the use of clearinghouses 
in the trading of over-the-counter derivatives. Such 
clearinghouses would in turn specify margin and mark-to-market 
procedures for such instruments, subject to the general 
oversight of the Fed or the SEC/CFTC (depending on the 
instrument). The industry will respond to this proposal by 
saying such a rule should only apply to ``standardized'' 
derivatives. But there is no clear line between 
``standardized'' and ``customized'' derivatives, and good 
lawyers can make any derivative customized in about 10 minutes 
if it will enable the issuer to escape additional regulatory 
costs. Thus, Congress or the SEC must draw a careful line so as 
not to permit the clearinghouse requirement to be trivialized.

Q.4. Corporate Governance--Majority Vote for Directors, Proxy 
Access, Say on Pay: The Council of Institutional Investors, 
which represents public, union and corporate pension funds with 
combined assets that exceed $3 trillion, has called for 
``meaningful investor oversight of management and boards'' and 
in a letter dated December 2, 2008, identified several 
corporate governance provisions that ``any financial markets 
regulatory reform legislation [should] include.'' Please 
explain your views on the following corporate governance 
issues:

  1.  Requiring a majority shareholder vote for directors to be 
        elected in uncontested elections;

  2.  Allowing shareowners the right to submit amendment to 
        proxy statements;

  3.  Allowing advisory shareowner votes on executive cash 
        compensation plans.

A.4. I support the SEC's proposals on access to the proxy 
statement and would require ``say on pay'' (i.e., an advisory 
shareholder vote on compensation) by legislation. I would urge 
Congress to expressly authorize the SEC to adopt its proposals 
on shareholder access to the proxy litigation, as otherwise 
there is certain to be litigation about the SEC's authority. 
Nor is the outcome of this litigation free from doubt. With 
respect to majority voting, I do not think it is necessary to 
overrule state law by mandating majority voting on directors, 
as the majority of the Fortune 1000 already follow this 
practice.

Q.5. Credit Rating Agencies: Please identify any legislative or 
regulatory changes you believe are warranted to improve the 
oversight of credit rating agencies.
    In addition, I would like to ask your views on two specific 
proposals:

  1.  The Peterson Institute report on ``Reforming Financial 
        Regulation, Supervision, and Oversight'' recommended 
        reducing conflicts of interest in the major rating 
        agencies by not permitting them to perform consulting 
        activities for the firms they rate.

  2.  The G30 Report ``Financial Reform; A Framework for 
        Financial Stability'' recommended that regulators 
        should permit users of ratings to hold NRSROs 
        accountable for the quality of their work product. 
        Similarly, Professor Coffee recommended creating 
        potential legal liability for recklessness when 
        ``reasonable efforts'' have not been made to verify 
        ``essential facts relied upon by its ratings 
        methodology.''

A.5. I favor the provisions set forth in the Reed Bill (S. 
1073) and in the more recent proposals made by the Bipartisan 
Policy Counsel's Credit Rating Agency Task Force. I agree that 
the rating agencies face a conflict when they perform 
consulting services for companies that they rate. Liability for 
``recklessness'' makes sense, but should be accompanied by a 
safe harbor that establishes clear standards that will enable 
the rating agency to avoid liability (as the Reed Bill does). 
Although Congress cannot resolve the First Amendment issues 
that the rating agencies raise in their defense, Congress can 
make legislative findings of fact (to which most courts do give 
deference) that find that credit ratings (particularly those on 
structured finance products) do not relate to matters of public 
concern and so do not merit constitutional protection beyond 
that normally accorded ``commercial speech.'' Finally, I would 
urge a statutory ceiling on the liability of a credit rating 
agency for any one rating or transaction, which ceiling would 
apply in both Federal and State court actions.

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds 
Association testified before the House Subcommittee on Capital 
Markets and said: ``MFA and its members acknowledge that at a 
minimum the hedge fund industry as a whole is of systemic 
relevance and, therefore, should be considered within the 
systemic risk regulatory framework.'' MFA supported the 
creation or designation of a ``single central systemic risk 
regulator'' that (1) has ``the authority to request and 
receive, on a confidential basis, from those entities that it 
determines . . . to be of systemic relevance, any information 
that the regulator determines is necessary or advisable to 
enable it to adequately assess potential risks to the financial 
system,'' (2) has a mandate of protection of the financial 
system, but not investor protection or market integrity and (3) 
has the authority to ensure that a failing market participant 
does not pose a risk to the entire financial system.
    Do you agree with MFA's position? Do you feel there should 
be regulation of hedge funds along these lines or otherwise?

A.6. I agree with the MFA's position. Systemic risk should be 
delegated to a different agency than the agency charged with 
consumer protection, as there are potential conflicts between 
these two roles. In short, a ``twin peaks'' model should be 
followed. Hedge funds are not inherently different than AIG in 
that any large financial institution could potentially fail in 
a manner that endangered counterparties and could therefore 
pose a systemic risk to the financial system.

Q.7. Self-Regulatory Organizations: How do you feel the self-
regulatory securities organizations have performed during the 
current financial crisis? Are there changes that should be made 
to the self-regulatory organizations to improve their 
performance? Do you feel there is still validity in maintaining 
the self-regulatory structure or that some powers should be 
moved to the SEC or elsewhere?

A.7. Principally, I believe that pre-dispute arbitration 
agreements should be limited, as the process is often unfair to 
investors. Beyond that, the position of investment advisers, 
who have no SRO, is anomalous and should be re-examined. I 
express no view on whether they should form their own SRO or be 
brought under FINRA.
    In overview, the SROs did not cause (but did little to 
prevent) the 2008 financial crisis. Conceivably, they could 
have discovered Mr. Madoff's fraud (but the SEC bears the 
greater responsibility). The SRO structure has some value, 
particularly because SROs are self-funding and can tax the 
industry. Also, they enforce ``fair and equitable'' rules that 
are far broader than the SEC's typically narrower anti-fraud 
rules.

Q.8. Structure of the SEC: Please share your views as to 
whether you feel that the current responsibilities and 
structure of the SEC should be changed.
    Please comment on the following specific proposals:

  1.  Giving some of the SEC's duties to a systemic risk 
        regulator or to a financial services consumer 
        protection agency;

  2.  Combining the SEC into a larger ``prudential'' financial 
        services regulator;

  3.  Adding another Federal regulators' or self-regulatory 
        organizations' powers or duties to the SEC.

A.8. I do not believe that merging the SEC with another 
regulator is sensible or politically feasible in the short run. 
Nor do I think that the SEC should (at least over the short-
run) assume any of the duties of other regulators. However, the 
SEC's ``Consolidated Supervised Entity'' Program, which was 
begun in 2004, clearly failed in 2008 and should not in any 
form be re-created. Large financial institutions (such as 
Goldman, Sachs or Morgan Stanley) are better monitored by the 
Federal Reserve as Tier One Bank Holding Companies, and the 
capital markets have greater confidence in the Fed's monitoring 
ability.

Q.9. SEC Staffing, Funding, and Management: The SEC has a staff 
of about 3,500 full-time employees and a budget of $900 
million. It has regulatory responsibilities with respect to 
approximately: 12,000 public companies whose securities are 
registered with it; 11,300 investment advisers; 950 mutual fund 
complexes; 5,500 broker-dealers (including 173,000 branch 
offices and 665,000 registered representatives); 600 transfer 
agents, 11 exchanges; 5 clearing agencies; 10 nationally 
recognized statistical rating organizations; SROs such as the 
Financial Industry Regulatory Authority, the Municipal 
Securities Rulemaking Board and the Public Company Accounting 
Oversight Board.
    To perform its mission effectively, do you feel that the 
SEC is appropriately staffed? funded? managed? How would you 
suggest that the Congress could improve the effectiveness of 
the SEC?

A.9. The SEC needs more funds and more staff. This is best 
accomplished by making the SEC at least partially ``self-
funding,'' specifically by allowing the SEC to keep the fees 
and other charges that it levies on issuers, brokers and other 
regulated entities. I would not, however, recommend that the 
SEC keep civil penalties and fines, as this would raise both 
due process and ``appearance of justice'' issues that are best 
avoided.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                    FROM JOHN C. COFFEE, JR.

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

    Would a merger or rationalization of the roles of the SEC 
and CFTC be a valuable reform, and how should that be 
accomplished?
    How is it that AIG was able to take such large positions 
that it became a threat to the entire financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
risk management, or some combination?
    How should we update our rules and guidelines to address 
the potential failure of a systematically critical firm?

A.1. Bernanke's Comments: I would strongly agree with Chairman 
Bernanke's above quoted remarks, and I believe that his final 
question about the desirability of a systemic risk regulator 
must be answered in the affirmative (although the identity of 
that regulators can be reasonably debated). The term ``too big 
to fail'' is a misnomer. In reality, a systemic risk regulator 
must have the authority to identify financial institutions that 
are ``too interconnected to fail'' and to regulate their 
capital structure and leverage so that they do not fail and 
thereby set off a chain reaction.
    SEC/CFTC Merger: Although a merger of the SEC and the CFTC 
would be desirable, it is not an essential reform that must be 
accomplished to respond effectively to the current financial 
crisis (and it would be a divisive issue that might stall 
broader reform legislation). At most, I would suggest that 
jurisdiction over financial futures be transferred from the 
CFTC to the SEC. An even narrower transfer would be to give the 
SEC jurisdiction over single stock futures and narrow-based 
stock indexes. Over the counter derivatives might be divided 
between the two in terms of whether the derivative related to a 
security or a stock index (in which case the SEC would receive 
jurisdiction) or to something else (in which case the CFTC 
should have jurisdiction).
    The AIG Failure: AIG's failure perfectly illustrates the 
systemic risk problem (because its failure could have caused a 
parade of falling financial dominoes). It also illustrates the 
multiple causes of such a failure. AIG Financial Products, 
Inc., the key subsidiary, was principally based in London and 
was the subsidiary of the parent of the insurance company. As a 
non-insurance subsidiary of an insurance holding company, it 
was beyond the effective oversight of the New York State 
Insurance Commissioner, and there is no Federal insurance 
regulator. Although AIG also owned a small thrift, the Office 
of Thrift Supervision (OTS) could not really supervise an 
unrelated subsidiary operating in London. Thus, this was a case 
of a financial institution that fell between the regulatory 
cracks.
    But it was also a case of a private governance failure 
caused by excessive and short-term executive compensation. The 
CEO of AIG Financial Products (Mr. Cassano) received well over 
a $100 million in compensation during a several year period 
between 2002 and 2006. This gave him a strong bias toward 
short-term profit maximization and incentivized him to continue 
to write credit default swaps for their short term income, 
while ignoring the long term risk to AIG of a default (for 
which no reserves were established). Thus, there were both 
private and public failures underlying the AIG collapse.
    Procedures for Failure of a ``Systematically Critical 
Firm'': The Lehman bankruptcy will remain in the courts for a 
decade or more, with considerable uncertainty overhanging the 
various outcomes. In contrast, the FDIC can resolve a bank 
failure over a weekend. This suggests the superiority of a 
resolution-like procedure following the FDIC model, given the 
uncertainty and resulting potential for panic in the case of a 
failure of any major financial institution. Both the Bush and 
Obama Administrations have endorsed such a FDIC-like model to 
reduce the prospect of a financial panic. I note, however, that 
one need not bail out all counterparties at the level of 100 
percent, as a lesser level of protection would avert any panic, 
while also leaving the counterparties with a strong incentive 
to monitor the solvency of their counterparty.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER
                    FROM JOHN C. COFFEE, JR.

Q.1. Are you concerned that too much reliance on investor 
protection through private right of action against the credit 
ratings agencies will dramatically increase both the number of 
law suits the companies will have to deal with as well as their 
cost of doing business? Have you thought about alternative ways 
to ensure adequate investor protections that will not result in 
driving capital from the U.S. in the same way that the fear of 
litigation and costs created by Sarbanes-Oxley has resulted in 
a decline in new listings in American capital markets?

A.1. I have two independent responses: First, authorizing a 
cause of action along the lines that Senator Reed's bill (S. 
1073--``The Rating Accountability and Transparency Enhancement 
Act of 2009'') does should not increase the number or aggregate 
recoveries in securities litigation to any significant degree. 
This is because the Reed bill's proposed cause of action 
against credit rating agencies contains an important safe 
harbor under which a credit rating agency that conducts due 
diligence or hires an independent due diligence firm will be 
protected against suit. In this light, I believe the real 
impact of this provision will be ex ante, rather than ex post, 
meaning that it will change the rating agency's behavior so as 
to avert litigation, rather than affecting the overall 
incidence or outcome of suits against it.
    Secondly, I have elsewhere proposed that all securities 
litigation against secondary defendants (i.e., persons other 
than the issuer or underwriter) be subject to a ceiling on 
damages to protect against such litigation causing their 
insolvency. So limited, securities litigation against secondary 
participants could deter, but not destroy.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                   FROM T. TIMOTHY RYAN, JR.

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets?
    Also, would you recommend more transparency for investors:

  1. LBy publicly held banks and other financial firms of off-
        balance sheet liabilities or other data?

  2. LBy credit rating agencies of their ratings methodologies 
        or other matters?

  3. LBy municipal issuers of their periodic financial 
        statements or other data?

  4. LBy publicly held banks, securities firms and GSEs of 
        their risk management policies and practices, with 
        specificity and timeliness?

A.1. We do not believe that there are ``additional types of 
disclosures'' that should be required regarding participants in 
the capital markets. The disclosures currently required in 
financial statements have increased substantially over the last 
decade and in particular over the last year, and have led some 
commentators to observe that re-organizing current mandated 
disclosures might result in a more concise but more 
intelligible set of disclosures for readers of financial 
statements. We think that such an approach would be more 
beneficial than simply increasing the amount of data required.
    Both FASB and the SEC have recognized the need for 
additional disclosure regarding off-balance sheet exposures. 
Those requirements will be phasing in over the course of this 
year and we believe will meaningfully increase the amount of 
information in the marketplace regarding off-balance sheet 
assets and liabilities.
    Last year, SIFMA formed a global, investor-led task force 
to identify and examine key issues related to the credit 
ratings paradigm. SIFMA's Credit Rating Agency Task Force 
issued its recommendations last July. These recommendations 
included the following related to disclosure:

   LCRAs should provide enhanced, clear, concise, and 
        standardized disclosure of CRA rating methodologies;

   LCRAs should disclose results of due diligence and 
        examination of underlying asset data examinations, and 
        limitations on available data, as well as certain other 
        information relied upon by the CRAs in the ratings 
        process;

   LCRAs should provide disclosure of CRA surveillance 
        procedures; this will foster transparency, and allow 
        market users of ratings to understand their bases and 
        limitations;

   LCRAs should provide access to data regarding CRA 
        performance; this will allow investors to assess how 
        CRAs differ both in the performance of their initial 
        ratings, and in their ongoing surveillance of existing 
        ratings; and

   LCRA fee structures, and identities of top payors, 
        should be disclosed by CRAs to their regulators.

    The report discusses these recommendations in detail. A 
copy of the report is attached and can also be found at http://
www.sifma.org/capital_markets/docs/SIFMA-CRARecommendations.pdf
    Municipal issuers are already required to provide annual 
financial statements and material event notice disclosures to 
investors pursuant to SEC Rule 15(c)2-12, and plans are 
underway for this information to be more easily accessed under 
the Municipal Securities Rulemaking Board's Electronic 
Municipal Market Access system (EMMA). As of July 1, 2009, EMMA 
will be the new central filing repository for municipal issuer 
annual financial statements and material events notices as well 
as a free Internet-based transparency vehicle for retail 
investors seeking this information.
    The current disclosure requirements already encompass a 
great deal of information on the risk management policies/
practices of banks and securities firms, particularly in the 
MD&A of financial statements. While improvements in the 
presentation and intelligibility of such disclosures may occur 
as a result of preparer interaction with investors, analysts, 
and other users of financial statements, we do not believe that 
at this point additional requirements per se are warranted.

Q.2. Conflicts of Interest: Concerns about the impact of 
conflicts of interest that are not properly managed have been 
frequently raised in many contexts--regarding accountants, 
compensation consultants, credit rating agencies, and others. 
For example, Mr. Turner pointed to the conflict of the board of 
FINRA including representatives of firms that it regulates. The 
Millstein Center for Corporate Governance and Performance at 
the Yale School of Management in New Haven, Connecticut on 
March 2 proposed an industry-wide code of professional conduct 
for proxy services that includes a ban on a vote advisor 
performing consulting work for a company about which it 
provides recommendations.
    In what ways do you see conflicts of interest affecting the 
integrity of the markets or investor protection? Are there 
conflicts affecting the securities markets and its participants 
that Congress should seek to limit or prohibit?

A.2. SIFMA agrees that effective management of conflicts of 
interest by market intermediaries builds confidence in the 
integrity of financial markets and promotes investor 
protection. We generally support initiatives to identify and 
manage conflicts and we believe the industry has made 
significant steps over the past several years to develop best 
practices in this area. For example, our members have developed 
an ``Investor's Bill of Rights'' which states that each 
investor has the right ``to be apprised of significant 
conflicts of interest identified in a financial relationship 
between an investor and his or her broker-dealer or account 
representative.'' This resource is available at http://
www.sifma.org/private_client/pdf/SIFMA_InvestorRights.pdf. In 
another example, our members have also developed ``Principles 
for Managing the Distributor-Individual Relationship'' for 
structured products that includes guidance on managing 
potential conflicts. This resource is available at http://
www.sifma.org/private_client/pdf/GlobalRSPDistributor-
PrinciplesFinal.pdf. Similarly, our proposed universal standard 
of care for retail investors, would also require financial 
professionals to provide full and fair disclosure of all 
material facts, including material conflicts of interest.

Q.3. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the nation's economy. Please summarize your 
recommendations on the best way to oversee these instruments.

A.3. Credit default swaps are important financial tools that 
allow companies across America access to capital at lower cost 
by allowing banks to efficiently hedge exposure to debt of 
these companies. We believe there is wide agreement that steps 
should be taken to address issues that have arisen in 
connection with CDS and other derivatives, but care should be 
taken not to impair the usefulness of these products. In 
particular, as recognized by the President's Working Group, 
market participants should be allowed to enter into customized 
bilateral contracts in order to accomplish their risk 
management objectives. We believe that Congress should consider 
subjecting all systemically significant participants in 
derivatives markets, whether they are investors or dealers, to 
oversight by a single Federal regulator with broad authority to 
identify who is systemically significant, to consult with 
industry and develop principles for prudent management of risk, 
to promulgate appropriate rules based on those principles, and 
to access information necessary to carry out its oversight 
responsibilities. Among other things, we believe the principles 
adopted by the systemic regulator should encourage submission 
of standardized credit default swaps to clearing houses that 
are subject to Federal regulatory oversight. This will help 
assure adequate collateral posting and decrease aggregate 
leverage in the financial system, both of which will reduce 
overall levels of risk. Because financial markets and the 
activities of major market participants are global, it is 
important that the Federal systemic risk regulator consult and 
coordinate with regulators in major markets outside of the 
United States.

Q.4. Corporate Governance--Majority Vote for Directors, Proxy 
Access, Say on Pay: The Council of Institutional Investors, 
which represents public, union and corporate pension funds with 
combined assets that exceed $3 trillion, has called for 
``meaningful investor oversight of management and boards'' and 
in a letter dated December 2, 2008, identified several 
corporate governance provisions that ``any financial markets 
regulatory reform legislation [should] include.'' Please 
explain your views on the following corporate governance 
issues:

  1. LRequiring a majority shareholder vote for directors to be 
        elected in uncontested elections;

  2. LAllowing shareowners the right to submit amendment to 
        proxy statements;

  3. LAllowing advisory shareowner votes on executive cash 
        compensation plans.

A.4. While requiring a majority shareholder vote for directors 
to be elected in uncontested elections may promote selection of 
well-qualified directors, SIFMA would note that for some 
issuers, this could be a difficult requirement to meet. The SEC 
is likely to prohibit brokerdealers from voting the 
uninstructed shares of clients in director elections in a 
current rulemaking project. SIFMA is concerned about protecting 
the privacy of those clients who object to direct contact with 
issuers. This will also increase costs for issuers who will 
need to spend significant sums to get out the vote. Finally, 
small issuers would likely be disadvantaged because their 
shares are more often held by retail investors rather than 
large, institutional investors.
    SIFMA does not have a position on this proposal but notes 
that the thresholds for when a shareholder or group of 
shareholders would be granted access to an issuer's proxy 
should be high enough so that the process isn't abused. The 
process for allowing shareholders to submit amendments to proxy 
statements would need to be clear and to minimize costs, 
uniform. It is very important that shareholders have the right 
to vote; the submission of amendments should not inhibit 
today's efficient and timely process for the arrival of proxy 
statements. Building in time for amendments could further delay 
the transmission of proxy material, this and other practical 
issues presented by the proposal warrant careful consideration.
    As the Committee knows, a number of SIFMA members are 
subject to the TARP requirement to conduct an advisory 
shareowner vote on compensation. Several firms have either 
implemented this requirement or are working toward meeting it. 
We caution that the results of this year's advisory votes may 
not be emblematic of potential future advisory votes. This year 
many of the TARP companies did not pay senior management any 
bonuses and it is quite possible that this factored heavily in 
the votes in favor. Also, many TARP companies that implemented 
the advisory vote were required to do so in a hasty manner and 
as a result included the ``boilerplate'' proposal language 
without thinking through what language made sense for their 
particular company. SIFMA has yet to take a position on whether 
annual advisory shareowner votes should be mandated for all 
public issuers as suggested by the Council of Institutional 
Investors or whether other mechanisms, such as issuer-specific 
surveys, would be more helpful to enhance communications 
between Boards and shareowners.

Q.5. Credit Rating Agencies: Please identify any legislative or 
regulatory changes you believe are warranted to improve the 
oversight of credit rating agencies.
    In addition, I would like to ask your views on two specific 
proposals:

  1. LThe Peterson Institute report on ``Reforming Financial 
        Regulation, Supervision, and Oversight'' recommended 
        reducing conflicts of interest in the major rating 
        agencies by not permitting them to perform consulting 
        activities for the firms they rate.

  2. LThe G30 Report ``Financial Reform; A Framework for 
        Financial Stability'' recommended that regulators 
        should permit users of ratings to hold NRSROs 
        accountable for the quality of their work product. 
        Similarly, Professor Coffee recommended creating 
        potential legal liability for recklessness when 
        ``reasonable efforts'' have not been made to verify 
        ``essential facts relied upon by its ratings 
        methodology.''

A.5. Last year, SIFMA formed a global, investor-led task force 
to identify and examine key issues related to the credit 
ratings paradigm. SIFMA's Credit Rating Agency Task Force 
issued its recommendations last July. A copy of the report is 
attached and can also be found at http://www.sifma.org/
capital_markets/docs/SIFMA-CRA-Recommendations.pdf.
    SIFMA's CRA Task Force found that there is a perception by 
some that the degree and nature of interaction between CRAs and 
issuers during the ratings process may result in conflicts of 
interest. This perception undermines investor confidence in the 
accuracy and reliability of ratings. These perceived conflicts 
can arise both from the interaction between CRAs and issuers in 
the course of a CRA assigning a rating to a particular 
security, and from the CRAs' provision of consulting or 
advisory services.
    The Task Force noted that each of five major CRAs (A.M. 
Best, DBRS, Fitch, Moody's, and Standard & Poor's) committed in 
their Joint Response to the IOSCO Consultation Report on the 
Role of Credit Rating Agencies in Structured Finance Markets to 
``plainly indicate'' that it does ``not and will not provide 
consulting or advisory services to the issuers the [CRA] 
rates.''
    In order to provide clarity to market participants, the 
Task Force recommended that ``core'' rating services be clearly 
defined by the CRAs and distinguished from such ``consulting or 
advisory'' services. The Task Force further recommended that 
CRAs clarify that ``consulting or advisory'' services exclude 
other ``ancillary'' services provided to issuers and 
intermediaries in the ordinary course of business.
    The Task Force viewed the CRAs' permissible ``core'' 
services as including:

  1. Lthe assignment and monitoring of public, private, and 
        private placement ratings;

  2. Lissuance of credit estimates and hypothetical ratings, 
        including requested Rating Evaluation Service and 
        Rating Advisory Service (RES/RAS) services regarding 
        issuer-proposed structures of hypothetical securities, 
        indicative, or preliminary ratings, and impact 
        assessments;

  3. Lhybrid securities assessment services;

  4. Linternal assessments;

  5. Lratings coverage of project and infrastructure finance 
        transactions and hybrid securities;

  6. Ldissemination of press releases and rating reports (that 
        include the rating opinion);

  7. Lresearch reports and other publications, including 
        methodologies, models, newsletters, commentaries, and 
        industry studies;

  8. Lregular oral and written dialogue with issuers, 
        intermediaries, investors, sponsors,regulators, 
        legislators, trade organizations, and the media; and

  9. Lconducting and participating in conferences, speaking 
        engagements, and educational seminars.

    In particular, the Task Force believes that these ``core'' 
services include the iterative process that occurs between an 
issuer, arranger, underwriter, and CRA during the rating of 
structured finance, project and infrastructure finance, and 
hybrid securities.
    The Task Force believes there is a misperception by some 
that this type of ``core'' interaction is essentially a 
consultation service by CRAs that gives rise to an insuperable 
conflict of interest, and which undermines the integrity and 
reliability of the resulting rating. As described above, 
however, the process of rating structured finance, project and 
infrastructure finance, and hybrid securities necessarily 
involves an iterative give-and-take between the issuer, 
arranger, underwriter, and CRA as part of the ``core'' services 
performed by the CRA.
    In light of this, the Task Force did not recommend placing 
limitations on this iterative process. Rather, the Task Force 
recommended that CRAs maintain an adequate governance structure 
that includes policies, procedures, mechanisms, and firewalls 
designed to minimize the likelihood that conflicts of interest 
will arise, and to manage the conflicts of interest that do 
arise.
    Similarly, ``ancillary'' services, in the view of the Task 
Force, are permissible rating-related services that are 
generally segregated by the CRA into separate business groups. 
The Task Force views examples of ``ancillary'' services as 
including, among others, market implied ratings (MIRS), KMV 
credit risk management, data services, credit risk solutions, 
and indices.
    SIFMA has not taken a position on legal liability for 
NRSROs.

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds 
Association testified before the House Subcommittee on Capital 
Markets and said: ``MFA and its members acknowledge that at a 
minimum the hedge fund industry as a whole is of systemic 
relevance and, therefore, should be considered within the 
systemic risk regulatory framework.'' MFA supported the 
creation or designation of a ``single central systemic risk 
regulator'' that (1) has ``the authority to request and 
receive, on a confidential basis, from those entities that it 
determines . . . to be of systemic relevance, any information 
that the regulator determines is necessary or advisable to 
enable it to adequately assess potential risks to the financial 
system,'' (2) has a mandate of protection of the financial 
system, but not investor protection or market integrity and (3) 
has the authority to ensure that a failing market participant 
does not pose a risk to the entire financial system.
    Do you agree with MFA's position? Do you feel there should 
be regulation of hedge funds along these lines or otherwise?

A.6. We support giving the financial markets stability 
regulator the authority to gather information from all U.S. 
financial institutions and markets in order to identify 
systemic risk and maintain financial stability. We believe this 
authority should apply to all financial institutions, 
regardless of charter, and regardless of whether they are 
currently functionally regulated or not, including hedge funds 
or private equity funds. One of the lessons learned from recent 
experience is that sectors of the market can be systemically 
important, even though no single institution in that sector is 
a significant player. The financial markets stability regulator 
will need information necessary to form and maintain a picture 
of the overall systemic risks in the U.S. financial system. The 
financial markets stability regulator should also have the 
authority, in consultation with any relevant Federal regulator, 
to make uniform rules to the extent necessary to reduce 
systemic risk and promote financial stability.
    As noted above, we have proposed that the financial markets 
stability regulator should probably have a more direct role in 
supervising systemically important financial institutions or 
groups. Such systemically important financial institutions or 
groups could include currently unregulated institutions, such 
as hedge funds or private equity funds, although we do not 
believe the financial markets stability regulator should become 
the functional regulator for such unregulated institutions. We 
agree with others that hedge funds should be regulated by a 
merged SEC and CFTC.
    Because we believe the financial markets stability 
regulator should have the authority to address a financial 
crisis, we believe such a regulator should have certain 
resolution powers, including the authority to appoint itself or 
another Federal regulatory agency as the conservator or 
receiver of any systemically important financial institution or 
group.

Q.7. Self-Regulatory Organizations: How do you feel the self-
regulatory securities organizations have performed during the 
current financial crisis? Are there changes that should be made 
to the self-regulatory organizations to improve their 
performance? Do you feel there is still validity in maintaining 
the self-regulatory structure or that some powers should be 
moved to the SEC or elsewhere?

A.7. The SRO structure remains a viable regulatory framework. 
Supplemented by government oversight, this tiered regulatory 
system can provide a greater level of investor protection than 
the government alone might be able to achieve. Self-policing by 
professionals who have the requisite working knowledge and 
expertise about both marketplace intricacies and the technical 
aspects of regulation creates a self-regulatory system with 
valuable checks and balances. SRO performance may be improved 
by eliminating duplicative regulation, filling regulatory gaps, 
and harmonizing standards that are appropriately applicable to 
all investment services providers. In harmonizing standards, 
however, we note that just as one size does not fit all broker-
dealers, it also does not fit all market users. There is a 
world of difference between an individual investor seeking to 
invest his/her retirement savings and a multi-billion dollar 
hedge fund implementing a sophisticated trading strategy. 
Indeed, there is a similar difference between a high net worth 
individual managing substantial assets and retail market 
participants seeking to save for college. While all 
participants must be protected from fraud, we need a flexible 
regulatory structure that can differentiate between the various 
types of market participants when it comes to mandatory 
prophylactic rules and requirements.

Q.8. Structure of the SEC: Please share your views as to 
whether you feel that the current responsibilities and 
structure of the SEC should be changed.
    Please comment on the following specific proposals:

  1. LGiving some of the SEC's duties to a systemic risk 
        regulator or to a financial services consumer 
        protection agency;

  2. LCombining the SEC into a larger ``prudential'' financial 
        services regulator;

  3. LAdding another Federal regulators' or self-regulatory 
        organizations' powers or duties to the SEC.

A.8. We have testified that we are in support of a merger of 
the SEC and the CFTC. The longstanding focus of the SEC has 
been investor protection, and we believe that this should 
continue to be so with any regulatory reform. We do not see a 
systemic risk regulator taking over any of the SEC's duties; 
rather, such a regulator would work with existing Federal 
functional regulators such as the SEC. For example, we agree 
with others that hedge funds should be regulated by a merged 
SEC and CFTC.
    The SEC's investor protection mandate could be expanded to 
other areas or products, and so we do not see the need for a 
separate financial services consumer protection agency for that 
purpose. On the other end of the spectrum, we do not see 
support for moving to an FSA-type model of a single prudential 
financial services regulator. Certain inefficiencies that 
result from the regulation of activities by the states and the 
SEC could be eliminated by vesting the regulatory authority for 
those activities in the SEC.

Q.9. SEC Staffing, Funding, and Management: The SEC has a staff 
of about 3,500 full-time employees and a budget of $900 
million. It has regulatory responsibilities with respect to 
approximately: 12,000 public companies whose securities are 
registered with it; 11,300 investment advisers; 950 mutual fund 
complexes; 5,500 broker-dealers (including 173,000 branch 
offices and 665,000 registered representatives); 600 transfer 
agents, 11 exchanges; 5 clearing agencies; 10 nationally 
recognized statistical rating organizations; SROs such as the 
Financial Industry Regulatory Authority, the Municipal 
Securities Rulemaking Board and the Public Company Accounting 
Oversight Board.
    To perform its mission effectively, do you feel that the 
SEC is appropriately staffed? funded? managed? How would you 
suggest that the Congress could improve the effectiveness of 
the SEC?

A.9. If the SEC is to take on a greater responsibility with 
respect to the regulation of hedge funds and other private 
equity vehicles, we believe that current staffing levels are 
inadequate. The SEC is currently unable to examine investment 
advisers in a timely manner, and with enhanced responsibilities 
their resources will be even more stretched. As a result, we 
believe additional funding of the SEC will be necessary. We 
would also support an internal reorganization of the SEC such 
that the examination functions, such as broker-dealer and 
investment adviser examinations, are combined with, and 
reporting into, the policy making units, so that the SEC speaks 
and acts consistently on policy issues.














































         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                   FROM T. TIMOTHY RYAN, JR.

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

A.1. We agree with Chairman Bernanke's remarks and support the 
proposal to establish a financial markets stability regulator. 
At present, no single regulator (or collection of coordinated 
regulators) has the authority or the resources to collect 
information system-wide or to use that information to take 
corrective action across all financial institutions and markets 
regardless of charter. The financial markets stability 
regulator will help fill these gaps.
    We have proposed that the financial markets stability 
regulator should have authority over all financial institutions 
and markets, regardless of charter, functional regulator or 
unregulated status, including the authority to gather 
information from all financial institutions and markets, and to 
make uniform regulations related to systemic risk. This could 
include review of regulatory policies and rules to ensure that 
they do not induce excessive procyclicality.
    We have proposed that the financial markets stability 
regulator should probably have a more direct role in 
supervising systemically important financial institutions or 
groups. This would address the risks associated with financial 
institutions that may be deemed ``too big to fail.'' Such 
systemically important financial institutions or groups could 
also include primary dealers, securities clearing agencies, 
derivatives clearing organizations and payment system 
operators, which would help strengthen the financial 
infrastructure, another key element of Chairman Bernanke's 
proposal for regulatory reform.

Q.2. Would a merger or rationalization of the roles of the SEC 
and CFTC be a valuable reform, and how should that be 
accomplished?

A.2. We have testified that we are in support of a merger of 
the SEC and the CFTC. The U.S. is the only jurisdiction that 
splits the oversight of securities and futures activities 
between two separate regulatory bodies. When the CFTC was 
formed, financial futures represented a very small percentage 
of futures activity. Now, an overwhelming majority of futures 
that trade today are financial futures. These products are 
nearly identical to SEC regulated securities options from an 
economic standpoint, yet they are regulated by the CFTC under a 
very different regulatory regime. This disparate regulatory 
treatment detracts from the goal of investor protection. An 
entity that combines the functions of both agencies could be 
better positioned to apply consistent rules to securities and 
futures. We would support legislation to accomplish such a 
merger.

Q.3. How is it that AIG was able to take such large positions 
that it became a threat to the entire financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
risk management, or some combination?

A.3. We believe the problems at AIG resulted from a combination 
of several factors. Its affiliate, AIG Financial Products, sold 
large amounts of credit protection in the form of credit 
default swaps on collateralized debt obligations with exposure 
to subprime mortgages, without hedging the risk it was taking 
on. At the same time, AIG's top credit rating gave many of its 
counterparties a false sense of security. Accordingly, many of 
the CDS agreements it negotiated provided that AIG would not be 
required to post collateral so long as it maintained a 
specified credit rating. AIG apparently believed its credit 
rating would never be downgraded, which enabled it to ignore 
the risk it would ever have to post collateral. Moreover, AIG 
appears to have under-estimated the default risk of the CDOs on 
which it sold credit protection, thus underestimating the size 
of its obligation to post large amounts of collateral in the 
event of its credit rating downgrade. While others might have 
made similar errors, it seems AIG in particular did not 
adequately account for the correlation of default risk among 
the different geographic areas where the mortgage assets 
underlying the CDOs originated. The market value of those CDOs 
fell by much more than AIG anticipated, leading to much greater 
collateral demands than it could possibly meet. It also appears 
that AIG Financial Products was not subject to adequate, 
effective regulatory oversight. All these factors are specific 
to AIG; its problems did not result from an inherent defect in 
CDS as a product.

Q.4. How should we update our rules and guidelines to address 
the potential failure of a systematically critical firm?

A.4. One of the most important gaps exposed during the current 
financial crisis was the lack of Federal resolution powers for 
systemically important financial groups. We believe that the 
proposed financial stability regulator should have the 
authority to appoint itself or another Federal regulatory 
agency as the conservator or receiver of any systemically 
important financial institution and all of its affiliates. Such 
conservator or receiver should have resolution powers similar 
to those contained in Sections 11 and 13 of the Federal Deposit 
Insurance Act. But because the avoidance powers, priorities and 
distribution schemes of the FDIA are very different from those 
in the Bankruptcy Code or other specialized insolvency laws 
that would otherwise apply to various companies in a 
systemically important financial group, the proposed resolution 
authority needs to be harmonized with the Bankruptcy Code and 
such other laws to avoid disrupting the reasonable expectations 
of creditors, counterparties and other stakeholders. Otherwise, 
the new resolution authority itself could create legal 
uncertainty and systemic risk.
    The Treasury's proposed resolution authority for 
systemically significant financial companies is a good first 
start, but its scope needs to be expanded to apply to all of 
the companies that comprise a systemically important financial 
group while the gap between its substantive provisions and 
those in the Bankruptcy Code and other specialized insolvency 
codes that would otherwise apply needs to be reduced in order 
to protect the reasonable expectations of creditors, 
counterparties and other stakeholders.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                    FROM PAUL SCHOTT STEVENS

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets? Also, would 
you recommend more transparency for investors:

   LBy publicly held banks and other financial firms of 
        off-balance sheet liabilities or other data?

   LBy credit rating agencies of their ratings 
        methodologies or other matters?

   LBy municipal issuers of their periodic financial 
        statements or other data?

   LBy publicly held banks, securities firms and GSEs 
        of their risk management policies and practices, with 
        specificity and timeliness?

A.1. Investment companies provide extensive disclosures and are 
highly transparent, especially as compared to many other 
investment products. As investors, investment companies 
generally favor efforts to increase transparency in the 
securities markets, unless countervailing policy objectives 
dictate otherwise or the information would not be meaningful to 
investors.
    Two specific areas in which ICI believes additional 
disclosure should be required are credit rating agencies and 
municipal securities. We strongly supported the Securities and 
Exchange Commission's recent credit rating agency proposals--
which would impose additional disclosure, reporting, and 
recordkeeping requirements on rating agencies for rating 
structured finance products--as an important first step to 
restoring investor confidence in the integrity of credit 
ratings and, ultimately, the market as a whole. We believe, 
however, that more must be done to increase disclosure and 
transparency not only in the area of structured finance 
products but also with respect to other debt securities, 
particularly municipal securities. We have urged the SEC to 
expand many of its proposed requirements for credit rating 
agencies to include these additional categories of securities, 
and to support legislation that would extend increased 
disclosure requirements to the issuers of these instruments. We 
also have recommended a number of additional disclosures to be 
made by rating agencies and issuers that should enhance 
disclosure for investors in a meaningful way. \1\ We believe 
the SEC currently has authority to implement many of our 
recommendations. Others (such as the repeal of the Tower 
Amendment and certain changes to improve municipal securities 
disclosure, discussed below) would require Congressional 
action.
---------------------------------------------------------------------------
     \1\ See Letter from Karrie McMillan, General Counsel, Investment 
Company Institute, to Florence Harmon, Acting Secretary, U.S. 
Securities and Exchange Commission, dated July 25, 2008; Letter from 
Karrie McMillan, General Counsel, Investment Company Institute, to 
Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange 
Commission, dated March 26, 2009.
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    Rating Agency Disclosure: ICI recommends the following 
additional disclosures, which go beyond the SEC's recent 
proposals, to improve the transparency of ratings and the 
rating process:

   LRating agencies should be required to provide 
        public disclosure of any material deviations between 
        the credit rating implied by a rating model and the 
        final credit rating issued.

   LRating agencies should make more timely disclosure 
        of their rating actions.

   LRating agencies should disclose additional 
        information regarding staffing issues, including 
        personnel turnover and resource levels.

   LRating agencies should disclose certain information 
        about the ongoing review of their ratings.

   LRating agencies should disclose additional 
        information regarding rating stability, including when 
        and how downgrades are conducted and the severity of 
        potential downgrades.

   LRating agencies should disclose additional 
        information regarding conflicts of interest.

   LRating agencies should be required to use 
        standardized performance measurement statistics to 
        facilitate comparability of these statistics.

   LRating agencies should be required to conduct due 
        diligence on the information they review to issue 
        ratings and to provide related disclosure.

    We also recommend that the SEC apply these suggested 
disclosure requirements in a consistent manner to all types of 
rating agencies. In addition, to realize the full potential of 
a meaningful and effective disclosure regime, we recommend that 
the SEC require the standardized presentation of disclosure 
information in a presale report issued by the rating agencies.
    Municipal Securities Issuer Disclosure: ICI strongly urges 
Congress and the SEC to improve the content and timing of 
required disclosures regarding municipal securities. The Tower 
Amendment, adopted by Congress in 1975, prohibits the SEC and 
the Municipal Securities Rulemaking Board from directly or 
indirectly requiring issuers of municipal securities to file 
documents with them before the securities are sold. As we have 
stated numerous times, because of these restrictions, the 
disclosure regime for municipal securities is woefully 
inadequate, and the regulatory framework is insufficient for 
investors in today's complex marketplace. \2\
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     \2\ See, e.g., Letter from Karrie McMillan, General Counsel, 
Investment Company Institute, to Florence Harmon, Acting Secretary, 
U.S. Securities and Exchange Commission, dated September 22, 2008.
---------------------------------------------------------------------------
    Legislative action regarding the Tower Amendment will be 
necessary to fully develop an adequate disclosure regime for 
municipal securities, including imposing certain disclosure 
requirements directly on municipal issuers. We would strongly 
support such action. We also recommend that Congress clarify 
the legal responsibilities of officials of municipal issuers 
for the disclosure documents that they authorize. In 
particular, Congress should spell out the responsibilities of 
underwriters with respect to municipal securities offering 
statements and the responsibilities of bond counsel and other 
participants in municipal offerings.
    In the meantime, important steps can be taken to improve 
municipal securities disclosure without legislative action. In 
particular, ICI recommends that the SEC expand the list of 
information that is required to be disclosed under current SEC 
rules. \3\ For example, the rule provision concerning notice of 
material events should be modified to more fully reflect the 
types of events that are material to today's investors. These 
events should include, among others, material litigation or 
regulatory action, pending or threatened, or failure to meet 
any financial covenants contained in the bond documents 
(especially the failure to make any monthly/quarterly payments 
due under the bond documents).
---------------------------------------------------------------------------
     \3\ ICI is not advocating a wholesale replication of the corporate 
disclosure framework for municipal securities. Instead, we are 
recommending a regulatory regime designed expressly for the needs of 
the municipal securities market.
---------------------------------------------------------------------------
    We also recommend changes to ensure that issuer financial 
information is provided to the public on a timely basis. \4\ 
Specifically, the SEC should establish meaningful timeframes 
for the delivery of information required pursuant to the 
undertakings in an issuer's continuing disclosure agreement. 
For example, issuers should be required to file financial 
reports within 180 days of the end of the fiscal year, instead 
of the more common practice of 270 days after fiscal year end. 
Also, if audited financial statements are not available within 
the recommended timeframe, issuers should be required to issue 
unaudited financials in the interim, as appropriate, in 
accordance with guidelines established by the National 
Federation of Municipal Analysts. Timely reporting would 
enhance the usefulness of the information reported, including 
by alerting investors to those issuers that may be experiencing 
problems that could affect the credit quality or other 
characteristics of their securities.
---------------------------------------------------------------------------
     \4\ Rule 15c2-12 under the Securities Exchange Act of 1934 
currently requires information about municipal securities issuers to be 
provided only annually. In contrast, corporate issuers are subject to 
quarterly reporting requirements. Moreover, the rule does not provide 
any outside deadline for the disclosure of financial information, thus 
leaving the timing completely to the discretion of the issuer. As a 
result, investors often receive financial information anywhere from 
three months to twelve months, or even longer, following the end of a 
fiscal year.
---------------------------------------------------------------------------
    Other Matters: In response to the question posed, ICI has 
no specific recommendations to offer regarding disclosure by 
publicly held banks or other financial institutions of off-
balance sheet liabilities or other data. As a general matter, 
however, we would support additional transparency of off-
balance sheet entities and activities. Such transparency should 
provide investment companies and other investors with important 
information about potential risk exposures faced by the 
companies in which they invest and should help avoid the market 
inefficiencies and other adverse consequences that the current 
lack of transparency has engendered. \5\ We understand that the 
Financial Accounting Standards Board is working on revisions to 
two of its standards (FAS 140 and FIN 46) that are intended to 
address deficiencies in the accounting and disclosure of risks 
associated with off-balance sheet entities (e.g., structured 
investment vehicles) that were revealed during the current 
financial crisis. We look forward to the implementation of 
these improvements.
---------------------------------------------------------------------------
     \5\ See Written Testimony of Elizabeth F. Mooney, CFA, CPA, 
Accounting Analyst, Capital Group Companies, before the U.S. Senate 
Committee on Banking, Housing, and Urban Affairs, Subcommittee on 
Securities, Insurance, and Investment, Hearing on ``Transparency in 
Accounting: Proposed Changes in Accounting for Off-Balance Sheet 
Entities'' (September 18, 2008).
---------------------------------------------------------------------------
    ICI likewise has no formal position on whether publicly 
held banks, securities firms, and GSEs should be required to 
disclose their risk management policies and practices. We would 
caution, however, that ``risk management'' means different 
things to different people and can also have varying 
connotations depending on the context. General disclosure would 
be of little value, and specific disclosure could create 
opportunities for exploitation. Disclosure describing policies 
and practices also would not convey how effective (or 
ineffective) any particular set of policies and practices are 
likely to be. Such disclosure therefore might create a false 
sense of security about an entity's ability to cope with 
various risks. We do not intend to suggest that sound risk 
management policies and practices are not important; we merely 
question the usefulness of required public disclosure 
concerning such policies and practices.

Q.2. Conflicts of Interest: Concerns about the impact of 
conflicts of interest that are not properly managed have been 
frequently raised in many contexts--regarding accountants, 
compensation consultants, credit rating agencies, and others. 
For example, Mr. Turner pointed to the conflict of the board of 
FINRA including representatives of firms that it regulates. The 
Millstein Center for Corporate Governance and Performance at 
the Yale School of Management in New Haven, Connecticut on 
March 2 proposed an industry-wide code of professional conduct 
for proxy services that includes a ban on a vote advisor 
performing consulting work for a company about which it 
provides recommendations.
    In what ways do you see conflicts of interest affecting the 
integrity of the markets or investor protection? Are there 
conflicts affecting the securities markets and its participants 
that Congress should seek to limit or prohibit?

A.2. Conflicts of interest that are unknown or not properly 
managed can have a negative impact on financial markets and 
market participants. ICI agrees, therefore, that it is 
important to identify conflicts or potential conflicts and 
determine how they can best be addressed, including through 
regulation. The appropriate solution may vary depending on the 
nature and extent of the conflict as well as the context in 
which it arises. For example, sometimes disclosure can be an 
effective tool for addressing conflicts, by putting investors 
and the marketplace on notice and allowing them to evaluate the 
significance and impact of the conflict. In other 
circumstances, different measures may be called for, such as 
restricting or prohibiting conduct or transactions that present 
conflicts.
    The laws governing investment advisers and investment 
companies have employed both of these approaches. Under the 
Investment Advisers Act of 1940, an investment adviser must 
disclose conflicts to clients, and often must seek their 
consent to proceed with a transaction notwithstanding a 
conflict. By contrast, the Investment Company Act of 1940 
addresses potential conflicts of interest in the context of 
investment company (fund) operations by prohibiting certain 
transactions between a fund and fund insiders or affiliated 
organizations (such as the corporate parent of the fund's 
adviser). The Investment Company Act authorizes the Securities 
and Exchange Commission (SEC) to grant exemptions by rule or 
order to the extent such exemptions are consistent with the 
underlying objectives of the statute. Pursuant to this 
authority, the SEC has issued exemptive rules and orders 
containing conditions designed to ensure that the interests of 
fund investors are amply protected.
    The restrictions on affiliated transactions under the 
Investment Company Act are widely viewed as a core investor 
protection and one that has served funds and their investors 
very well over nearly 70 years. Congress may wish to consider 
whether it would be appropriate and beneficial to apply similar 
restrictions to other financial market participants or 
activities, coupled with exemptive authority similar to that 
granted to the SEC. At the same time, as noted above, ICI 
recognizes that this approach does not fit every situation that 
involves conflicts of interest. \6\
---------------------------------------------------------------------------
     \6\ Likewise, a disclosure and consent model would be 
impracticable in the context of a pooled investment vehicle if each 
investor in the pooled vehicle were required to provide consent.
---------------------------------------------------------------------------
    While ICI does not have any specific legislative 
recommendations at this time regarding conflicts of interest 
that may affect the integrity of the markets or investor 
protection, we have commented extensively in the debate over 
possible regulatory actions to address conflicts of interest 
involving credit rating agencies--one of the issues mentioned 
in the question above. \7\ We provide our comments on that 
topic below.
---------------------------------------------------------------------------
     \7\ ICI believes that the SEC currently has authority under the 
Credit Rating Agency Reform Act of 2006 to implement the necessary 
regulatory reforms to address rating agency conflicts of interest.
---------------------------------------------------------------------------
    The SEC has recently increased the list of conflicts of 
interest that must be disclosed and managed by rating agencies 
or, alternatively, that are prohibited. ICI supported these 
amendments but we believe that more should be done in this 
area. \8\ We recommend that the SEC require additional 
disclosures by rating agencies regarding their conflicts of 
interest including, for example, the number of other products 
rated by a rating agency for a particular issuer. In addition, 
the SEC recently adopted a requirement that rating agencies 
disclose information regarding the conflict of being paid by 
certain parties to rate structured finance products. The 
targeted conflict of interest, however, is not confined to the 
ratings of these instruments. The disclosure requirement 
therefore should be extended to ratings of municipal 
securities.
---------------------------------------------------------------------------
     \8\ See Letter from Karrie McMillan, General Counsel, Investment 
Company Institute, to Florence Harmon, Acting Secretary, U.S. 
Securities and Exchange Commission, dated July 25, 2008; Letter from 
Karrie McMillan, General Counsel, Investment Company Institute, to 
Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange 
Commission, dated March 26, 2009.
---------------------------------------------------------------------------
    Public disclosure of conflict of interest information 
should improve transparency surrounding the information and 
processes used by rating agencies for rating products. It will 
provide users of ratings with a more complete picture of a 
rating agency's rating process and expose that process to 
greater scrutiny. This exposure, in turn, should promote the 
issuance of more accurate, high-quality ratings, and could 
prevent rating agencies from being unduly influenced to produce 
higher than warranted ratings. It should also assist investors 
and other market professionals in performing an independent 
assessment of these products. To achieve these goals, it is 
critical that the SEC's rules governing conflicts of interest 
be actively enforced and that rating agencies be held 
accountable for any failures to comply with the rules and their 
policies and procedures adopted under the rules.
    Moreover, to fully and properly address concerns about 
conflicts of interest, ICI believes the government should 
ensure that regulatory reforms for rating agencies are applied 
in a uniform and consistent manner equally to all types of 
credit rating agencies. Each type of rating agency business 
model--be it issuer-paid, subscriber-paid, or other \9\--poses 
concerns and harbors conflicts of interest. Indeed, it is not 
clear that one model poses fewer risks of conflicts or 
invariably produces higher quality ratings.
---------------------------------------------------------------------------
     \9\ While the focus of the current debate has been on issuer-paid 
versus subscriber-paid models, we recognize that there may be other 
compensation models worthy of consideration that may better incentivize 
rating agencies to produce high quality ratings. For example, payment 
for public ratings could be linked to ``quality provided'' as 
determined by the end user--the investors. We believe these or other 
models should be subject to the same regulatory oversight as the more 
common issuer-paid and subscriber-paid models.

Q.3. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the nation's economy. Please summarize your 
---------------------------------------------------------------------------
recommendations on the best way to oversee these instruments.

A.3. As we stated in our testimony, we believe that a single 
independent Federal regulator should be responsible for 
oversight of U.S. capital markets, market participants, and all 
financial investment products. We envision this ``Capital 
Markets Regulator'' as a new regulator that would encompass the 
combined functions of the Securities and Exchange Commission 
(SEC) and those of the Commodity Futures Trading Commission 
that are not agriculture-related. The Capital Markets Regulator 
should have express authority to regulate derivatives, 
including credit default swaps (CDS), including clear authority 
to adopt measures to increase transparency and reduce 
counterparty risk, while not unduly stifling innovation. \10\
---------------------------------------------------------------------------
     \10\ To the extent that no Capital Markets Regulator is formed, we 
believe that the SEC is the regulator best suited to provide effective 
oversight of financial derivatives, including CDS.
---------------------------------------------------------------------------
    The current initiatives toward centralized clearing for CDS 
are a positive step in this regard. Central clearing of CDS 
should help reduce counterparty risk and bring transparency to 
trading in the types of CDS that can be standardized. We 
support these initiatives.
    Not all CDS are sufficiently standardized to be centrally 
cleared, however, and institutional investors will continue to 
need to conduct over-the-counter transactions in CDS. 
Accordingly, we do not support efforts to require the mandatory 
clearing of all CDS. We do support, however, reasonable 
reporting requirements for these CDS transactions in order to 
allow the Capital Markets Regulator to have enough data on the 
CDS market to provide effective oversight.
    Institutional market participants should also be required 
to make periodic public disclosure of their CDS positions. SEC 
registered investment companies currently make these types of 
periodic public disclosures. To the extent that registered 
funds buy or sell CDS, they provide extensive quarterly 
financial statement disclosures that typically include both 
textual note disclosure on the nature and operation of CDS and 
tabular disclosure describing the terms of outstanding CDS at 
the report date. Textual note disclosures typically include: 
objectives, strategies, risks, cash flows, and credit events 
requiring performance. Tabular disclosures typically include: 
the reference entity, the counterparty, the pay/receive fixed 
rate, the expiration date, the notional amount, and the 
unrealized appreciation/depreciation (i.e., the fair value of 
the position). The Financial Accounting Standards Board (FASB) 
has recently taken steps to improve disclosures by the sellers 
of credit derivatives. \11\ We fully supported that effort, and 
will continue to support similar initiatives that we believe 
will improve marketplace transparency in derivatives.
---------------------------------------------------------------------------
     \11\ See FASB Staff Position No. 133-1 and FIN 45-4, Disclosures 
about Credit Derivatives and Certain Guarantees: An Amendment of FASB 
Statement No. 133 and FASB Interpretation No. 45; and Clarification of 
the Effective Date of FASB Statement No. 161 (Sept. 12, 2008), 
available at http://fasb.org/pdf/fsp_fas133-1&fin45-4.pdf

Q.4. Corporate Governance--Majority Vote for Directors, Proxy 
Access, Say on Pay: The Council of Institutional Investors, 
which represents public, union and corporate pension funds with 
combined assets that exceed $3 trillion, has called for 
``meaningful investor oversight of management and boards'' and 
in a letter dated December 2, 2008, identified several 
corporate governance provisions that ``any financial markets 
regulatory reform legislation [should] include'' Please explain 
---------------------------------------------------------------------------
your views on the following corporate governance issues:

  1. LRequiring a majority shareholder vote for directors to be 
        elected in uncontested elections;

  2. LAllowing shareowners the right to submit amendment to 
        proxy statements;

  3. LAllowing advisory shareowner votes on executive cash 
        compensation plans.

A.4. Investment companies (funds) are major shareholders in 
public companies and support strong governance and effective 
management of all companies whose shares they own. Funds 
typically are charged with seeking to maximize returns on 
behalf of fund investors, and they use a variety of methods to 
influence corporate conduct to this end. These methods include 
deciding whether to invest in a company, or to continue to hold 
shares; engaging directly with company management; and voting 
proxies for the shares they own.
    Since 2004, funds--alone among all institutional 
investors--have been required to publicly disclose their proxy 
votes. As a result of this unique disclosure requirement, the 
manner in which fund firms vote proxies has been intensely 
scrutinized, and critics have sought to politicize fund 
portfolio management.
    While critics have mischaracterized the data, the 
availability of fund voting records demonstrates how funds use 
the corporate franchise to promote the interests of their 
shareholders. ICI published a report last year on a study we 
conducted of more than 3.5 million votes cast by funds in the 
12-month period ended June 30, 2007. Our report, Proxy Voting 
by Registered Investment Companies: Promoting the Interests of 
Fund Shareholders, made numerous important findings including, 
among others, that: (1) funds devote substantial resources to 
proxy voting; (2) funds vote proxies in accordance with their 
board-approved guidelines; and (3) funds do not reflexively 
vote ``with management,'' as some critics claim, but rather 
make nuanced judgments in determining how to vote on both 
management and shareholder proposals. \12\
---------------------------------------------------------------------------
     \12\ The report is available at http://www.ici.org/stats/res/
per14-01.pdf
---------------------------------------------------------------------------
    ICI has recommended that Congress extend proxy vote 
disclosure requirements to other institutional investors, and 
we reiterate that recommendation here. Greater transparency 
around proxy voting by institutional investors should enhance 
the quality of the debate concerning how the corporate 
franchise is used.
    We are not the only proponents for increased transparency 
about the proxy votes of other institutional investors. Senator 
Edward M. Kennedy (D-MA) commissioned a 2004 GAO study entitled 
``Pension Plans: Additional Transparency and Other Actions 
Needed in Connection with Proxy Voting,'' which concluded, 
among other things, that workers and retirees would benefit 
from increased transparency in proxy voting by pension plans. 
Similarly, in his testimony for the March 10, 2009, Senate 
Banking Committee hearing, former Securities and Exchange 
Commission Chief Accountant Lynn Turner expressed support for 
legislation to ``require all institutional investors, including 
public, corporate and labor pension funds to disclose their 
votes, just as mutual funds currently are required to disclose 
their votes.'' \13\ House Financial Services Committee Chairman 
Barney Frank (D-MA) also has expressed interest in considering 
this issue. \14\ If disclosure of proxy votes promotes 
important public policy objectives, then similar requirements 
should apply to all institutional investors.
---------------------------------------------------------------------------
     \13\ See Statement of Lynn E. Turner Before the Senate Committee 
on Banking, Housing, and Urban Affairs on Enhancing Investor Protection 
and the Regulation of the Securities Markets (March 10, 2009) at 13.
     \14\ See Siobhan Hughes, Rep. Frank Plans Hearing on Disclosure of 
Proxy Votes, Dow Jones News Service, March 22, 2007.
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    Below we provide our views on shareholder access to company 
proxy materials for director-related bylaw amendments and 
shareholder advisory votes on executive pay.
    Proxy Access: In their dual role as major, long-term 
investors in securities of public companies and as issuers with 
their own shareholders and boards of directors, funds have a 
valuable perspective to offer on the topic of shareholder 
access to company proxy materials and the need to appropriately 
balance the interests of shareholders with those of company 
management. ICI generally supports affording certain 
shareholders direct access to a company's proxy materials for 
director-related bylaw amendments. \15\ We agree that long-term 
shareholders with a significant stake in a company have a 
legitimate interest in having a voice in the company's 
corporate governance. We believe that the ability to submit 
bylaw amendments concerning director nomination procedures 
could be an effective additional tool for use by funds and 
others to enhance shareholder value.
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     \15\ ICI has presented its views on this matter in Congressional 
testimony and in a comment letter to the SEC. See Statement of Paul 
Schott Stevens, President and CEO, Investment Company Institute, Before 
the Committee on Financial Services, United States House of 
Representatives on ``SEC Proxy Access Proposals: Implications for 
Investors'' (September 27, 2007); Letter from Karrie McMillan, General 
Counsel, Investment Company Institute, to Ms. Nancy M. Morris, 
Secretary, U.S. Securities and Exchange Commission, dated October 2, 
2007, available at http://www.ici.org/statements/cmltr/
07_sec_proxy_access_com.html#TopOfPage
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    At the same time, the privilege of proxy access should not 
be granted lightly. The Federal securities laws should not 
facilitate efforts to use a company's proxy machinery--at 
company expense--to advance parochial or short-term interests 
not shared by the company's other shareholders. Instead, the 
regulatory scheme should be crafted to afford access to a 
company's proxy only when the interests of shareholder 
proponents are demonstrably aligned with those of long-term 
shareholders.
    To achieve this objective, appropriate limits on the 
ability to use company resources to propose changes to a 
company's governing documents are critically important. In our 
view, these limits should include:

   LRestricting the privilege of proxy access to 
        shareholders who do not acquire or hold the securities 
        for the purpose of changing or influencing control of 
        the company. Shareholders seeking to change or 
        influence control of the company should be required to 
        follow the regulatory framework for proxy contests and 
        bear the related costs.

   LRequiring shareholder proponents to demonstrate 
        that they are long-term stakeholders with a significant 
        ownership interest. We recommend that there be a 
        meaningful required holding period, such as two years, 
        to provide assurance that shareholder proponents are 
        committed to the long-term mission of the company, 
        rather than seeking the opportunity for personal gain 
        and quick profits or advancement of parochial interests 
        at the expense of the company and other shareholders. 
        Similarly, we support establishing a relative high 
        minimum ownership threshold that would encourage 
        shareholders to come together to effect change. We 
        believe a five percent ownership threshold may not be 
        sufficiently high to assure that the company's proxy 
        machinery would be used to advance the common interests 
        of many shareholders in addressing legitimate concerns 
        about the management and operation of the company. 
        Consideration should be given to varying the required 
        ownership threshold based on factors such as the 
        company's market capitalization. The Securities and 
        Exchange Commission (SEC) should study share ownership 
        and holding period information to arrive at well-
        reasoned criteria that will encourage would-be 
        shareholder proponents to work together to achieve 
        goals that benefit all shareholders.

   LExcluding borrowed shares from the determination of 
        ownership level and holding period. Beneficial 
        ownership of shares should be required to assure that 
        the proponents' interests truly are aligned with those 
        of long-term shareholders.

    Another important element of proxy access is disclosure. 
Shareholder proponents should be required to provide disclosure 
for inclusion in proxy materials that would allow a company's 
other shareholders to make informed voting decisions (e.g., 
information about their background, intentions, and course of 
dealing with the company). SEC rules also should hold 
shareholder proponents--and not companies--responsible for the 
disclosure those shareholders provide.
    SEC Chairman Mary Schapiro recently indicated that the SEC 
will soon consider a proposal ``to ensure that a company's 
owners have a meaningful opportunity to nominate directors.'' 
\16\ We look forward to reviewing and commenting on the SEC's 
proposal.
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     \16\ See SEC Speech: Address to the Council of Institutional 
Investors, by Chairman Mary L. Schapiro, U.S. Securities and Exchange 
Commission (May 6, 2009), available at http://www.sec.gov/news/speech/
2009/spch040609mls.htm
---------------------------------------------------------------------------
    Say on Pay: As noted above, funds are significant holders 
of public companies. When deciding whether to invest in a 
company or to continue to hold its stock, funds consider many 
factors, including how the company compensates its top 
executives. This information is important because it allows 
funds to decide whether (1) there is an alignment of interests 
between the executives running the company and the shareholders 
who own the company and (2) executives have incentives to 
maximize value for shareholders. ICI has supported SEC efforts 
to ensure that investors receive clear and complete disclosure 
regarding executive pay packages.
    The financial crisis has fanned the flames of public 
outrage over executive compensation, particularly where such 
compensation appears to be grossly excessive in light of a 
company's performance or where the compensation seems to 
promote the short-term interests of managers over the longer-
term interests of shareholders. Funds are deeply mindful of 
these issues. ICI would not oppose requiring public companies 
to put the compensation packages of their key executive 
officers to a non-binding advisory vote of shareholders as an 
additional way to encourage sound decision-making by companies 
regarding the composition of executive pay packages.
    We strongly urge, however, that any such requirement be 
coupled with requiring other institutional investors to 
disclose their proxy votes, as we recommend above. Otherwise, 
the votes of funds on executive compensation, but not those of 
any other institutional investor, would be subject to scrutiny 
and, often we feel, unfair second-guessing. Moreover, the 
potential benefits of greater transparency of the proxy voting 
process would seem to be particularly evident here, where the 
public disclosure of executive compensation votes would 
maximize their influence over management.

Q.5. Credit Rating Agencies: A. Please identify any legislative 
or regulatory changes you believe are warranted to improve the 
oversight of credit rating agencies. In addition, I would like 
to ask your views on two specific proposals:

  1. LThe Peterson Institute report on ``Reforming Financial 
        Regulation, Supervision, and Oversight'' recommended 
        reducing conflicts of interest in the major rating 
        agencies by not permitting them to perform consulting 
        activities for the firms they rate.

  2. LThe G30 Report ``Financial Reform; A Framework for 
        Financial Stability'' recommended that regulators 
        should permit users of ratings to hold NRSROs 
        accountable for the quality of their work product. 
        Similarly, Professor Coffee recommended creating 
        potential legal liability for recklessness when 
        ``reasonable efforts'' have not been made to verify 
        ``essential facts relied upon by its ratings 
        methodology.''

A.5. Measures To Improve the Oversight of Rating Agencies: ICI 
is committed to the objective of improving the rating process 
to make ratings more accurate and useful to investors and to 
promote the sound functioning of our capital markets. \17\ We 
recommend several regulatory measures to enhance the oversight 
of credit rating agencies and thereby improve the quality, 
accuracy, and integrity of ratings and the rating process. \18\ 
Generally speaking, our recommendations would enhance 
disclosure, address conflicts of interest, and hold rating 
agencies accountable for their ratings. \19\
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     \17\ ICI recently participated in the SEC's Roundtable on the 
oversight of credit rating agencies in an effort to further the 
discussion on ways in which to improve ratings and the ratings process. 
See Statement of Paul Schott Stevens, President and CEO, Investment 
Company Institute, SEC Roundtable on Oversight of Credit Rating 
Agencies, dated April 15, 2009, available at http://www.ici.org/home/
09_oversight_stevens_stmt.html#TopOfPage. See also Statements of Paul 
Schott Stevens, President, Investment Company Institute, on the 
``Credit Rating Agency Duopoly Relief Act of 2005,'' before the 
Committee on Financial Services, U.S. House of Representatives 
(November 29, 2005) and on ``Assessing the Current Oversight and 
Operation of Credit Rating Agencies,'' before the Committee on Banking, 
Housing, and Urban Affairs, U.S. Senate (March 7, 2006).
     \18\ See Letter from Karrie McMillan, General Counsel, Investment 
Company Institute, to Florence Harmon, Acting Secretary, U.S. 
Securities and Exchange Commission, dated July 25, 2008; Letter from 
Karrie McMillan, General Counsel, Investment Company Institute, to 
Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange 
Commission, dated March 26, 2009.
     \19\ We believe the SEC currently has authority to implement many 
of our recommendations. Others (such as certain changes to improve 
municipal securities disclosure, discussed below) would require 
Congressional action.
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    Specifically, we recommend that the Securities and Exchange 
Commission (SEC) improve disclosure about credit ratings and 
the rating process for structured finance securities and other 
debt securities. Public disclosure of information about a 
credit rating agency's policies, procedures, and other 
practices relating to rating decisions will allow investors to 
evaluate more effectively a rating agency's independence, 
objectivity, capability, and operations. Disclosure will serve 
as a powerful additional mechanism for ensuring the integrity 
and quality of the credit ratings themselves. To realize the 
full potential of such a disclosure regime, the SEC should 
require the standardized presentation of this information in a 
presale report issued by the rating agencies.
    The SEC also should take steps to strengthen the incentives 
to produce quality ratings, because such incentives are clearly 
insufficient in the current system. To this end, the SEC should 
require rating agencies to conduct ``due diligence'' 
assessments of the information they review to issue ratings. 
This should help build investor confidence in ratings and the 
rating process over time, by enabling users of ratings to gauge 
both the accuracy of the information being analyzed by the 
rating agency and the rating agency's ability to assess the 
creditworthiness of the underlying security. We also recommend 
that rating agencies have greater legal accountability to 
investors for their ratings. Both of these recommendations 
should encourage rating agencies to improve the quality of 
their ratings.
    Today's rating system is hampered by deep concerns about 
conflicts of interest, poor disclosure, and lack of 
accountability. To address these concerns effectively, the SEC 
should apply necessary regulatory reforms in a consistent 
manner to all types of credit rating agencies. A consistent 
approach is not only critical to improving ratings quality and 
allowing investors to identify and assess potential conflicts 
of interest, but also to increasing competition among rating 
agencies. The SEC must also employ a consistent and active 
approach to enforcement of the oversight regime, holding rating 
agencies accountable for any failures to comply with the SEC's 
rules and the rating agency's own policies and procedures 
adopted under the rules. Finally, we recommend that the SEC 
address the need for better disclosure by certain issuers 
(e.g., expand issuer disclosure for structured finance 
products, expand and standardize issuer disclosure for asset-
backed securities, and require that disclosure for asset-backed 
securities be ongoing). In addition, we recommend that the SEC 
improve issuer disclosure for municipal securities. \20\ Better 
disclosure will assist investors in making their own risk 
assessments and should foster better quality ratings.
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     \20\ See Letter from Karrie McMillan, General Counsel, Investment 
Company Institute, to Florence Harmon, Acting Secretary, U.S. 
Securities and Exchange Commission, dated September 22, 2008.
---------------------------------------------------------------------------
    Controlling Conflicts of Interest--Limiting or Prohibiting 
Consulting Activities: Addressing conflicts of interest at 
rating agencies is particularly important given the role that 
ratings play in today's capital markets. For this reason, ICI 
has recommended that the SEC require rating agencies to 
disclose information, including: (1) any material ancillary 
business relationships between a rating agency and an issuer 
and (2) information regarding the separation of a rating 
agency's consulting and rating activities. \21\ If such 
information is available, we believe that it is unnecessary to 
prohibit rating agencies from performing any consulting 
activities for the firms they rate. The SEC already has 
prohibited rating agencies from rating a product in which the 
rating agency has been consulted on the structure of the 
product. We believe that this measure, in combination with the 
disclosure we have recommended, should curtail opportunities 
for questionable conduct. In addition, it should put investors 
on notice regarding potential conflicts of interest arising 
from a rating agency's consulting business and provide 
investors with the information needed to assess the ability and 
effectiveness of a rating agency to manage those conflicts of 
interest.
---------------------------------------------------------------------------
     \21\ See Letter from Karrie McMillan, General Counsel, Investment 
Company Institute, to Florence Harmon, Acting Secretary, U.S. 
Securities and Exchange Commission, dated July 25, 2008.
---------------------------------------------------------------------------
    Enhancing Accountability, Due Diligence, and Legal 
Liability of Rating Agencies: Given the role of ratings in the 
investment process and the use of ratings by investors, ICI 
agrees with the recommendation in the G30 Report and by 
Professor Coffee: credit rating agencies should have greater 
legal accountability for their ratings. Currently, investors do 
not have sufficient legal recourse against rating agencies if, 
for example, a rating agency issues an erroneous rating.
    We believe that the exemption for nationally recognized 
statistical rating organizations (NRSROs) from Section 11 of 
the Securities Act of 1933 should be reconsidered. \22\ Under 
current regulations, the SEC exempts NRSROs, but not other 
rating agencies, from treatment as experts subject to liability 
under Section 11 and, thus, allows NRSRO ratings in 
prospectuses and financial reports. Although the SEC has stated 
that NRSROs remain subject to antifraud rules, the NRSROs have 
steadfastly maintained that, under the First Amendment, they 
cannot be held liable for erroneous ratings absent a finding of 
malice.
---------------------------------------------------------------------------
     \22\ Section 11 under the Securities Act creates liability for 
issuers and certain professionals who prepared or certified any part of 
a registration statement for any materially false statements or 
omissions in the registration statement.
---------------------------------------------------------------------------
    While it may be argued that rating agencies should not be 
liable for an erroneous rating as such, they should, at a 
minimum, have some accountability for ratings issued in 
contravention of their own disclosed procedures and standards. 
As we have stated in the past, even if the First Amendment 
applies to credit ratings, it should not immunize rating 
agencies for false or misleading disclosures to the SEC and to 
the investing public. Quite simply, if a rating agency obtains 
an NRSRO designation based on, for example, a specific ratings 
process, it should be held accountable to the SEC and to 
investors if it fails to follow that process.
    A rating agency's ability to continue to claim First 
Amendment rights also has been questioned based on the business 
decisions and the roles undertaken by rating agencies over the 
last decade. Rating agencies have abandoned their former 
practice of rating most or all securities whether or not hired 
to do so, and rating agencies have become deeply involved in 
the structuring of complex securities, which are normally not 
sold to retail investors. These changes warrant serious 
attention when considering whether rating agencies still merit 
the protection that the First Amendment may have provided to 
them in their more traditional role. \23\
---------------------------------------------------------------------------
     \23\ Rating agencies have cited the First Amendment in statements 
to Congress, the courts, and the investing public, stating that their 
ratings are opinions only--not ``recommendations or commentary on the 
suitability of a particular investment.'' See, e.g., Statement of Deven 
Sharma, President, Standard & Poor's, on ``Credit Rating Agencies and 
the Financial Crisis,'' before the Committee on Oversight and 
Government Reform, U.S. House of Representatives (October 22, 2008). 
See also Not ``The World's Shortest Editorial'': Why the First 
Amendment Does Not Shield Rating Agencies From Liability for Over-
Rating CDOs, David J. Grais and Kostas D. Katsiris, Grais & Ellsworth, 
Bloomberg Law Reports (November 2007).
---------------------------------------------------------------------------
    In addition to increasing legal accountability for rating 
agencies, we believe that rating agencies would have greater 
ability to produce high quality and more reliable ratings if 
they were required to conduct better due diligence and 
verification. Under current SEC rules, it is difficult for a 
user of a rating to gauge the accuracy of the information being 
analyzed by the rating agency and, thus, evaluate the rating 
agency's ability to assess the creditworthiness of a structured 
finance product. \24\ Rating agencies are required neither to 
verify the information underlying a structured finance product 
received from an issuer nor to compel issuers to perform due 
diligence or to obtain reports concerning the level of due 
diligence performed by issuers of structured finance products.
---------------------------------------------------------------------------
     \24\ Current rules only require that rating agencies provide a 
description of: (1) the public and nonpublic sources of information 
used in determining credit ratings, including information and analysis 
provided by third-party vendors; (2) whether and how information about 
verification performed on assets underlying structured finance 
securities is relied upon in determining credit ratings; and (3) 
whether and how assessments of the quality of originators of structured 
finance securities factor into the determination of credit ratings.
---------------------------------------------------------------------------
    To address these concerns, we recommend that credit rating 
agencies be required to conduct due diligence on the 
information they review to issue ratings. In addition, to raise 
investor confidence in the quality of ratings and the rating 
process as a whole, the due diligence requirements should apply 
(as appropriate) to all rated debt securities, not only 
structured finance products. Specifically, we recommend that:

   LRating agencies be required to have policies and 
        procedures in place reasonably sufficient to assess the 
        credibility of the information they receive from 
        issuers and underwriters.

   LRating agencies disclose these policies and 
        procedures, the specific steps taken to verify 
        information about the assets underlying a security, and 
        the results of the verification process.

   LRating agencies disclose the limitations of the 
        available information or data, any actions they take to 
        compensate for any missing information or data, and any 
        risks involved with the assumptions and methodologies 
        they use in providing a rating.

   LRating agencies be required to certify that the 
        rating agency has satisfied its stated policies and 
        procedures for performing due diligence on the security 
        being rated.

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds 
Association testified before the House Subcommittee on Capital 
Markets and said: ``MFA and its members acknowledge that at a 
minimum the hedge fund industry as a whole is of systemic 
relevance and, therefore, should be considered within the 
systemic risk regulatory framework.'' MFA supported the 
creation or designation of a ``single central systemic risk 
regulator'' that (1) has ``the authority to request and 
receive, on a confidential basis, from those entities that it 
determines . . . to be of systemic relevance, any information 
that the regulator determines is necessary or advisable to 
enable it to adequately assess potential risks to the financial 
system,'' (2) has a mandate of protection of the financial 
system, but not investor protection or market integrity and (3) 
has the authority to ensure that a failing market participant 
does not pose a risk to the entire financial system.
    Do you agree with MFA's position? Do you feel there should 
be regulation of hedge funds along these lines or otherwise?

A.6. Systemic Risk Regulation: Over the past year, various 
policymakers and other commentators have called for the 
establishment of a formal mechanism for identifying, 
monitoring, and managing risks to the financial system as a 
whole. ICI concurs with those commentators and with the Managed 
Funds Association (MFA) that creation of such a mechanism is 
necessary. The ongoing financial crisis has highlighted the 
vulnerability of our financial system to risks that have the 
potential to spread rapidly throughout the system and cause 
significant damage. A mechanism that will allow Federal 
regulators to look across the system should equip them to 
better anticipate and address such risks.
    Generally speaking, MFA's statement about a ``single 
central systemic risk regulator'' touches on some of the same 
themes that ICI addressed in its March 3, 2009, white paper, 
Financial Services Regulatory Reform: Discussion and 
Recommendations. \25\ In our white paper, we endorsed the 
designation of a new or existing agency or inter-agency body as 
a ``Systemic Risk Regulator.'' Broadly stated, the goal in 
establishing a Systemic Risk Regulator should be to provide 
greater overall stability to the financial system as a whole. 
The Systemic Risk Regulator should have responsibility for: (1) 
monitoring the financial markets broadly; (2) analyzing 
changing conditions in domestic and overseas markets; (3) 
evaluating the risks of practices as they evolve and 
identifying those that are of such nature and extent that they 
implicate the health of the financial system at large; and (4) 
acting to mitigate such risks in coordination with other 
responsible regulators.
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     \25\ See Financial Services Regulatory Reform: Discussion and 
Recommendations, which is available at http://www.ici.org/pdf/
ppr_09_reg_reform.pdf. We note that the white paper was included as an 
attachment to ICI's written testimony.
---------------------------------------------------------------------------
    In ICI's view, Congress should determine the composition 
and authority of the Systemic Risk Regulator with two important 
cautions in mind. First, the legislation establishing the 
Systemic Risk Regulator should be crafted to avoid imposing 
undue constraints or inapposite forms of regulation on normally 
functioning elements of the financial system, or stifling 
innovations, competition or efficiencies. By way of example, it 
has been suggested that a Systemic Risk Regulator could be 
given the authority to identify financial institutions that are 
``systemically significant'' and to oversee those institutions 
directly. Such an approach could have very serious 
anticompetitive effects if the identified institutions were 
viewed as ``too big to fail'' and thus judged by the 
marketplace as safer bets than their smaller, ``less 
significant'' competitors. \26\
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     \26\ See, e.g., Peter J. Wallison, Regulation Without Reason: The 
Group of Thirty Report, AEI Financial Services Outlook (Jan. 2009), 
available at http://www.aei.org/publications/pubID.29285/pub_detail.asp
---------------------------------------------------------------------------
    Second, the Systemic Risk Regulator should not be 
structured to simply add another layer of bureaucracy or to 
displace the primary regulator(s) responsible for capital 
markets, banking or insurance. We strongly concur with MFA that 
the Systemic Risk Regulator should focus principally on 
protecting the financial system--as discussed in detail in our 
white paper, we believe that a strong and independent Capital 
Markets Regulator (or, until such agency is established by 
Congress, the Securities and Exchange Commission) should focus 
principally on the equally important mandates of protecting 
investors and maintaining market integrity. Legislation 
establishing the Systemic Risk Regulator should define the 
nature of the relationship between this new regulator and the 
primary regulator(s) for each industry sector. This should 
involve carefully defining the extent of the authority granted 
to the Systemic Risk Regulator, as well as identifying 
circumstances under which the Systemic Risk Regulator and 
primary regulator(s) should coordinate their efforts and work 
together. We believe, for example, that the primary regulators 
have a critical role to play by acting as the first line of 
defense with regard to detecting potential risks within their 
spheres of expertise.
    In view of the two cautions outlined above, ICI believes 
that the Systemic Risk Regulator would be best structured as a 
statutory council comprised of senior Federal regulators. 
Membership should include, at a minimum, the Secretary of the 
Treasury, Chairman of the Federal Reserve Board of Governors, 
and the heads of the Federal bank and capital markets 
regulators (and insurance regulator, if one emerges at the 
Federal level).
    Regulation of the Hedge Fund Industry--Appropriate Focus of 
Regulatory Oversight: In 2004, the Securities and Exchange 
Commission (SEC) adopted a rule to require hedge fund advisers 
to register with the SEC as investment advisers. ICI supported 
this registration requirement as a way to provide the SEC with 
reliable, current, and meaningful information about this 
significant segment of the capital markets without adversely 
impacting the legitimate operations of hedge fund advisers. 
Many ICI member firms--all of whom are registered with the 
SEC--currently operate hedge funds and have found that 
registration is not overly burdensome and does not interfere 
with their investment activities.
    In June 2006, the SEC's hedge fund adviser registration 
rule was struck down by the U.S. Court of Appeals for the D.C. 
Circuit. The following month, in testimony before this 
Committee, then SEC Chairman Christopher Cox commented that the 
rule's invalidation had forced the SEC ``back to the drawing 
board to devise a workable means of acquiring even basic census 
data that would be necessary to monitor hedge fund activity in 
a way that could mitigate systemic risk.'' \27\
---------------------------------------------------------------------------
     \27\ See Written Testimony of SEC Chairman Before the U.S. Senate 
Committee on Banking, Housing and Urban Affairs (July 25, 2006) 
(concerning the regulation of hedge funds), available at http://
www.sec.gov/news/testimony/2006/ts072506cc.htm
---------------------------------------------------------------------------
    In our white paper, we call for this regulatory gap to be 
closed. Specifically, ICI recommends that the Capital Markets 
Regulator (or SEC) have express regulatory authority to provide 
oversight over hedge funds (through their advisers) with 
respect to, at a minimum, their potential impact on the capital 
markets. \28\ For example, similar to MFA's recommendation, we 
state that the regulator could require nonpublic reporting of 
information such as investment positions and strategies that 
could bear on systemic risk and adversely impact other market 
participants.
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     \28\ It is imperative, of course, that the Capital Markets 
Regulator (or SEC) be organized and staffed, and have sufficient 
resources, to effectively perform this oversight function.
---------------------------------------------------------------------------
    We continue to believe that hedge fund adviser registration 
is an appropriate response to address the risks that hedge 
funds can pose to the capital markets and other market 
participants. In this regard, the Capital Markets Regulator (or 
SEC) may wish to consider the adoption of specific rules under 
the Investment Advisers Act of 1940 that are tailored to the 
specific business practices of, and market risks posed by, 
hedge funds. Areas of focus for such rulemaking should include, 
for example, disclosure regarding valuation practices and the 
calculation of investment performance; both of these areas have 
been criticized as lacking transparency and presenting the 
potential for abuse.
    ICI does not support, however, requiring the registration 
of individual hedge funds with the SEC. Rather, as discussed in 
detail below, ICI believes there must continue to be a strict 
dividing line between registered, highly regulated investment 
companies and unregistered, lightly regulated hedge funds. A 
registration requirement for hedge funds would blur this line, 
invariably causing confusion for both investors and the 
marketplace. This confusion would likely exacerbate already 
imprecise uses of the term ``fund'' to refer to investment 
pools, whether registered or not. Further, we believe it is 
imperative to keep any problems in the hedge fund area from 
bleeding over in the public's mind to include mutual funds, 
which are owned by almost half of all U.S. households.
    Maintaining the distinctions between investment companies 
and hedge funds--Compared to registered investment companies, 
which are subject to the comprehensive and rigorous regulatory 
regime set forth in the Investment Company Act of 1940 and 
related rules, hedge funds are lightly regulated investment 
products. Hedge funds are effectively outside the purview of 
the Investment Company Act by reason of Sections 3(c)(1) and 
3(c)(7), which require that the hedge fund is not making or 
proposing to make a public offer of its securities and that 
those securities be sold only to certain specific groups of 
investors. These provisions thus place express statutory limits 
on both the offer and the sale of securities issued by a hedge 
fund. ICI firmly believes that these limits must be preserved 
and should be reconfirmed in any legislation enacted to 
regulate hedge funds or their advisers.
    No general solicitation or public advertising by hedge 
funds--Despite clear statutory language precluding a hedge fund 
from ``making or proposing to make a public offer of its 
securities,'' there have been several occasions in the recent 
past where the hedge fund industry has argued that it should be 
able to advertise through the public media, while remaining 
free from the regulatory restrictions and shareholder 
protections imposed by the Investment Company Act. 
Additionally, in 2003, the SEC staff recommended that the SEC 
consider eliminating the prohibition on general solicitation in 
offerings by certain hedge funds. ICI emphatically opposes any 
such efforts, because allowing hedge funds organized pursuant 
to Sections 3(c)(1) and 3(c)(7) to engage in any form of 
general solicitation or public advertising is fundamentally 
inconsistent with hedge funds' exclusion from regulation under 
the Investment Company Act.
    Section 3(c)(7) was added to the Investment Company Act in 
1996, in apparent recognition that the full panoply of 
investment company regulation is not necessary for hedge funds 
(and other private investment pools) offered and sold only to 
financially sophisticated investors able to bear the risk of 
loss associated with their investment. The ``no public 
offering'' language used by Congress in Section 3(c)(7) 
generally tracks the language in Section 4(2) of the Securities 
Act of 1933. For almost five decades, the SEC has taken the 
position that public advertising is inconsistent with a 
nonpublic offering of securities under Section 4(2). \29\
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     \29\ See Non-Public Offering Exemption, SEC Rel. No. 33-4552 (Nov. 
6, 1962) at text preceding n.2, text preceding n.3 (``Consideration 
must be given not only to the identity of the actual purchasers but 
also to the offerees. Negotiations or conversations with or general 
solicitations of an unrestricted and unrelated group of prospective 
purchasers for the purpose of ascertaining who would be willing to 
accept an offer of securities is inconsistent with a claim that the 
transaction does not involve a public offering even though ultimately 
there may only be a few knowledgeable purchasers . . . . Public 
advertising of the offerings would, of course, be incompatible with a 
claim of a private offering.'').
---------------------------------------------------------------------------
    In its rulemaking to implement Section 3(c)(7) and related 
provisions, the SEC observed that ``while the legislative 
history . . . does not explicitly discuss Section 3(c)(7)'s 
limitation on public offerings by Section 3(c)(7) funds, the 
limitation appears to reflect Congress's concerns that 
unsophisticated individuals not be inadvertently drawn into 
[such] funds.'' \30\ A member of Congress intimately involved 
in this debate later concurred with the SEC's interpretation in 
a letter to then SEC Chairman Arthur Levitt. His letter further 
explained:
---------------------------------------------------------------------------
     \30\ See Privately Offered Investment Companies, SEC Rel. No. IC-
22597 (April 3, 1997), at n.5.

        In 1996, as part of the National Securities Markets Improvement 
        Act, Congress reaffirmed that hedge funds should not be 
        publicly marketed, specifically adding this restriction to a 
        modernized hedge fund exemption that was included in the final 
        bill. As you will recall, I was one of the authors of this 
        provision . . . I believe that the Congress has appropriately 
        drawn the lines regarding hedge fund marketing, and intend to 
        strongly oppose any effort to liberalize them. \31\
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     \31\ See Letter from Rep. Edward J. Markey (D-Mass.) to SEC 
Chairman Arthur Levitt, dated Dec. 18, 2000.

    Any form of general solicitation or public advertising of 
unregistered hedge funds would surely cause investors to 
confuse such funds with registered, highly regulated investment 
companies. It also would present greater opportunities for 
perpetrators of securities fraud to identify and target 
unsophisticated investors. This potential for investor 
confusion and fraudulent activity would be compounded by the 
fact that the SEC simply would not have the resources to 
monitor advertisements by hedge funds--whether legitimate or 
fraudulent--in any meaningful way.
    For all of these reasons, ICI firmly believes that there 
must continue to be a strict prohibition on any form of general 
solicitation or public advertising in connection with hedge 
fund offerings.
    Limitations on who may invest in hedge funds--No less 
critical is the need to ensure that interests in hedge funds 
are sold only to financially sophisticated investors able to 
bear the economic risk of their investment. To this end, ICI 
believes that the accredited investor standards in Regulation D 
under the Securities Act of 1933 (which determine investor 
eligibility to participate in unregistered securities offerings 
by hedge funds and other issuers) should be immediately 
adjusted to correct for the substantial erosion in those 
standards since their adoption in 1982. This one-time 
adjustment should be coupled with periodic future adjustments 
to keep pace with inflation. Specifically, ICI has recommended 
that the SEC's Office of Economic Analysis be required to reset 
the accredited investor thresholds every 5 years, so that the 
percentage of the population qualifying as accredited investors 
would remain stable over time. This would entail a 
straightforward economic analysis that could be performed using 
widely available government databases. \32\
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     \32\ For a detailed discussion of the Institute's views on these 
issues, see Letter from Paul Schott Stevens, President and CEO, 
Investment Company Institute, to Nancy M. Morris, Secretary, U.S. 
Securities and Exchange Commission, dated Oct. 9, 2007, available at 
http://www.sec.gov/comments/s7-18-07/s71807-37.pdf
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    Also in this regard, ICI continues to support the SEC's 
2006 proposal to raise the eligibility threshold for 
individuals wishing to invest in hedge funds (and other private 
investment pools) organized under Section 3(c)(1) of the 
Investment Company Act. Specifically, an individual would need 
to be an ``accredited investor'' based upon specified net worth 
or income levels, as is now required, and own at least $2.5 
million in investments. According to the SEC, this new two-step 
approach would mirror the existing eligibility requirements 
that Congress determined were appropriate for investors in 
hedge funds organized under Section 3(c)(7).

Q.7. Self-Regulatory Organizations: How do you feel the self-
regulatory securities organizations have performed during the 
current financial crisis? Are there changes that should be made 
to the self-regulatory organizations to improve their 
performance? Do you feel there is still validity in maintaining 
the self-regulatory structure or that some powers should be 
moved to the SEC or elsewhere?

A.7. Self-regulatory organizations (SROs) form an integral part 
of the current system of securities markets oversight. ICI has 
had a longstanding interest in the effective and efficient 
operation of SROs, and we support an examination of their role 
and operations. We believe there may be several ways to improve 
SROs' performance and operations, particularly through 
enhancements to their rules and rulemaking processes, and their 
governance structure.
    SRO rules should be crafted both to protect investors and 
to promote efficiency, competition and capital formation. To 
achieve these objectives, it is critically important that SROs 
consider the relative costs and benefits of their rules. We 
have recommended on several occasions that Congress by law, or 
the SEC by rule, require that all SROs evaluate the costs and 
benefits of their rule proposals prior to submission to the SEC 
and establish a process for reexamining certain existing rules. 
\33\ This process should be designed to determine whether the 
rules are working as intended, whether there are satisfactory 
alternatives of a less burdensome nature, and whether changes 
should be made.
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     \33\ See Statement of the Investment Company Institute on the 
Review of the U.S. Financial Markets and Global Markets 
Competitiveness, Submitted to the Senate Republican Capital Markets 
Task Force, U.S. Senate (February 25, 2008) and Submission of the 
Investment Company Institute to the Department of the Treasury, Review 
of the Regulatory Structure Associated with Financial Institutions 
(December 7, 2007).
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    The SRO rulemaking process itself serves important policy 
goals, including, among other things, assuring that interested 
persons have an opportunity to provide input regarding SRO 
actions that could have a significant effect on the market and 
market participants. ICI has supported amendments that would 
improve the ability of interested persons to submit comments on 
SRO actions. In particular, we have recommended extending the 
length of the comment period for any significant SRO proposal. 
\34\
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     \34\ See Letters from Craig S. Tyle, General Counsel, Investment 
Company Institute, to Jonathan G. Katz, Secretary, U.S. Securities and 
Exchange Commission, dated April 6, 2001, and Dorothy M. Donohue, 
Associate Counsel, Investment Company Institute, to Jonathan G. Katz, 
Secretary, U.S. Securities and Exchange Commission, dated June 4, 2004.
---------------------------------------------------------------------------
    Finally, ICI supports efforts to strengthen SRO governance 
processes. \35\ For example, to ensure that the views of 
investors are adequately represented, we have recommended that 
SROs be required to have sufficient representation from funds 
and other institutional investors in their governance 
structures. In addition, to address concerns that SROs are 
inherently subject to conflicts of interest, consideration 
should be given to requiring SRO boards to have an appropriate 
balance between public members and members with industry 
expertise. \36\
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     \35\ See, e.g., Letter from Ari Burstein, Associate Counsel, 
Investment Company Institute, to Jonathan G. Katz, Secretary, U.S. 
Securities and Exchange Commission, dated March 8, 2005.
     \36\ See Regulating Broker-Dealers and Investment Advisers: 
Demarcation or Harmonization?, Speech by SEC Commissioner Elisse B. 
Walter Before the Mutual Fund Directors Forum Ninth Annual Policy 
Conference (May 5, 2009), available at http://www.sec.gov/news/speech/
2009/spch050509ebw.htm

Q.8. Structure of the SEC: Please share your views as to 
whether you feel that the current responsibilities and 
structure of the SEC should be changed.
    Please comment on the following specific proposals:

  1. LGiving some of the SEC's duties to a systemic risk 
        regulator or to a financial services consumer 
        protection agency;

  2. LCombining the SEC into a larger ``prudential'' financial 
        services regulator;

  3. LAdding another Federal regulators' or self-regulatory 
        organizations' powers or duties to the SEC.

A.8. Investment companies (funds) are both major holders of 
securities issued by public companies and issuers of securities 
(fund shares) held by almost half of all U.S. households. As 
such, they have a vested interest in the effective regulation 
of the capital markets by a strong and independent regulator. 
Funds and their shareholders stand to benefit if that regulator 
has the tools it needs to fulfill important policy objectives, 
such as: preserving the integrity of the capital markets; 
ensuring the adequacy and accuracy of periodic disclosures by 
public issuers; and promoting fund regulation that protects 
investors, encourages innovation, and does not hinder market 
competition.
    As discussed in its March 3, 2009, white paper, Financial 
Services Regulatory Reform: Discussion and Recommendations, 
\37\ ICI supports the creation of a new Capital Markets 
Regulator that would encompass the combined functions of the 
Securities and Exchange Commission (SEC) and those of the 
Commodity Futures Trading Commission (CFTC) that are not 
agriculture-related. In our response below to part A of the 
question, we briefly discuss this recommendation and our 
suggestions relating to the Capital Markets Regulator's 
responsibilities and structure. Pending, or in the absence of, 
Congressional action to create a Capital Markets Regulator, 
most of our recommendations just as appropriately could be 
applied to the SEC. Where appropriate for ease of discussion, 
we use the term ``agency'' to refer equally to the SEC or a new 
Capital Markets Regulator.
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     \37\ See Financial Services Regulatory Reform: Discussion and 
Recommendations, which is available at http://www.ici.org/pdf/
ppr_09_reg_reform.pdf. We note that the white paper was included as an 
attachment to ICI's written testimony.
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    We then address the issues outlined in part B of the 
question in the context of a discussion about how the SEC or a 
new Capital Markets Regulator should fit within the broader 
financial services regulatory framework.
    Reforming the Responsibilities and Structure of the SEC: To 
bring a consistent policy focus to U.S. capital markets, ICI 
strongly recommends the creation of a new Capital Markets 
Regulator. Currently, securities and futures are subject to 
separate regulatory regimes under different Federal regulators. 
This system reflects historical circumstances that have changed 
significantly. As recently as the mid-1970s, for example, 
agricultural products accounted for most of the total U.S. 
futures exchange trading volume. By the late 1980s, a shift 
from the predominance of agricultural products to financial 
instruments and currencies was readily apparent in the volume 
of trading on U.S. futures exchanges. In addition, as new, 
innovative financial instruments were developed, the lines 
between securities and futures often became blurred. The 
existing, divided regulatory approach has resulted in 
jurisdictional disputes between the SEC and the CFTC, 
regulatory inefficiency, and gaps in investor protection and 
market oversight. With the increasing convergence of securities 
and futures products, markets, and market participants, the 
current system simply makes no sense.
    As envisioned by ICI, the Capital Markets Regulator would 
be a single, independent Federal regulator responsible for 
oversight of U.S. capital markets, market participants, and all 
financial investment products. It would have an express 
statutory mission and the rulemaking and enforcement powers 
necessary to carry out that mission. \38\ From the perspective 
of the fund industry, the mission of the Capital Markets 
Regulator must involve maintaining a sharp focus on investor 
protection, supported by a comprehensive enforcement program. 
This core feature of the SEC's mission has consistently 
distinguished the SEC from the banking regulators, who are 
principally concerned with the safety and soundness of the 
financial institutions they regulate, and it has generally 
served investors well over the years.
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     \38\ Currently, regulatory oversight of both the securities and 
futures industries involves various self-regulatory organizations. In 
establishing a Capital Markets Regulator, Congress would need to 
determine the appropriate role for any such organization(s).
---------------------------------------------------------------------------
    Examination of the recent financial crisis has prompted 
calls for Congress to close regulatory gaps to ensure 
appropriate oversight of all market participants and investment 
products. In our white paper, we recommend that the Capital 
Markets Regulator (or SEC) have express regulatory authority to 
provide oversight with regard to hedge funds, derivatives, and 
municipal securities. We further recommend that the agency be 
given explicit authority to harmonize the legal standards 
applicable to investment advisers and broker-dealers.
    How a regulatory agency is managed, and the details of its 
organizational structure, can have significant implications for 
the agency's effectiveness. In our white paper, we offer the 
following suggestions with regard to management and 
organization of the Capital Markets Regulator (or SEC).

   LEnsure high-level focus on agency management. One 
        approach would be to designate a Chief Operating 
        Officer for this purpose.

   LImplement a comprehensive process for setting 
        regulatory priorities and assessing progress. It may be 
        helpful to draw upon the experience of the United 
        Kingdom's Financial Services Authority, which seeks to 
        follow a methodical approach that includes developing a 
        detailed annual business plan establishing agency 
        priorities and then reporting annually the agency's 
        progress in meeting prescribed benchmarks.

   LPromote open and effective lines of communication 
        among the Commissioners and between the Commissioners 
        and staff. Such communication is critical to fostering 
        awareness of issues and problems as they arise, thus 
        increasing the likelihood that the agency will be able 
        to act promptly and effectively. A range of approaches 
        may be appropriate to consider in meeting this goal, 
        including whether sufficient flexibility is provided 
        under the Government in the Sunshine Act, and whether 
        the number of Commissioners should be greater than the 
        current number at the SEC (five).

   LAlign the inspections and examinations functions 
        and the policymaking divisions. This approach would 
        have the benefit of keeping staff in the policymaking 
        divisions updated on current market and industry 
        developments, as well as precluding any de facto 
        rulemaking by the agency's inspections staff.

   LDevelop mechanisms to facilitate coordination and 
        information sharing among the policymaking divisions. 
        These mechanisms would help to ensure that the agency 
        speaks with one voice.

    How the SEC (or a New Capital Markets Regulator) Fits 
Within the Broader Financial Services Regulatory Framework: 
Today's financial crisis has demonstrated that the current 
system for oversight of U.S. financial institutions is 
insufficient to address modern financial markets. In its white 
paper, ICI recommends changes to create a regulatory framework 
that enhances regulatory efficiency, limits duplication, closes 
regulatory gaps, and emphasizes the national character of the 
financial services industry. In brief, ICI supports:

   LCreating a consolidated Capital Markets Regulator, 
        as discussed above;

   LEstablishing a ``Systemic Risk Regulator'' that 
        would identify, monitor and manage risks to the 
        financial system as a whole;

   LConsidering consolidation of the regulatory 
        structure for the banking sector;

   LAuthorizing an optional Federal charter for 
        insurance companies; and

   LPromoting effective coordination and information 
        sharing among the various financial regulators, 
        including in particular the new Systemic Risk 
        Regulator.

    Increased consolidation of financial services regulators, 
combined with the establishment of a Systemic Risk Regulator 
and more robust inter-agency coordination and information 
sharing, should facilitate monitoring and mitigation of risks 
across the financial system. We believe that consolidation of 
regulatory agencies also may further the competitive posture of 
the U.S. financial markets and could make it easier, when 
appropriate, to harmonize U.S. regulations with regulations in 
other jurisdictions. Reducing the number of U.S. regulatory 
agencies, while also strengthening the culture of cooperation 
and dialogue among senior officials of the agencies, will 
likely facilitate coordinated interaction with regulators 
around the world.
    By providing for one or more dedicated regulators to 
oversee each major financial services sector, this proposed 
structure would maintain the specialized focus and expertise 
that is a hallmark of effective regulation. This structure also 
would allow appropriate tailoring of regulation to accommodate 
fundamental differences in regulated entities, products and 
activities. Additionally, it would avoid the potential for one 
industry sector to take precedence over the others in terms of 
regulatory priorities or approaches or the allocation of 
regulatory resources.
    In particular, the regulatory structure favored by ICI 
would preserve the important distinctions between the mission 
of the Capital Markets Regulator (or SEC), which is sharply 
focused on investor protection, and that of the banking 
regulators, which is principally concerned with the safety and 
soundness of the banking system. Both regulatory approaches 
have a critical role to play in ensuring a successful and 
vibrant financial system, but neither should be allowed to 
trump the other. For this reason, we believe it would be 
inappropriate to combine the SEC into a larger ``prudential'' 
financial services regulator, a move that could result in 
diminished investor protections.
    Preserving regulatory balance, and bringing to bear 
different perspectives, is a theme that has influenced ICI's 
thinking on how to structure a Systemic Risk Regulator. In our 
white paper, we suggested that very careful consideration must 
be given to the specifics of how a Systemic Risk Regulator 
would be authorized to perform its functions. We offered two 
important cautions in that regard. First, we recommended that 
the legislation establishing the Systemic Risk Regulator should 
be crafted to avoid imposing undue constraints or inapposite 
forms of regulation on normally functioning elements of the 
financial system, or stifling innovations, competition or 
efficiencies. Second, we recommended that the Systemic Risk 
Regulator should not be structured to simply add another layer 
of bureaucracy or to displace the primary regulator(s) 
responsible for capital markets, banking, or insurance.
    Legislation establishing the Systemic Risk Regulator thus 
should define the nature of the relationship between this new 
regulator and the primary regulator(s) for each industry 
sector. This should involve carefully defining the extent of 
the authority granted to the Systemic Risk Regulator, as well 
as identifying circumstances under which the Systemic Risk 
Regulator and primary regulator(s) should coordinate their 
efforts and work together. We believe, for example, that the 
primary regulators have a critical role to play by acting as 
the first line of defense with regard to detecting potential 
risks within their spheres of expertise.
    In view of the two cautions outlined above, ICI believes 
that the Systemic Risk Regulator would be best structured as a 
statutory council comprised of senior Federal regulators. 
Membership should include, at a minimum, the Secretary of the 
Treasury, Chairman of the Federal Reserve Board of Governors, 
and the heads of the Federal bank and capital markets 
regulators (and insurance regulator, if one emerges at the 
Federal level).
    Finally, we note that the question requests comment on 
whether some of the SEC's duties should be given to a financial 
services consumer protection agency. As a general matter, we 
observe that Federal regulators must improve their ability to 
keep up with new market developments. This will require both 
nimbleness at the regulatory level and Congressional 
willingness to close regulatory gaps, provide new authority 
where appropriate, and even provide additional resources. ICI 
does not believe, however, that it would be helpful to create a 
new ``financial products safety commission'' or ``financial 
services consumer protection agency.'' Financial products and 
services arise and exist in the context of a larger 
marketplace, and they need to be understood in that context. 
The primary regulator is best positioned to perform this 
function.

Q.9. SEC Staffing, Funding, and Management: The SEC has a staff 
of about 3,500 full-time employees and a budget of $900 
million. It has regulatory responsibilities with respect to 
approximately: 12,000 public companies whose securities are 
registered with it; 11,300 investment advisers; 950 mutual fund 
complexes; 5,500 broker-dealers (including 173,000 branch 
offices and 665,000 registered representatives); 600 transfer 
agents, 11 exchanges; 5 clearing agencies; 10 nationally 
recognized statistical rating organizations; SROs such as the 
Financial Industry Regulatory Authority, the Municipal 
Securities Rulemaking Board and the Public Company Accounting 
Oversight Board.
    To perform its mission effectively, do you feel that the 
SEC is appropriately staffed? funded? managed? How would you 
suggest that the Congress could improve the effectiveness of 
the SEC?

A.9. Investment companies (funds) are both major holders of 
securities issued by public companies and issuers of securities 
(fund shares) that are held by almost half of all U.S. 
households. As such, they have a vested interest in effective 
regulation of the capital markets by a strong and independent 
regulator. Funds, and therefore their shareholders, stand to 
benefit if that regulator has the tools it needs to fulfill 
important policy objectives, such as: preserving the integrity 
of the capital markets; ensuring the adequacy and accuracy of 
periodic disclosures by public issuers; and promoting fund 
regulation that protects our investors, encourages innovation, 
and does not hinder market competition.
    As discussed in our March 3, 2009, white paper, Financial 
Services Regulatory Reform: Discussion and Recommendations, 
\39\ ICI supports the creation of a new Capital Markets 
Regulator that would encompass the combined functions of the 
Securities and Exchange Commission (SEC) and the Commodity 
Futures Trading Commission (CFTC). The white paper makes a 
series of recommendations--including several concerning the 
staffing, funding, and management of the Capital Markets 
Regulator--aimed at maximizing this regulator's ability to 
perform its mission effectively. Pending, or in the absence of, 
Congressional action to create a Capital Markets Regulator, 
most of our recommendations just as appropriately could be 
applied to the SEC. An outline of those recommendations is 
included in the response below. Where appropriate for ease of 
discussion, we use the term ``agency'' to refer equally to the 
SEC or a new Capital Markets Regulator.
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     \39\ See Financial Services Regulatory Reform: Discussion and 
Recommendations, which is available at http://www.ici.org/pdf/
ppr_09_reg_reform.pdf. We note that the white paper was included as an 
attachment to ICI's written testimony.
---------------------------------------------------------------------------
    Agency Funding, and Staffing: ICI consistently has called 
for adequate funding for the SEC in order to support its 
critical regulatory functions. We note that, in testimony 
before the House Financial Services Committee in March of this 
year, SEC Commissioner Elisse Walter stated that the SEC's 
examination and enforcement resources are inadequate to keep 
pace with the growth and innovation in the securities markets. 
\40\ We believe that Congress must seriously consider any 
suggestion from senior SEC officials that additional resources 
are required. We were pleased, therefore, to hear about the 
recent bipartisan effort, led by Senators Charles Schumer (D-
NY) and Richard Shelby (R-AL) and endorsed by SEC Chairman Mary 
Schapiro, to increase the SEC's budget by $20 million for 
fiscal years 2010 and 2011 in order to add enforcement staff 
and fund needed technology upgrades.
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     \40\ See Testimony of Elisse B. Walter, Commissioner, U.S. 
Securities and Exchange Commission, Before the House Committee on 
Financial Services, Concerning Securities Law Enforcement in the 
Current Financial Crisis (March 20, 2009) at 30-31.
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    ICI believes that the agency also must have greater ability 
(and resources) to attract and retain professional staff having 
significant prior industry experience. Their practical 
perspectives would enhance the agency's ability to keep current 
with market and industry developments and better understand the 
impact of such developments on regulatory policy. The SEC's 
announcement of a new Industry and Market Fellows Program is an 
encouraging step in the right direction. \41\ As discussed 
further below, the agency also should build strong economic 
research and analytical capabilities and should consider having 
economists resident in each division.
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     \41\ See SEC Announces New Initiative to Identify and Assess Risks 
in Financial Markets (April 30, 2009), available at http://www.sec.gov/
news/press/2009/2009-98.htm
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    Examination of the recent financial crisis has prompted 
calls for Congress to close regulatory gaps to ensure 
appropriate oversight of all market participants and investment 
products. In our white paper, we recommend that the Capital 
Markets Regulator (or SEC) have express regulatory authority to 
provide oversight with regard to hedge funds, derivatives, and 
municipal securities. To the extent that the scope of the 
agency's responsibilities is expanded, it will be imperative 
that it have sufficient staffing and resources to effectively 
perform all of its oversight functions.
    Agency Management and Organization: How a regulatory agency 
is managed, and the details of its organizational structure, 
can have significant implications for the agency's 
effectiveness. In our white paper, we offer the following 
suggestions with regard to agency management and organization.

   LEnsure high-level focus on agency management. One 
        approach would be to designate a Chief Operating 
        Officer for this purpose.

   LImplement a comprehensive process for setting 
        regulatory priorities and assessing progress. It may be 
        helpful to draw upon the experience of the United 
        Kingdom's Financial Services Authority, which seeks to 
        follow a methodical approach that includes developing a 
        detailed annual business plan establishing agency 
        priorities and then reporting annually the agency's 
        progress in meeting prescribed benchmarks.

   LPromote open and effective lines of communication 
        among the Commissioners and between the Commissioners 
        and staff. Such communication is critical to fostering 
        awareness of issues and problems as they arise, thus 
        increasing the likelihood that the agency will be able 
        to act promptly and effectively. A range of approaches 
        may be appropriate to consider in meeting this goal, 
        including whether sufficient flexibility is provided 
        under the Government in the Sunshine Act, and whether 
        the number of Commissioners should be greater than the 
        current number at the SEC (five).

   LAlign the inspections and examinations functions 
        and the policymaking divisions. This approach would 
        have the benefit of keeping staff in the policymaking 
        divisions updated on current market and industry 
        developments, as well as precluding any de facto 
        rulemaking by the agency's inspections staff.

   LDevelop mechanisms to facilitate coordination and 
        information sharing among the policymaking divisions. 
        These mechanisms would help to ensure that the agency 
        speaks with one voice.

    Improving Agency Effectiveness: Our white paper recommends 
the following additional ways to enhance the agency's ability 
to fulfill its mission successfully when carrying out its 
regulatory responsibilities:

  1. LEstablish the conditions necessary for constructive, 
        ongoing dialogue with the regulated industry: The 
        agency should seek to facilitate closer, cooperative 
        interaction with the entities it regulates to identify 
        and resolve problems, to determine the impact of 
        problems or practices on investors and the market, and 
        to cooperatively develop best practices that can be 
        shared broadly with market participants. Incorporating 
        a more preventative approach would likely encourage 
        firms to step forward with self-identified problems and 
        proposed resolutions. The net result is that the agency 
        would pursue its investor protection responsibilities 
        through various means not always involving enforcement 
        measures, although strong enforcement must remain an 
        important weapon in the agency's arsenal.

  2. LEstablish mechanisms to stay abreast of market and 
        industry developments: The agency would benefit from 
        the establishment of one or more external mechanisms 
        designed to help it stay abreast of market and industry 
        issues and developments, including developments and 
        practices in non-U.S. jurisdictions as appropriate. For 
        example, several Federal agencies--including both the 
        SEC and CFTC--utilize a range of advisory committees. 
        Such committees, which generally have significant 
        private sector representation, may be established to 
        provide recommendations on a discrete set of issues 
        facing the agency (e.g., the SEC's Advisory Committee 
        on Improvements to Financial Reporting) or to provide 
        regular information and guidance to the agency (e.g., 
        the CFTC's Agricultural Advisory Committee).

    LICI believes that a multidisciplinary ``Capital Markets 
        Advisory Committee'' could be a very effective 
        mechanism for providing the agency with ``real world'' 
        perspectives and insights on an ongoing basis. We 
        recommend that such a committee be comprised primarily 
        of private sector representatives from all major 
        sectors of the capital markets, and include one or more 
        members representing funds and asset managers. 
        Additionally, the Capital Markets Advisory Committee 
        should be specifically established in, and required by, 
        legislation. Such a statutory mandate would emphasize 
        the importance of this advisory committee to the 
        agency's successful fulfillment of its mission.

    LThe establishment of an advisory committee would 
        complement other efforts by the agency to monitor 
        developments affecting the capital markets and market 
        participants. These efforts should include, first and 
        foremost, hiring more staff members with significant 
        prior industry experience. As indicated above, their 
        practical perspectives would enhance the agency's 
        ability to keep current with market and industry 
        developments and better understand the impact of such 
        developments on regulatory policy.

  3. LApply reasonably comparable regulation to like products 
        and services: Different investment products often are 
        subject to different regulatory requirements, often 
        with good reason. At times, however, heavier regulatory 
        burdens have been placed on some investment products or 
        services than on others, even where they share similar 
        features and are sold to the same customer base. It 
        does not serve investors well if the regulatory 
        requirements placed on funds--which serve over 93 
        million investors--end up discouraging investment 
        advisers from entering or remaining in the fund 
        business, dissuading portfolio managers from managing 
        funds as opposed to other investment products, or 
        creating disincentives for brokers and other 
        intermediaries to sell fund shares. It is critically 
        important for the agency to be sensitive to this 
        dynamic in its rulemakings.

    LAmong other things, in analyzing potential new regulatory 
        requirements for funds or in other situations as 
        appropriate, the agency should consider whether other 
        investment products raise similar policy concerns and 
        thus should be subject to comparable requirements. In 
        this regard, we note that separately managed accounts 
        sometimes are operated much like mutual funds and other 
        investment companies and yet do not offer the same 
        level of investor protection. For example, as the 
        fallout from the Ponzi scheme perpetrated by Bernard 
        Madoff has highlighted, separately managed accounts are 
        not subject to all of the restrictions on custody 
        arrangements that serve to protect fund assets, and 
        existing rules leave room for abuse. \42\
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     \42\ The SEC has scheduled an open meeting on May 14, 2009, at 
which it will consider proposed rule amendments designed to enhance the 
protections provided to advisory clients when they entrust their funds 
and securities to an investment adviser. The SEC's meeting announcement 
indicates that if adopted, the amendments would require investment 
advisers having custody of client funds and securities to obtain a 
surprise examination by an independent public accountant, and, unless 
the client assets are maintained with an independent custodian, obtain 
a review of custodial controls from an independent public accountant. 
See SEC News Digest (May 7, 2009), available at http://www.sec.gov/
news/digest/2009/dig050709.htm

  4. LDevelop strong capability to conduct economic analysis to 
        support sound rulemaking and oversight: The agency will 
        be best positioned to accomplish its mission if it 
        conducts economic analysis in various aspects of the 
        agency's work, including rulemaking, examinations, and 
        enforcement. Building strong economic research and 
        analytical capabilities is an important way to enhance 
        the mix of disciplines that will inform the agency's 
        activities. From helping the agency look at broad 
        trends that shed light on how markets or individual 
        firms are operating to enabling it to demonstrate that 
        specific policy initiatives are well-grounded, 
        developing the agency's capability to conduct economic 
        analysis will be well worth the long-term effort 
        required. The agency should consider having economists 
        resident in each division to bring additional, 
        important perspectives to bear on regulatory 
---------------------------------------------------------------------------
        challenges.

    LIt is important that economic analysis play an integral 
        role in the rulemaking process, because many regulatory 
        costs ultimately are borne by investors. When new 
        regulations are required, or existing regulations are 
        amended, the agency should thoroughly examine all 
        possible options and choose the alternative that 
        reflects the best trade-off between costs to, and 
        benefits for, investors. Effective cost benefit 
        analysis does not mean compromising protections for 
        investors or the capital markets. Rather, it challenges 
        the regulator to consider alternative proposals and 
        think creatively to achieve appropriate protections 
        while minimizing regulatory burdens, or to demonstrate 
        that a proposal's costs and burdens are justified in 
        light of the nature and extent of the benefits that 
        will be achieved. \43\
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     \43\ See, e.g., Special Report on Regulatory Reform, Congressional 
Oversight Panel (submitted under Section 125(b)(2) of Title I of the 
Emergency Economic Stabilization Act of 2008) (Jan. 2009) (``In 
tailoring regulatory responses . . . the goal should always be to 
strike a reasonable balance between the costs of regulation and its 
benefits. Just as speed limits are more stringent on busy city streets 
than on open highways, financial regulation should be strictest where 
the threats-especially the threats to other citizens--are greatest, and 
it should be more moderate elsewhere.'').

  5. LModernize regulations that no longer reflect current 
        market structures and practices: Financial markets and 
        related services are constantly evolving, frequently at 
        a pace that can make the regulations governing them (or 
        the rationale behind those regulations) become less 
        than optimal, if not entirely obsolete. Requiring 
        industry participants to comply with outmoded 
        regulations imposes unnecessary costs on both firms and 
        investors, may impede innovation, and, most troubling 
        of all, could result in inadequate protection of 
        investors. It is thus important that the agency engage 
        in periodic reviews of its existing regulations to 
        determine whether any such regulations should be 
---------------------------------------------------------------------------
        modernized or eliminated.

  6. LGive heightened attention to investor education: The 
        recent turmoil in the financial markets has underscored 
        how important it is that investors be knowledgeable and 
        understand their investments. Well-informed investors 
        are more likely to develop realistic expectations, take 
        a long-term perspective, and understand the trade-off 
        between risk and reward. They are less likely to panic 
        and make mistakes.

    LTo better equip investors to make good decisions about 
        their investments, the agency should assign a high 
        priority to pursuing regulatory initiatives that will 
        help educate investors. The SEC has an Office of 
        Investor Education and Advocacy and provides some 
        investor education resources on its Web site. These 
        types of efforts should be expanded, possibly in 
        partnership with other governmental or private 
        entities, and better publicized. Many industry 
        participants, too, have developed materials and other 
        tools to help educate investors; additional investor 
        outreach efforts should be encouraged.

Q.10. Systemic Risk Regulatory Structure: You have put forth 
the idea of a systemic risk regulator that is organized as a 
committee of financial regulatory heads. Could you please 
elaborate on the structure and organization of such a systemic 
risk regulatory you are suggesting? Also, please describe the 
positives and negatives of such an arrangement and the reasons 
why it would be superior to other possibilities.

A.10. In light of the financial crisis, it is imperative that 
Congress establish in statute responsibility to address risks 
to the financial system at large. For certain specific and 
identifiable purposes, such as assuring effective consolidated 
global supervision of the largest bank holding companies and 
overseeing the robust functioning of the payment and settlement 
system as appropriate, this systemic risk management 
responsibility might be lodged with the Federal Reserve Board. 
Beyond this context, however, I recommend that systemic risk 
management responsibility should be assigned to a statutory 
council comprised of senior Federal regulators.
    In concept, such a council would be similar to the National 
Security Council (NSC), which was established by the National 
Security Act of 1947. In the aftermath of World War II, 
Congress recognized the need to assure better coordination and 
integration of ``domestic, foreign, and military policies 
relating to the national security'' and the ongoing assessment 
of ``policies, objectives, and risks.'' The 1947 Act 
established the NSC under the President as a Cabinet-level 
council with a dedicated staff. In succeeding years, the NSC 
has proved to be a key mechanism utilized by Presidents to 
address the increasingly complex and multi-faceted challenges 
of national security policy. It was my honor from 1987-89 to 
serve as statutory head (i.e., Executive Secretary) of the NSC.
    As with national security, addressing risks to the 
financial system at large requires, in my view, diverse inputs 
and perspectives. Membership of such a council accordingly 
should draw upon a broad base of expertise, and should include 
at a minimum the Secretary of the Treasury, Chairman of the 
Board of Governors of the Federal Reserve System, and the heads 
of the Federal bank and capital markets regulators (and 
insurance regulator, if one emerges at the Federal level). As 
with the NSC, flexibility should exist to enlist other 
regulators into the work of the council on specific issues as 
required--including, for example, State insurance regulators 
and self-regulatory organizations.
    By statute, the council should have a mandate to monitor 
conditions and developments in the domestic and international 
financial markets, to assess their implications for the health 
of the financial system at large, to identify regulatory 
actions to be taken to address systemic risks as they emerge, 
to assess the effectiveness of these actions, and to advise the 
President and the Congress on emerging risks and necessary 
legislative or regulatory responses. The council would be 
responsible for coordinating and integrating the national 
response to systemic financial risks, but it would not have a 
direct operating role (much as the NSC coordinates and 
integrates military and foreign policy that is implemented by 
the Defense or State Department and not by the NSC itself). 
Rather, responsibility for addressing identified risks would 
lie with the existing functional regulators, who would act 
pursuant to their normal statutory authorities but under the 
council's direction.
    The Secretary of the Treasury, as the senior-most member of 
the council, should be designated chairman. An executive 
director, appointed by the President, should run the day-to-day 
operations of the council and serve as head of the council's 
staff. The council should meet on a regular basis, with an 
interagency process coordinated through the council's staff to 
support and follow through on its ongoing deliberations.
    To accomplish its mission, the council should have the 
support of a dedicated, highly-experienced staff. The staff 
should represent a mix of disciplines (e.g., economics, finance 
and law) and should consist of individuals seconded from 
government departments and agencies (Federal and state), as 
well as recruited from the private sector with a business, 
professional or academic background. As with the NSC, the 
staff's focus would be to support the work of the council as 
such, and thus the staff would operate independently from the 
functional regulators. Nonetheless, the background and 
experience of the staff would help assure the kind of strong 
working relationships with the functional regulators necessary 
for the council's success. Such a staff could be recruited and 
at work in a relatively short period of time. The focus in 
recruiting such a staff should be on quality, not quantity, and 
the council's staff accordingly should not and need not be 
large.
    Such a council structure has many advantages to recommend 
it:

   LSystemic risks may arise in different ways and 
        affect different parts of the domestic and global 
        financial system. No existing agency or department has 
        a comprehensive frame of reference or the necessary 
        expertise to assess and respond to any and all such 
        risks. Creating such an all-purpose systemic risk 
        manager would be a long and complex undertaking, and 
        would involve developing expertise that duplicates that 
        which exists in today's functional regulators. The 
        council structure by contrast would enlist the 
        expertise of the entire regulatory community in 
        identifying and devising strategies to mitigate 
        systemic risks. It also could be established and begin 
        operation much more quickly.

   LThe council structure would avoid risks inherent in 
        the leading alternative that has been proposed--i.e., 
        designating an existing agency like the Federal Reserve 
        Board to serve as an all-purpose systemic risk 
        regulator. In this role, the Federal Reserve 
        understandably may tend to view risks and risk 
        mitigation through its lens as a bank regulator focused 
        on prudential regulation and ``safety and soundness'' 
        concerns, potentially to the detriment of consumer and 
        investor protection concerns and of non-bank financial 
        institutions. In my view, a council such as I have 
        outlined would bring all these competing perspectives 
        to bear and, as a result, would seem far more likely to 
        strike the proper balance.

   LSuch a council would provide a high degree of 
        flexibility in convening those Federal and State 
        regulators whose input and participation is necessary 
        to addressing a specific issue, without creating an 
        unwieldy or bureaucratic structure. As is the case with 
        the NSC, the council should have a core membership of 
        senior Federal officials and the ability to expand its 
        participants on an ad hoc basis when a given issue so 
        requires.

   LWith an independent staff dedicated solely to 
        pursuing the council's agenda, the council would be 
        well positioned to test or challenge the policy 
        judgments or priorities of various functional 
        regulators. Moreover, by virtue of their participation 
        on the council, the various functional regulators are 
        themselves likely to be more attentive to emerging 
        risks or regulatory gaps. This would help assure a far 
        more coordinated and integrated approach. Over time, 
        the council also would assist in identifying and 
        promoting political consensus about significant 
        regulatory gaps and necessary policy responses.

   LThe council model anticipates that functional 
        regulators, as distinct from the council itself, would 
        be charged with implementing regulations to mitigate 
        systemic risks as they emerge. This operational role is 
        appropriate because the functional regulators will have 
        the greatest in depth knowledge of their respective 
        regulated industries. Nonetheless, the council and its 
        staff will have an important independent role in 
        evaluating the effectiveness of the measures taken by 
        functional regulators to mitigate systemic risk and, 
        where necessary, in prompting further actions.

   LA potential criticism of the council structure is 
        that it may diffuse responsibility and pose 
        difficulties in assuring proper follow-through by the 
        functional regulators. I agree it is important that the 
        council have ``teeth,'' and this can be accomplished, 
        in crafting the legislation, through appropriate 
        amendments to the organic statutes governing the 
        functional regulators.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                    FROM PAUL SCHOTT STEVENS

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

A.1. In his March 10 speech to the Council on Foreign 
Relations, Chairman Bernanke suggested that policymakers should 
begin to think about ``reforms to the financial architecture, 
broadly conceived, that could help prevent a similar 
[financial] crisis from developing in the future.'' He further 
highlighted the need for ``a strategy that regulates the 
financial system as a whole, in a holistic way.'' ICI concurs 
with Chairman Bernanke that the four areas outlined in the 
question, and discussed in turn below, are key elements of such 
a strategy. It bears emphasizing that this list is not 
exclusive (and that Chairman Bernanke himself did not suggest 
otherwise). In ICI's view, other key elements of a reform 
strategy include consolidating and strengthening the primary 
regulators for each financial sector, and ensuring more 
effective coordination and information sharing among those 
regulators. These issues are addressed in detail in ICI's March 
3, 2009, white paper, Financial Services Regulatory Reform: 
Discussion and Recommendations. \1\
---------------------------------------------------------------------------
     \1\ See Financial Services Regulatory Reform: Discussion and 
Recommendations, which is available at http://www.ici.org/pdf/
ppr_09_reg_reform.pdf. We note that the white paper was included as an 
attachment to ICI's written testimony.
---------------------------------------------------------------------------
    ``Too big to fail'': ICI agrees that the notion of 
financial institutions that are too big or too interconnected 
to fail deserves careful attention. The financial crisis has 
highlighted how the activities of large financial institutions 
can have wide-ranging effects on the economy. It is incumbent 
upon policymakers and other interested parties to consider how 
best to mitigate the risks that the activities of large 
financial institutions can pose to the financial system as a 
whole.
    As part of this analysis, one issue is how to define what 
is meant by ``too big to fail.'' If it means that certain large 
financial institutions will receive either explicit or implicit 
Federal guarantees of their debt, such institutions will gain 
an unfair competitive advantage. Allowing these institutions to 
borrow at risk-free (or near risk-free) interest rates could 
encourage them to take excessive risks, and may cause them to 
grow faster than their competitors, both of which potentially 
would magnify systemic risks. Ultimately, U.S. taxpayers would 
bear the costs of such actions.
    Chairman Bernanke echoed these concerns in his March 10 
remarks. He described the undesirable effects if market 
participants believe that a firm is considered too big to fail, 
indicating that this belief:

        reduces market discipline and encourages excessive risk-taking 
        by the firm. It also provides an artificial incentive for firms 
        to grow, in order to be perceived as too big to fail. And it 
        creates an unlevel playing field with smaller firms, which may 
        not be regarded as having implicit government support. 
        Moreover, government rescues of too-big-to-fail firms can be 
        costly to taxpayers, as we have seen recently.

    Legislative or regulatory reforms aimed at addressing risks 
to the financial system posed by the activities of large and 
complex financial firms must be designed to avoid these 
results.
    Strengthening the Financial Infrastructure: ICI strongly 
concurs with Chairman Bernanke's comments about the need to 
strengthen the financial infrastructure, in order to improve 
the ability of the financial system to withstand future shocks 
and ``reduc[e] the range of circumstances in which systemic 
stability concerns might prompt government intervention.'' For 
example, we support current initiatives toward centralized 
clearing for credit default swaps (CDS). Central clearing 
should help reduce counterparty risk and bring transparency to 
trading in the types of CDS that can be standardized. Not all 
CDS are sufficiently standardized to be centrally cleared, 
however, and institutional investors will continue to need to 
conduct over-the-counter transactions in CDS. For those 
transactions, we support reasonable reporting requirements, in 
order to ensure that regulators have enough data on the CDS 
market to provide effective oversight. In addition, we would be 
generally supportive of efforts to improve the market for 
repurchase agreements. Steps such as those we have outlined may 
serve to deepen the relevant markets, encourage buyers and 
sellers to continue to transact during times of market turmoil 
and, in particular, help foster greater price transparency.
    We further concur with Chairman Bernanke's assessment of 
the importance of money market funds--particularly their 
``crucial role'' in the commercial paper market and as a 
funding source for businesses--and his call for policymakers to 
consider ``how to increase the resiliency of those funds that 
are susceptible to runs.'' Similarly, Treasury Secretary 
Geithner has outlined the Administration's position on systemic 
risk and called for action in six areas, including the adoption 
of new requirements for money market funds to reduce the risk 
of rapid withdrawals. In this regard, ICI and its members, 
working through our Money Market Working Group, recently issued 
a comprehensive report outlining a range of measures to 
strengthen money market funds and help them withstand difficult 
market conditions in the future. \2\ More specifically, the 
Working Group's recommendations are designed to strengthen and 
preserve the unique attributes of a money market fund as a low-
cost, efficient cash management tool that provides a high 
degree of liquidity, stability in principal value, and a 
market-based yield. The proposed standards and regulations 
would ensure that money market funds are better positioned to 
sustain prolonged and extreme redemption pressures and that 
mechanisms are in place to ensure that all shareholders are 
treated fairly if a fund sees its net asset value fall below 
$1.00.
---------------------------------------------------------------------------
     \2\ See Report of the Money Market Working Group, Investment 
Company Institute (March 17, 2009), available at http://www.ici.org/
pdf/ppr_09_mmwg.pdf
---------------------------------------------------------------------------
    Secretary Geithner specifically identified the SEC as the 
agency to implement any new requirements for money market 
funds. ICI wholeheartedly concurs that the SEC, as the primary 
regulator for money market funds, is uniquely qualified to 
evaluate and implement potential changes to the existing scheme 
of money market fund regulation. SEC Chairman Shapiro and 
members of her staff have indicated on several occasions that 
her agency is currently conducting such a review on an 
expedited basis, and we are pleased that the review will 
include consideration of the Working Group's recommendations.
    Preventing Excessive Procyclicality: Some financial 
institutions have criticized the use of mark-to-market 
accounting in the current environment as overstating losses, 
diminishing bank capital, and exacerbating the crisis. Others 
have applauded its use as essential in promptly revealing the 
extent of problem assets and the deteriorating financial 
condition of institutions. Investment companies, as investors 
in securities, rely upon financial reporting that accurately 
portrays the results and financial position of companies 
competing for investment capital. ICI supports the work of the 
Financial Accounting Standards Board and its mission to develop 
financial reporting standards that provide investors with 
relevant, reliable and transparent information about corporate 
financial performance. Certainly, regulatory policies and 
accounting rules should not induce excessive procyclicality. At 
the same time, accounting standards should not be modified to 
achieve any objective other than fair and accurate reporting to 
investors and the capital markets. Any concerns regarding the 
procyclical effects of mark-to-market accounting on lending 
institutions' capital may be better addressed through changes 
to capital standards themselves. Consideration should be given 
to, for example, developing countercyclical capital standards 
and requiring depositaries and other institutions to build up 
capital more amply in favorable market conditions and thus 
position themselves to weather unfavorable conditions more 
easily.
    Monitoring and Addressing Systemic Risk: Over the past 
year, various policymakers and other commentators have called 
for the establishment of a formal mechanism for identifying, 
monitoring, and managing risks to the financial system as a 
whole. ICI concurs with those commentators that creation of 
such a mechanism is necessary. The ongoing financial crisis has 
highlighted the vulnerability of our financial system to risks 
that have the potential to spread rapidly throughout the system 
and cause significant damage. A mechanism that will allow 
Federal regulators to look across the system should equip them 
to better anticipate and address such risks.
    In its recent white paper on regulatory reform, ICI 
endorsed the designation of a new or existing agency or inter-
agency body as a ``Systemic Risk Regulator.'' Broadly stated, 
the goal in establishing a Systemic Risk Regulator should be to 
provide greater overall stability to the financial system as a 
whole. The Systemic Risk Regulator should have responsibility 
for: (1) monitoring the financial markets broadly; (2) 
analyzing changing conditions in domestic and overseas markets; 
(3) evaluating the risks of practices as they evolve and 
identifying those that are of such nature and extent that they 
implicate the health of the financial system at large; and (4) 
acting to mitigate such risks in coordination with other 
responsible regulators.
    In ICI's view, Congress should determine the composition 
and authority of the Systemic Risk Regulator with two important 
cautions in mind. First, the legislation establishing the 
Systemic Risk Regulator should be crafted to avoid imposing 
undue constraints or inapposite forms of regulation on normally 
functioning elements of the financial system, or stifling 
innovations, competition or efficiencies. Second, the Systemic 
Risk Regulator should not be structured to simply add another 
layer of bureaucracy or to displace the primary regulator(s) 
responsible for capital markets, banking or insurance. Rather, 
the Systemic Risk Regulator should focus principally on 
protecting the financial system--as discussed in detail in our 
white paper, we believe that a strong and independent Capital 
Markets Regulator (or, until such agency is established by 
Congress, the SEC) should focus principally on the equally 
important mandates of protecting investors and maintaining 
market integrity.
    Legislation establishing the Systemic Risk Regulator should 
define the nature of the relationship between this new 
regulator and the primary regulator(s) for each industry 
sector. This should involve carefully defining the extent of 
the authority granted to the Systemic Risk Regulator, as well 
as identifying circumstances under which the Systemic Risk 
Regulator and primary regulator(s) should coordinate their 
efforts and work together. We believe, for example, that the 
primary regulators have a critical role to play by acting as 
the first line of defense with regard to detecting potential 
risks within their spheres of expertise.
    We recognize that it may be appropriate, for example, to 
lodge responsibility for ensuring effective consolidated global 
supervision of the largest bank holding companies with a 
designated regulator such as the Federal Reserve Board. Beyond 
this context, however, and in view of the two cautions outlined 
above, ICI believes that responsibility for systemic risk 
management more broadly should be assigned to a Systemic Risk 
Regulator structured as a statutory council comprised of senior 
Federal regulators. Membership should include, at a minimum, 
the Secretary of the Treasury, Chairman of the Federal Reserve 
Board of Governors, and the heads of the Federal bank and 
capital markets regulators (and insurance regulator, if one 
emerges at the Federal level).

Q.2. Would a merger or rationalization of the roles of the SEC 
and CFTC be a valuable reform, and how should that be 
accomplished?

A.2. Establishment of a New Capital Markets Regulator: ICI 
strongly believes that a merger or rationalization of the roles 
of the Securities and Exchange Commission (SEC) and Commodity 
Futures Trading Commission (CFTC) would be a valuable reform. 
Currently, securities and futures are subject to separate 
regulatory regimes under different Federal regulators. This 
system reflects historical circumstances that have changed 
significantly. As recently as the mid-1970s, for example, 
agricultural products accounted for most of the total U.S. 
futures exchange trading volume. By the late 1980s, a shift 
from the predominance of agricultural products to financial 
instruments and currencies was readily apparent in the volume 
of trading on U.S. futures exchanges. In addition, as new, 
innovative financial instruments were developed, the lines 
between securities and futures often became blurred. The 
existing, divided regulatory approach has resulted in 
jurisdictional disputes, regulatory inefficiency, and gaps in 
investor protection and market oversight. With the increasing 
convergence of securities and futures products, markets, and 
market participants, the current system simply makes no sense. 
To bring a consistent policy focus to U.S. capital markets, ICI 
strongly recommends the creation of a Capital Markets Regulator 
as a new agency that would encompass the combined functions of 
the SEC and those of the CFTC that are not agriculture-related.
    As the Federal regulator responsible for overseeing all 
financial investment products, it is imperative that the 
Capital Markets Regulator--like the SEC and the CFTC--be 
established by Congress as an independent agency, with an 
express statutory mission and the rulemaking and enforcement 
powers necessary to carry out that mission. A critical part of 
that mission should be for the new agency to maintain a sharp 
focus on investor protection and law enforcement. And Congress 
should ensure that the agency is given the resources it needs 
to fulfill its mission. Most notably, the Capital Markets 
Regulator must have the ability to attract personnel with the 
necessary market experience to fully grasp the complexities of 
today's global marketplace.
    To preserve regulatory efficiencies achieved under the 
National Securities Markets Improvement Act of 1996, Congress 
should affirm the role of the Capital Markets Regulator as the 
regulatory standard setter for all registered investment 
companies. ICI further envisions the Capital Markets Regulator 
as the first line of defense with respect to identifying and 
addressing risks across the capital markets. The new agency 
should be granted explicit authority to regulate in certain 
areas where there are currently gaps in regulation--in 
particular, with regard to hedge funds, derivatives, and 
municipal securities--and explicit authority to harmonize the 
legal standards applicable to investment advisers and 
brokerdealers. These areas are discussed in greater detail in 
ICI's March 3, 2009, white paper, Financial Services Regulatory 
Reform: Discussion and Recommendations. \3\
---------------------------------------------------------------------------
     \3\ See Financial Services Regulatory Reform: Discussion and 
Recommendations, which is available at http://www.ici.org/pdf/
ppr_09_reg_reform.pdf. We note that the white paper was included as an 
attachment to ICI's written testimony.
---------------------------------------------------------------------------
    Organization and Management of the Capital Markets 
Regulator: In the private sector, a company's success is 
directly related to the soundness of its management. The same 
principle holds true for public sector entities. Establishing a 
new agency presents a very valuable opportunity to ``get it 
right'' as part of that process. There is also an opportunity 
to make sound decisions up-front about how to organize the new 
agency. In so doing, it is important not to simply use the 
current structure of the SEC and/or the CFTC as a starting 
point. The SEC's current organizational structure, for example, 
largely took shape in the early 1970s and reflects the 
operation of the securities markets of that day. Rather, the 
objective should be to build an organization that not only is 
more reflective of today's markets, market participants and 
investment products, but also will be flexible enough to 
regulate the markets and products of tomorrow.
    ICI offers the following thoughts with regard to 
organization and management of the Capital Markets Regulator:

   LEnsure high-level focus on agency management. One 
        approach would be to designate a Chief Operating 
        Officer for this purpose.

   LImplement a comprehensive process for setting 
        regulatory priorities and assessing progress. It may be 
        helpful to draw upon the experience of the United 
        Kingdom's Financial Services Authority, which seeks to 
        follow a methodical approach that includes developing a 
        detailed annual business plan establishing agency 
        priorities and then reporting annually the agency's 
        progress in meeting prescribed benchmarks.

   LPromote open and effective lines of communication 
        among the regulator's Commissioners and between its 
        Commissioners and staff. Such communication is critical 
        to fostering awareness of issues and problems as they 
        arise, thus increasing the likelihood that the 
        regulator will be able to act promptly and effectively. 
        A range of approaches may be appropriate to consider in 
        meeting this goal, including whether sufficient 
        flexibility is provided under the Government in the 
        Sunshine Act, and whether the number of Commissioners 
        should be greater than the current number at the SEC 
        and at the CFTC (currently, each agency has five).

   LAlign the inspections and examinations functions 
        and the policymaking divisions. This approach would 
        have the benefit of keeping staff in the policymaking 
        divisions updated on current market and industry 
        developments, as well as precluding any de facto 
        rulemaking by the regulator's inspections staff.

   LDevelop mechanisms to facilitate coordination and 
        information sharing among the policymaking divisions. 
        These mechanisms would help to ensure that the 
        regulator speaks with one voice.

    Process of Merging the SEC and CFTC: Legislation to merge 
the SEC and CFTC should outline a process by which to harmonize 
the very different regulatory philosophies of the two agencies, 
as well as to rationalize their governing statutes and current 
regulations. There is potential peril in leaving open-ended the 
process of merging the two agencies. ICI accordingly recommends 
that the legislation creating the Capital Markets Regulator set 
forth a specific timetable, with periodic benchmarks and 
accountability requirements, to ensure that the merger of the 
SEC and CFTC is completed as expeditiously as possible.
    The process of merging the two agencies will be lengthy, 
complex, and have the potential to disrupt the functioning of 
the SEC, CFTC, and their regulated industries. ICI suggests 
that, in anticipation of the merger, the SEC and CFTC undertake 
detailed consultation on all relevant issues and take all steps 
possible toward greater harmonization of the agencies. This 
work should be facilitated by the Memorandum of Understanding 
the two agencies signed last year regarding coordination in 
areas of common regulatory interest. \4\ ICI believes that its 
recommendations with respect to the Capital Markets Regulator, 
outlined in detail in its white paper, may provide a helpful 
framework for these efforts.
---------------------------------------------------------------------------
     \4\ See SEC, CFTC Sign Agreement to Enhance Coordination, 
Facilitate Review of New Derivative Products (SEC press release dated 
March 11, 2008), available at http://www.sec.gov/news/press/2008/2008-
40.htm

Q.3. How is it that AIG was able to take such large positions 
that it became a threat to the entire Financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
---------------------------------------------------------------------------
risk management, or some combination?

A.3. ICI does not have particular insight to offer with regard 
to AIG, the size of its positions in credit default swaps 
(CDS), and the effect that those positions ultimately had on 
the broader financial markets. Nevertheless, our sense is that 
the answers lie in a combination of all the factors outlined 
above. We note that Congress seems poised to establish a 
bipartisan commission to investigate the causes of the current 
financial crisis. A thorough examination of what happened with 
AIG would no doubt be a very useful part of the commission's 
inquiry.
    With regard to CDS generally, ICI believes that a single 
independent Federal regulator for capital markets should have 
clear authority to adopt measures to increase transparency and 
reduce counterparty risk, while not unduly stifling innovation. 
\5\ We support current initiatives toward centralized clearing 
for CDS, which should help to reduce counterparty risk and 
bring transparency to trading in the types of CDS that can be 
standardized. Not all CDS are sufficiently standardized to be 
centrally cleared, however, and institutional investors will 
continue to need to conduct over-the counter transactions in 
CDS. For those transactions, we support reasonable reporting 
requirements, in order to ensure that regulators have enough 
data on the CDS market to provide effective oversight. Finally, 
we believe that all institutional market participants should be 
required to periodically disclose their CDS positions publicly, 
as funds are currently required to do.
---------------------------------------------------------------------------
     \5\ In our March 3, 2009 white paper, Financial Services 
Regulatory Reform: Discussion and Recommendations (which is available 
at http://www.ici.org/pdf/ppr_09_reg_reform.pdf), ICI recommended the 
creation of a Capital Markets Regulator as a new agency that would 
encompass the combined functions of the SEC and those of the CFTC that 
are not agriculture-related. To the extent that no Capital Markets 
Regulator is formed, we believe that the SEC is the regulator best 
suited to provide effective oversight of financial derivatives, 
including CDS.

Q.4. How should we update our rules and guidelines to address 
---------------------------------------------------------------------------
the potential failure of a systematically critical firm?

A.4. Experience during the financial crisis has prompted calls 
to establish a better process for dealing with large, 
diversified financial institutions whose solvency problems 
could have significant adverse effects on the financial system 
or the broader economy. Depository institutions already have in 
place a resolution framework administered by the Federal 
Deposit Insurance Corporation. In contrast, other 
``systemically important'' financial institutions facing 
insolvency either have to rely on financial assistance from the 
government (as was the case with AIG) or file for bankruptcy 
(as was the case with Lehman Brothers).
    The Treasury Department has expressed concern that these 
``options do not provide the government with the necessary 
tools to manage the resolution of [a financial institution] 
efficiently and effectively in a manner that limits systemic 
risk with the least cost to the taxpayer.'' \6\ Treasury has 
sent draft legislation to Congress that is designed to address 
this concern. The legislation would authorize the FDIC to take 
a variety of actions (including appointing itself as 
conservator or receiver) with respect to a ``financial 
company'' if the Treasury Secretary, in consultation with the 
President and based on the written recommendation of the 
Federal Reserve Board and the ``appropriate Federal regulatory 
agency,'' makes a systemic risk determination concerning that 
company.
---------------------------------------------------------------------------
     \6\ See Treasury Proposes Legislation for Resolution Authority 
(March 25, 2009), available at http://www.treas.gov/press/releases/
tg70.htm
---------------------------------------------------------------------------
    ICI agrees that it would be helpful to establish rules 
governing the resolution of certain large, diversified 
financial institutions in order to minimize the impact of the 
potential failure of such an institution on the financial 
system and consumers as a whole. Such a resolution process 
could benefit investors, including investment companies (and 
their shareholders). The rules for a federally-facilitated wind 
down should be clearly established so that creditors and other 
market participants understand the process that will be 
followed and the likely ramifications. Uncertainty associated 
with ad hoc approaches that differ from one resolution to the 
next will be very destabilizing to the financial markets. Clear 
rules and a transparent process are critical to bolster 
confidence and avoid potentially creating reluctance on the 
part of market participants to transact with an institution 
that is perceived to be ``systemically important.''
    In determining which institutions might be subject to this 
resolution process, we recommend taking into consideration not 
simply ``size'' or the specific type of institution but 
critical factors such as the nature and extent of an 
institution's leverage and trading positions, the nature of its 
borrowing relationships, the amount of difficult-to-value 
assets on its books, its off-balance sheet liabilities, and the 
degree to which it engages in activities that are opaque or 
unregulated.
    More broadly, the reforms recommended in ICI's recent white 
paper, \7\ if enacted, would lead to better supervision of 
systemically critical financial institutions and would help 
avoid in the future the types of situations that have arisen in 
the financial crisis, such as the failure or near failure of 
systemically important firms. Our recommendations include:
---------------------------------------------------------------------------
     \7\ See Financial Services Regulatory Reform: Discussion and 
Recommendations, which is available at http://www.ici.org/pdf/
ppr_09_reg_reform.pdf. We note that the white paper was included as an 
attachment to ICI's written testimony.

   LEstablishing a ``Systemic Risk Regulator'' that 
        would identify, monitor and manage risks to the 
---------------------------------------------------------------------------
        financial system as a whole;

   LCreating a consolidated Capital Markets Regulator 
        that would encompass the combined functions of the 
        Securities and Exchange Commission and those of the 
        Commodity Futures Trading Commission that are not 
        agriculture-related;

   LConsidering consolidation of the regulatory 
        structure for the banking sector;

   LAuthorizing an optional Federal charter for 
        insurance companies; and

   LPromoting effective coordination and information 
        sharing among the various financial regulators.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                     FROM MERCER E. BULLARD

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets?
    Also, would you recommend more transparency for investors:

  1. LBy publicly held banks and other financial firms of off-
        balance sheet liabilities or other data?

  2. LBy credit rating agencies of their ratings methodologies 
        or other matters?

  3. LBy municipal issuers of their periodic financial 
        statements or other data?

  4. LBy publicly held banks, securities firms and GSEs of 
        their risk management policies and practices, with 
        specificity and timeliness?

A.1. Witness declined to respond to written questions for the 
record.

Q.2. Conflicts of Interest: Concerns about the impact of 
conflicts of interest that are not properly managed have been 
frequently raised in many contexts--regarding accountants, 
compensation consultants, credit rating agencies, and others. 
For example, Mr. Turner pointed to the conflict of the board of 
FINRA including representatives of firms that it regulates. The 
Millstein Center for Corporate Governance and Performance at 
the Yale School of Management in New Haven, Connecticut on 
March 2 proposed an industry-wide code of professional conduct 
for proxy services that includes a ban on a vote advisor 
performing consulting work for a company about which it 
provides recommendations.
    In what ways do you see conflicts of interest affecting the 
integrity of the markets or investor protection? Are there 
conflicts affecting the securities markets and its participants 
that Congress should seek to limit or prohibit?

A.2. Witness declined to respond to written questions for the 
record.

Q.3. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the nation's economy. Please summarize your 
recommendations on the best way to oversee these instruments.

A.3. Witness declined to respond to written questions for the 
record.

Q.4. Corporate Governance--Majority Vote for Directors, Proxy 
Access, Say on Pay: The Council of Institutional Investors, 
which represents public, union and corporate pension funds with 
combined assets that exceed $3 trillion, has called for 
``meaningful investor oversight of management and boards'' and 
in a letter dated December 2, 2008, identified several 
corporate governance provisions that ``any financial markets 
regulatory reform legislation [should] include.'' Please 
explain your views on the following corporate governance 
issues:

  1. LRequiring a majority shareholder vote for directors to be 
        elected in uncontested elections;

  2. LAllowing shareowners the right to submit amendment to 
        proxy statements;

  3. LAllowing advisory shareowner votes on executive cash 
        compensation plans.

A.4. Witness declined to respond to written questions for the 
record.

Q.5. Credit Rating Agencies: Please identify any legislative or 
regulatory changes you believe are warranted to improve the 
oversight of credit rating agencies.
    In addition, I would like to ask your views on two specific 
proposals:

  1. LThe Peterson Institute report on ``Reforming Financial 
        Regulation, Supervision, and Oversight'' recommended 
        reducing conflicts of interest in the major rating 
        agencies by not permitting them to perform consulting 
        activities for the firms they rate.

  2. LThe G30 Report ``Financial Reform; A Framework for 
        Financial Stability'' recommended that regulators 
        should permit users of ratings to hold NRSROs 
        accountable for the quality of their work product. 
        Similarly, Professor Coffee recommended creating 
        potential legal liability for recklessness when 
        ``reasonable efforts'' have not been made to verify 
        ``essential facts relied upon by its ratings 
        methodology.''

A.5. Witness declined to respond to written questions for the 
record.

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds 
Association testified before the House Subcommittee on Capital 
Markets and said: ``MFA and its members acknowledge that at a 
minimum the hedge fund industry as a whole is of systemic 
relevance and, therefore, should be considered within the 
systemic risk regulatory framework.'' MFA supported the 
creation or designation of a ``single central systemic risk 
regulator'' that (1) has ``the authority to request and 
receive, on a confidential basis, from those entities that it 
determines . . . to be of systemic relevance, any information 
that the regulator determines is necessary or advisable to 
enable it to adequately assess potential risks to the financial 
system,'' (2) has a mandate of protection of the financial 
system, but not investor protection or market integrity and (3) 
has the authority to ensure that a failing market participant 
does not pose a risk to the entire financial system.
    Do you agree with MFA's position? Do you feel there should 
be regulation of hedge funds along these lines or otherwise?

A.6. Witness declined to respond to written questions for the 
record.

Q.7. Self-Regulatory Organizations: How do you feel the self-
regulatory securities organizations have performed during the 
current financial crisis? Are there changes that should be made 
to the self-regulatory organizations to improve their 
performance? Do you feel there is still validity in maintaining 
the self-regulatory structure or that some powers should be 
moved to the SEC or elsewhere?

A.7. Witness declined to respond to written questions for the 
record.

Q.8. Structure of the SEC: Please share your views as to 
whether you feel that the current responsibilities and 
structure of the SEC should be changed.
    Please comment on the following specific proposals:

  1. LGiving some of the SEC's duties to a systemic risk 
        regulator or to a financial services consumer 
        protection agency;

  2. LCombining the SEC into a larger ``prudential'' financial 
        services regulator;

  3. LAdding another Federal regulators' or self-regulatory 
        organizations' powers or duties to the SEC.

A.8. Witness declined to respond to written questions for the 
record.

Q.9. SEC Staffing, Funding, and Management: The SEC has a staff 
of about 3,500 full-time employees and a budget of $900 
million. It has regulatory responsibilities with respect to 
approximately: 12,000 public companies whose securities are 
registered with it; 11,300 investment advisers; 950 mutual fund 
complexes; 5,500 broker-dealers (including 173,000 branch 
offices and 665,000 registered representatives); 600 transfer 
agents, 11 exchanges; 5 clearing agencies; 10 nationally 
recognized statistical rating organizations; SROs such as the 
Financial Industry Regulatory Authority, the Municipal 
Securities Rulemaking Board and the Public Company Accounting 
Oversight Board.
    To perform its mission effectively, do you feel that the 
SEC is appropriately staffed? funded? managed? How would you 
suggest that the Congress could improve the effectiveness of 
the SEC?

A.9. Witness declined to respond to written questions for the 
record.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                     FROM MERCER E. BULLARD

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

    Would a merger or rationalization of the roles of the SEC 
and CFTC be a valuable reform, and how should that be 
accomplished?
    How is it that AIG was able to take such large positions 
that it became a threat to the entire financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
risk management, or some combination?
    How should we update our rules and guidelines to address 
the potential failure of a systematically critical firm?

A.1. Witness declined to respond to written questions for the 
record.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                       FROM ROBERT PICKEL

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets? Also, would 
you recommend more transparency for investors:

   LBy publicly held banks and other financial firms of 
        off-balance sheet liabilities or other data?

   LBy credit rating agencies of their ratings 
        methodologies or other matters?

   LBy municipal issuers of their periodic financial 
        statements or other data?

   LBy publicly held banks, securities firms, and GSEs 
        of their risk management policies and practices, with 
        specificity and timeliness?

A.1. Transparency plays an important role in encouraging market 
participation. At the same time, in some instances proprietary 
information must be kept confidential in order to encourage 
market participation. There is a balancing act that must be 
performed with respect to when enhanced transparency will 
assist the proper functioning of a market (which should be the 
default assumption) and when it might prove counter-productive.

Q.2. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the Nation's economy. Please summarize your 
recommendations on the best way to oversee these instruments.

A.2. Credit default swaps play an important role in 
facilitating financing, and ensuring their continued 
availability to sophisticated market participants is in the 
best interest of promoting U.S. economic growth. At the same 
time it is clear that our regulatory system as a whole is in 
need of reform and restructuring in order to accommodate new 
types of products and markets. CDS and OTC derivatives in 
general are currently subject to a range of oversight, 
extending from regulation of the primary dealers in these 
markets (such as banks), through to different levels of 
oversight by the CFTC and SEC with respect to different types 
of underlying products. With regard to CDS in particular, 
change in the current regulatory structure should be focused on 
ensuring the continued availability of the product while 
preventing potentially destabilizing regulation of certain 
types of CDS as insurance at the State level.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                       FROM ROBERT PICKEL

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

    Would a merger or rationalization of the roles of the SEC-
and CFTC be a valuable reform, and how should that be 
accomplished?
    How is it that AIG was able to take such large positions 
that it became a threat to the entire financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
risk management, or some combination?
    How should we update our rules and guidelines to address 
the potential failure of a systematically critical firm?

A.1. ISDA supports legislative efforts to create a governmental 
authority to monitor, assess and take action to address 
potential systemic risk within the financial system. This 
systemic risk regulator should have the authority to: monitor 
large exposures across firms and markets; assess potential 
deficiencies in risk management practices; analyze the 
exposures of highly connected firms; identify regulatory gaps; 
and have the ability to promulgate rules necessary to carry out 
its authorities. The powers of the systemic risk regulator 
should be focused on markets as a whole, and not limited to 
narrow categories of products or participants. The systemic 
risk regulator should work cooperatively with other regulators 
globally to help promote internationally consistent standards.
    Merger of the SEC and CFTC is a complicated issue which 
presents many issues extending beyond the OTC derivatives 
industry. The framework of regulation created by the Commodity 
Futures Modernization Act of 2000, which provides elements of 
oversight of OTC derivatives activity by both agencies, has 
been very successful in promoting the growth of the business in 
the United States.
    AIG's ability to take large positions appears to stem 
primarily from a failure of AIG to follow widely used, 
generally accepted best practices with respect to 
collateralization. It appears that a failure of prudent risk 
management as well as lax oversight contributed to AIG's 
downfall.
    The U.S. Bankruptcy Code and Federal Deposit Insurance 
Corporation Act provide mechanisms for the orderly wind down of 
qualified financial contracts; these provisions appear to have 
functioned well during the failures of both banks and non-banks 
(such as Lehman Bros.).
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                     FROM DAMON A. SILVERS

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets?
    Also, would you recommend more transparency for investors:

  1. LBy publicly held banks and other financial firms of off-
        balance sheet liabilities or other data?

  2. LBy credit rating agencies of their ratings methodologies 
        or other matters?

  3. LBy municipal issuers of their periodic financial 
        statements or other data?

  4. LBy publicly held banks, securities firms and GSEs of 
        their risk management policies and practices, with 
        specificity and timeliness?

A.1. (1) I do not understand why after Enron we continued to 
allow off-balance sheet activities as a general matter. FASB 
has finally acted to tighten the rules on off-balance sheet 
activity, it is unclear whether those efforts will be 
successful. In my view, if a liability is close enough to a 
company to be called an off-balance sheet liability, it should 
be on-balance sheet.
    (2) Yes, credit rating agencies should both be required to 
disclore their methods, and should be substantively regulated, 
much as audit firms are, by either the SEC, the PCAOB, or a new 
agency. However, I am opposed to undoing the NRSRO approach to 
ratings agencies, there needs to be a basic minimum standard 
for firms holding themselves out to the public as ratings 
agencies, just as we have such standards for banks, broker 
dealers, lawyers, etc.
    (3) I am unaware of a good reason there should not be 
periodic financial disclosures by public debt issuers.
    (4) There should be increased disclosure of risk management 
policies and practices, and there should be changes to SEC 
current practices around shareholder proposals to allow 
shareholders to file proposals under Rule 14a-8 addressing risk 
management policies and the creation of risk management 
committees of boards in publicly held financial institutions.

Q.2. Conflicts of Interest: Concerns about the impact of 
conflicts of interest that are not properly managed have been 
frequently raised in many contexts--regarding accountants, 
compensation consultants, credit rating agencies, and others. 
For example, Mr. Turner pointed to the conflict of the board of 
FINRA including representatives of firms that it regulates. The 
Millstein Center for Corporate Governance and Performance at 
the Yale School of Management in New Haven, Connecticut on 
March 2 proposed an industry-wide code of professional conduct 
for proxy services that includes a ban on a vote advisor 
performing consulting work for a company about which it 
provides recommendations.
    In what ways do you see conflicts of interest affecting the 
integrity of the markets or investor protection? Are there 
conflicts affecting the securities markets and its participants 
that Congress should seek to limit or prohibit?

A.2. Conflicts of interest are a permanent feature of our 
markets, where both people and firms have vast webs of 
relationships. However, certain types of conflicts are simply 
inconsistent with doing the jobs we ask key gatekeepers and 
intermediaries to perform. I do not think it is consistent with 
the role of proxy advisor to also be a hired consultant to the 
firms whose governance the proxy advisor is supposed to analyze 
on behalf of investors.
    The crisis should lead Congress to take a close look at 
conflicts of interest in the dealings between originators, 
servicers, and investors in the mortgage markets and other 
secondary markets, and in the business model of ratings 
agencies.
    Finally, there is a conflict of interest inherent in 
executive pay--we ask executives to be loyal to the firm they 
work for, knowing that they also will seek to enhance their own 
personal economic interests through their pay packages. That is 
why executive pay must be closely watched, by boards, by 
shareholders, by the press, and by investors. In this respect, 
the advisors to board of directors in negotiating executive pay 
should be particularly free of conflict. It is inappropriate 
for executive pay consultants working for boards to 
simultaneously receive lucrative consulting engagements from 
the very CEO's whose pay they evaluate. This is substantially 
the same problem as infected outside auditors prior to the 
passage of Sarbanes-Oxley.

Q.3. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the nation's economy. Please summarize your 
recommendations on the best way to oversee these instruments.

A.3. Credit default swaps are a form of insurance economically. 
They should be regulated according to the same principles as 
insurance-full disclosure of terms, and most importantly, 
capital requirements.
    More generally, credit default swaps are one example of 
financial derivatives, contracts that can replicate any 
financial transaction or investment. It is possible to 
synthesize an insurance contract, e.g., a credit default swap, 
to synthesize an equity or debt investment through a total 
return swap, or to synthesize a short position. Derivatives 
need to be regulated based on what they actually are 
economically, or to put it a different way, what the underlying 
assets are referred to in the derivative contract. So for 
example, the SEC should require the disclosure of synthetic 
positions in public securities under Section 13 of the 
Securities Exchange Act by large investors, just as it requires 
the disclosure of actual positions.
    A key step in derivatives regulation should be to require 
all derivatives written based on a standard contract, such as 
the ISDA forms, be traded on exchanges, with transparency to 
all market participants, and collateral requirements. A 
clearinghouse approach is insufficient because it lacks 
transparency. Exceptions to this requirement should be very 
narrowly tailored. In this respect, as many commentators have 
noted, the Treasury Department White Paper falls short.
    I support and endorse the efforts at closing some of the 
loopholes in the Treasury white paper made in correspondence 
with Congress by CFTC Chairman Gary Gensler. The details of my 
views are in the attached written statement I made to a joint 
roundtable convened by the SEC and the CFTC on coordinating 
their regulation of derivatives and futures.

Q.4. Corporate Governance--Majority Vote for Directors, Proxy 
Access, Say on Pay: The Council of Institutional Investors, 
which represents public, union and corporate pension funds with 
combined assets that exceed $3 trillion, has called for 
``meaningful investor oversight of management and boards'' and 
in a letter dated December 2, 2008, identified several 
corporate governance provisions that ``any financial markets 
regulatory reform legislation [should] include.'' Please 
explain your views on the following corporate governance 
issues:

  1. LRequiring a majority shareholder vote for directors to be 
        elected in uncontested elections;

  2. LAllowing shareowners the right to submit amendment to 
        proxy statements;

  3. LAllowing advisory shareowner votes on executive cash 
        compensation plans.

A.4. (1) Majority voting has become common practice in 
corporate America in recent years, thanks in large part to the 
efforts of institutional investors, including workers' pension 
funds. I think this is a positive development. However, in many 
cases the form of majority voting is weak, more of a guideline 
than a rule. Companies should adopt clear bylaws embodying the 
principle of majority voting.
    (2) I believe this question is designed to get at the SEC's 
somewhat convoluted decision to reverse the court's finding in 
AIG v. AFSCME and bar shareholder proposals addressing proxy 
access, the right of shareholder nominated directors, if they 
enjoy substantial shareholder support, to appear on the 
company's proxy materials. This decision was mistaken and 
should be reversed. Furthermore, the SEC should move promptly 
to adopt a mandatory floor process for proxy access. Proxy 
access makes real the mandate to the Commission under Section 
14 of the Securities Exchange Act to ensure that proxies fairly 
represent the agenda before company annual meetings. When 
shareholder nominated candidates have significant support, 
their candidacy is clearly a relevant fact that shareholders 
should be aware of when the management solicits their vote. I 
strongly support the draft rule proposed by the Commission 
earlier this summer, and urge Congress to support the 
Commission in this effort.
    (3) Shareholder advisory votes on executive pay have been a 
feature of the corporate governance system in the United 
Kingdom for several years. Pension funds in the UK are strongly 
supportive of this measure, and that enthusiasm is shared by 
institutional investors in the United States. It is important 
to note that in the UK say on pay is advisory, and most 
proposals I am aware of for adopting the practice in the United 
States are for an advisory vote.
    I should note that say on pay might not be necessary if 
boards were strong on the issue of executive pay. But after 20 
years of runaway executive pay, it seems clearly necessary to 
involve shareholders directly in trying to control this excess.

Q.5. Credit Rating Agencies: Please identify any legislative or 
regulatory changes you believe are warranted to improve the 
oversight of credit rating agencies.
    In addition, I would like to ask your views on two specific 
proposals:

  1. LThe Peterson Institute report on ``Reforming Financial 
        Regulation, Supervision, and Oversight'' recommended 
        reducing conflicts of interest in the major rating 
        agencies by not permitting them to perform consulting 
        activities for the firms they rate.

  2. LThe G30 Report ``Financial Reform; A Framework for 
        Financial Stability'' recommended that regulators 
        should permit users of ratings to hold NRSROs 
        accountable for the quality of their work product. 
        Similarly, Professor Coffee recommended creating 
        potential legal liability for recklessness when 
        ``reasonable efforts'' have not been made to verify 
        ``essential facts relied upon by its ratings 
        methodology.''

A.5. Please see my answer to Question 1 from Chairman Dodd in 
terms of general reforms to the regulation of credit ratings 
agencies.
    For the reasons discussed above in response to a general 
question on conflicts of interest, I think a ban on side 
consulting arrangements for credit rating agencies is 
appropriate and necessary.
    I do not see how the NRSRO structure, which makes clear 
that rating agencies are acting as a gatekeeper, is consistent 
with absolute legal immunity for misconduct in the role of 
gatekeeper. On the other hand, Congress should recognize the 
reality that credit rating agencies cannot act as insurers of 
the credit market. The way to do that is to have liability 
standards that recognize liability for extraordinary 
misconduct, and to pair that liability regime with a strong 
regime of oversight and inspection, modeled on that created by 
the Sarbanes-Oxley Act for auditors. Professor Coffee's 
formulation of such a thoughtful liability standard seems 
reasonable to me. As a general matter, the AFL-CIO supports the 
approach taken to these issues in S. 1073, the Rating 
Accountability and Transparency Enhancement Act of 2009, and we 
are appreciative of Senator Reed's leadership on this issue.

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds 
Association testified before the House Subcommittee on Capital 
Markets and said: ``MFA and its members acknowledge that at a 
minimum the hedge fund industry as a whole is of systemic 
relevance and, therefore, should be considered within the 
systemic risk regulatory framework.'' MFA supported the 
creation or designation of a ``single central systemic risk 
regulator'' that (1) has ``the authority to request and 
receive, on a confidential basis, from those entities that it 
determines . . . to be of systemic relevance, any information 
that the regulator determines is necessary or advisable to 
enable it to adequately assess potential risks to the financial 
system,'' (2) has a mandate of protection of the financial 
system, but not investor protection or market integrity and (3) 
has the authority to ensure that a failing market participant 
does not pose a risk to the entire financial system.
    Do you agree with MFA's position? Do you feel there should 
be regulation of hedge funds along these lines or otherwise?

A.6. It is true that hedge funds as a group, and certain large 
funds, are systemically significant. It is also true that hedge 
funds are not a distinct form of economic activity, they are a 
legal structure designed to enable people who manage money to 
evade regulatory oversight. If regulatory arbitrage of this 
type is allowed to continue, we will repeat the events of 2008, 
and probably with greater severity.
    Thus the MFA position is an effort to avoid oversight by 
the SEC, to perpetuate regulatory arbitrage in our system of 
financial regulation and to prevent meaningful regulation of 
hedge funds in the public interest, and meaningful protection 
of hedge fund investors. It also illustrates the danger that 
systemic risk regulation can, in the wrong hands, be a vehicle 
for insulating irresponsible market practices from effective 
regulation.
    The AFL-CIO strongly supports the Treasury Department's 
recommendation that Congress require hedge fund and private 
equity fund managers to register as investment advisors with 
the Securities and Exchange Commission. However, regulating the 
manager is not sufficient. Congress should adopt a regulatory 
framework for hedge funds and private equity funds themselves, 
a version of the Investment Company Act that recognizes these 
funds are different than mutual funds, but nonetheless are 
money management enterprises profoundly embedded in our public 
markets. Such regulation should recognize that hedge funds are 
not directly marketed to the general public, but the general 
public is exposed to hedge fund risks through pension funds, 
university endowments, and foundations. Most importantly, 
giving the SEC clear jurisdiction over the fund itself would 
enable the Commission to oversee the governance of these funds 
and to ensure they operate in the best interests of their 
investors.
    Ultimately, no financial reform is more important than 
closing jurisdictional loopholes in ways that will not allow 
new loopholes to open. This was the genius of the New Deal 
securities laws until they began to be eaten away during the 
1980s and 1990s. We need to restore this type of comprehensive 
regulatory approach to SEC jurisdiction.
    The MFA's proposal is to do the opposite.

Q.7. Self-Regulatory Organizations: How do you feel the self-
regulatory securities organizations have performed during the 
current financial crisis? Are there changes that should be made 
to the self-regulatory organizations to improve their 
performance? Do you feel there is still validity in maintaining 
the self-regulatory structure or that some powers should be 
moved to the SEC or elsewhere?

A.7. In general, I am not supportive of self-regulatory 
structures. I think there is however a general view among 
investors that NASD is superior to the structures that 
preceeded it. It is not clear to me that given the scale of 
what NASD does, it makes sense to bring it within the SEC. 
However, I think Congress may want to look closely at the 
NASD's governance, and those regulatory functions that remain 
with the exchanges themselves, to see if NASD's governance can 
be improved, and to see whether it is sensible for any 
regulatory functions to remain with the exchanges. Part of this 
examination should include an in-depth look at how the NASD and 
the exchanges performed their functions during the runup to the 
financial crisis. In this respect, the new Financial Crisis 
Commission chaired by Philip Angelides may be helpful.

Q.8. Structure of the SEC: Please share your views as to 
whether you feel that the current responsibilities and 
structure of the SEC should be changed.
    Please comment on the following specific proposals:

  1. LGiving some of the SEC's duties to a systemic risk 
        regulator or to a financial services consumer 
        protection agency;

  2. LCombining the SEC into a larger ``prudential'' financial 
        services regulator;

  3. LAdding another Federal regulators' or self-regulatory 
        organizations' powers or duties to the SEC.

A.8. In general, the SEC's needs expanded jurisidiction to 
cover all financial products that interact with the public 
markets-derivatives linked to publically traded securities, 
financial futures, hedge funds and private equity funds. As I 
mentioned above, the lack of comprehensive jurisdiction that 
cannot be evaded is the principal structural problem facing the 
SEC.
    The AFL-CIO strongly supports the Treasury Department's 
proposal for creating a consumer financial protection agency 
with the jurisdiction outlined in the Treasury's report. That 
jurisdiction does not include taking anything away from the 
SEC. Investments are different than financial services such as 
mortgages, credit cards, and bank accounts, and need to be 
regulated in a consolidated way by the SEC.
    As to taking away responsibilities from the SEC and giving 
them to a systemic risk regulator, that would be an invitation 
to further regulatory arbitrage, and would be opposed by the 
AFL-CIO. See my answer to Question 6 for an example of why this 
would be a bad idea.
    The SEC is fundamentally about ensuring that we have fair 
and transparent securities market. It is not about protecting 
the safety and soundness of particular participants in that 
market. Merging those two obligations would ensure we will have 
unfair and opaque securities markets, run in the interests of 
ensuring the safety and soundness of issuers.
    Congress should in general keep in mind that safety and 
soundness, consumer protection and investor protection are 
three distinct, important regulatory functions that are 
nonetheless in tension with each other. They need to be as much 
as possible consolidated within each category, but kept in 
separate categories. Much of the failure of regulation in the 
mortgage bubble came from asking the Federal Reserve to be both 
guardian of safety and soundness of bank holding companies, and 
protector of consumers in the mortgage market. Ultimately the 
Fed did neither effectively. Some of the most embarrassing 
moments of the financial crisis have come from efforts to have 
the same people make decisions about safety and soundness and 
investor protection, most notably at Bank of America. These 
incidents should not be the model of our regulatory future.
    I think that the CFTC should be merged with the SEC, or 
alternatively its financial jurisdiction, as opposed to its 
jurisdiction over instruments linked to physical commodities, 
should be transferred to the SEC in the interests of preventing 
regulatory arbitrage. As to the NASD and the exchanges, see my 
answer to Question 7.

Q.9. SEC Staffing, Funding, and Management: The SEC has a staff 
of about 3,500 full-time employees and a budget of $900 
million. It has regulatory responsibilities with respect to 
approximately: 12,000 public companies whose securities are 
registered with it; 11,300 investment advisers; 950 mutual fund 
complexes; 5,500 broker-dealers (including 173,000 branch 
offices and 665,000 registered representatives); 600 transfer 
agents, 11 exchanges; 5 clearing agencies; 10 nationally 
recognized statistical rating organizations; SROs such as the 
Financial Industry Regulatory Authority, the Municipal 
Securities Rulemaking Board and the Public Company Accounting 
Oversight Board.
    To perform its mission effectively, do you feel that the 
SEC is appropriately staffed? funded? managed? How would you 
suggest that the Congress could improve the effectiveness of 
the SEC?

A.9. The SEC is underfunded, and suffers from funding 
uncertainty. In the immediate aftermath of disasters like 
Enron, the SEC gets big budget increases, only to see them 
taken away when the spotlight moves on. The consequences for 
the Commission go beyond a general lack of resources to 
profound difficulties in attracting and developing career 
staff.
    The AFL-CIO supports both substantial budget increases and 
dedicated funding for the Commission similar to that which the 
Board of Governors of the Federal Reserve enjoys.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                     FROM DAMON A. SILVERS

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

A.1. I would cover some of the same ground that Chairman 
Bernanke did in a different way. I think regulatory reform 
must:

  1. LProtect the public by creating an independent consumer 
        protection agency for financial services, which would, 
        among other duties, ensure mortgage markets are 
        properly regulated

  2. LReregulate the shadow markets-in particular, derivatives, 
        hedge funds, private equity funds, and off-balance 
        sheet vehicles, so that it is no longer possible for 
        market actors to choose to conduct activities like bond 
        insurance or money management either in a regulated or 
        an unregulated manner. As President Obama said in 2008 
        at Cooper Union, financial activity should be regulated 
        for its content, not its form.

  3. LProvide for systemic risk regulation by a fully public 
        entity, including the creation of a resolution 
        mechanism applicable to any financial firm that would 
        be the potential subject of government support. The 
        Federal Reserve System under its current governance 
        structure, which includes significant bank involvement 
        at the Reserve Banks, is too self-regulatory to be a 
        proper systemic risk regulator. Either the Federal 
        Reserve System needs to be fully public, or the 
        systemic risk regulatory function needs to reside 
        elsewhere, perhaps in a committee that would include 
        the Fed Chairman in its leadership.

    The issue of procyclicality is complex. I think 
anticyclicality in capital requirements may be a good idea. I 
have become very skeptical of the changes that have been made 
to GAAP that have had the effect, in my opinion, of making 
financial institutions' balance sheets and income statements 
less transparent and reliable. See the August, 2009, report of 
the Congressional Oversight Panel. Most importantly, moves that 
appear to be anticyclical may be procyclical, by allowing banks 
not to write down assets that are in fact impaired, these 
measures may be a disincentive, for example, for banks to 
restructure mortgages in ways that allow homeowners to stay in 
their homes.

Q.2. Would a merger or rationalization of the roles of the SEC 
and CFTC be a valuable reform, and how should that be 
accomplished?

A.2. A merger of the SEC and the CFTC would be a valuable 
reform. Alternatively, jurisdiction over financial futures and 
derivatives could be transferred from the CFTC to the SEC so 
that there is no possibility of regulatory arbitrage between 
securities on the one hand and financial futures and 
derivatives on the other. Recent efforts by both agencies to 
harmonize their approaches to financial regulation, while 
productive, have highlighted the degree to which they are 
regulating the same market, and the extent of the continuing 
threat of regulatory arbitrage created by having separate 
agencies.
    If there were to be a merger, it must be based on adopting 
the SEC's greater anti-fraud and market oversight powers. The 
worst idea that has surfaced in the entire regulatory reform 
debate, going back to 2006, was the proposal in the Paulson 
Treasury blueprint to use an SEC-CFTC merger to gut the 
investor protection and enforcement powers of the SEC.
    For more details on these issues, the Committee should 
review the transcript of the second day of the joint SEC-CFTC 
roundtable on coordination issues held on September 3, 2009. I 
have attached my written statement to that roundtable. [See, 
Joint Hearing Testimony, below.]

Q.3. How is it that AIG was able to take such large positions 
that it became a threat to the entire financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
risk management, or some combination?

A.3. AIG took advantage of three regulatory loopholes that 
should be closed. Their London-based derivatives office was 
part of a thrift bank, regulated by the OTS, an agency which 
during the period in question advertised itself to potential 
``customers'' as a compliant regulator. This ability to play 
regulators off against each other needs to end. Second, the 
Basel II capital standards for banks allowed banks with AAA 
ratings not to have to set capital aside to back up derivatives 
commitments. Third, thanks to the Commodities Futures 
Modernization Act, there was no ability of any agency to 
regulate derivatives as products, or to require capital to be 
set aside to back derivative positions.
    Within AIG, the large positions taken by the London 
affiliate represent a colossal managerial and governance 
failure. It is a managerial failure in that monitoring capital 
at risk and leverage is a central managerial function in a 
financial institution. It is a governance failure in that the 
scale of the London operation, and its apparent contribution to 
AIG's profits in the runup to the collapse, was such that the 
oversight of the operation should have been of some importance 
to the board. The question now is, what sort of accountability 
has there really been for these failures?

Q.4. How should we update our rules and guidelines to address 
the potential failure of a systematically critical firm?

A.4. We need to make the following changes to our financial 
regulatory system to address the need to protect the financial 
system against systemic risk:

  1. LWe need to give the FDIC and a systemic risk regulator 
        the power to resolve any financial institution, much as 
        that power is now given to the FDIC to resolve insured 
        depositary institutions, if that financial institution 
        represents a systemic threat.

  2. LCapital requirements and deposit insurance premiums need 
        to increase as a percentage of assets as the size of 
        the firm increases. The Obama Administration has 
        proposed a two tier approach to this idea. More of a 
        continuous curve would be better for a number of 
        reasons--in particular it would not tie the hands of 
        policy makers when a firm fails in the way a two tier 
        system would. If we have a two tier system, the names 
        of the firm in the top tier must be made public. These 
        measures both operate as a deterrent to bigness, and 
        compensate the government for the increased likelihood 
        that we will have to rescue larger institutions.

  3. LBank supervisory regulators need to pay much closer 
        attention to executive compensation structures in 
        financial institutions to ensure they are built around 
        the proper time horizons and the proper orientation 
        around risk. This is not just true for the CEO and 
        other top executives--it is particularly relevant for 
        key middle management employees in areas like trading 
        desks and internal audit. Fire alarms should go off if 
        internal audit is getting incentive pay based on stock 
        price.

  4. LWe need to close regulatory loopholes in the shadow 
        markets so that all financial activity has adequate 
        capital behind it and so regulators have adequate line 
        of site into the entire market landscape. This means 
        regulating derivatives, hedge funds, private equity and 
        off-balance sheet vehicles based on the economic 
        content of what they are doing, not based on what they 
        are called.

  5. LWe need to end regulatory arbitrage, among bank 
        regulators; between the SEC and the CFTC, and to the 
        extent possible, internationally by creating a global 
        financial regulatory floor.

  6. LWe need to adopt the recommendation of the Group of 
        Thirty, chaired by Paul Volcker, to once again separate 
        proprietary securities and derivatives trading from the 
        management of insured deposits.
 AMERICAN FEDERATION OF LABOR AND CONGRESS OF INDUSTRIAL ORGANIZATIONS

   Joint Hearing of the CFTC and the SEC--Harmonization of Regulation

                           September 3, 2009

    Good morning Chairman Schapiro and Chairman Gensler. My name is 
Damon Silvers, I am an Associate General Counsel of the AFL-CIO, and I 
am the Deputy Chair of the Congressional Oversight Panel created under 
the Emergency Economic Stabilization Act of 2008 to oversee the TARP. 
My testimony reflects my views and the views of the AFL-CIO unless 
otherwise noted, and is not on behalf of the Panel, its staff or its 
chair, Elizabeth Warren. I should however note that a number of the 
points I am making in this testimony were also made in the 
Congressional Oversight Panel's Report on Financial Regulatory Reform's 
section on reregulating the shadow capital markets, and I commend that 
report to you. \1\
---------------------------------------------------------------------------
     \1\ Congressional Oversight Panel, Special Report on Regulatory 
Reform, at 22-24 (Jan. 29, 2009), available at http://cop.senate.gov/
documents/cop-012909-report-regulatoryreform.pdf
---------------------------------------------------------------------------
    Thank you for the opportunity to share my views with you today on 
how to best harmonize regulation by the SEC and the CFTC. Before I 
begin, I would like to thank you both for bringing new life to 
securities and commodities regulation in this country. Your dedication 
to and enforcement of the laws that ensure fair dealing in the 
financial and commodities markets has never been more important than it 
is today.
    Derivatives are a classic shadow market. To say a financial 
instrument is a derivative says nothing about its economic content. 
Derivative contracts can be used to synthesize any sort of insurance 
contract, including most prominently credit insurance. Derivatives can 
synthesize debt or equity securities, indexes, futures and options. 
Thus the exclusion of derivatives from regulation by any federal agency 
in the Commodity Futures Modernization Act ensured that derivatives 
could be used to sidestep thoughtful necessary regulations in place 
throughout our financial system. \2\ The deregulation of derivatives 
was a key step in creating the Swiss cheese regulatory system we have 
today, a system that has proven to be vulnerable to shocks and 
threatening to the underpinnings of the real economy. The result--
incalculable harm throughout the world, and harm in particular to 
working people and their benefit funds who were not invited to the 
party and in too many cases have turned out to be paying for the 
cleanup.
---------------------------------------------------------------------------
     \2\ Commodity Futures Modernization Act of 2000, Pub. L. No. 106-
554, 114 Stat. 2763 (2000).
---------------------------------------------------------------------------
    There are three basic principles that the AFL-CIO believes are 
essential to the successful harmonization of SEC and CFTC regulation 
and enforcement, and to the restoration of effective regulation across 
our financial system:

  1.  Regulators must have broad, flexible jurisdiction over the 
        derivatives markets that prevents regulatory arbitrage or the 
        creation of new shadow markets under the guise of innovation.

  2.  So long as the SEC and the CFTC remain separate agencies, the SEC 
        should have authority to regulate all financial markets 
        activities, including derivatives that reference financial 
        products. The CFTC should have authority to regulate physical 
        commodities markets and all derivatives that reference such 
        commodities.

  3.  Anti-fraud and market conduct rules for derivatives must be no 
        less robust than the rules for the underlying assets the 
        derivatives reference.

    The Administration's recently proposed Over-the-Counter Derivatives 
Markets Act of 2009 (``Proposed OTC Act'') will help to close many, but 
not all, of the loopholes that make it difficult for the SEC and the 
CFTC to police the derivatives markets. It will also make it even more 
important that the SEC and the CFTC work together to ensure that 
regulation is comprehensive and effective.
Regulators Must Have Broad, Flexible Jurisdiction Over the Entire 
        Derivatives Market
    Derivatives as a general matter should be traded on fully 
regulated, publicly transparent exchanges. The relevant regulatory 
agencies should ensure that the exchanges impose tough capital adequacy 
and margin requirements that reflect the risks inherent in contracts. 
Any entity that markets derivatives products must be required to 
register with the relevant federal regulators and be subject to 
business conduct rules, comprehensive recordkeeping requirements, and 
strict capital adequacy standards.
    The Proposed OTC Act addresses many of the AFL-CIO's concerns about 
the current lack of regulation in the derivatives markets. If enacted, 
the Proposed OTC Act would ensure that all derivatives and all dealers 
face increased transparency, capital adequacy, and business conduct 
requirements. \3\ It would also require heightened regulation and 
collateral and margin requirements for OTC derivatives.
---------------------------------------------------------------------------
     \3\ Available at http://www.financialstability.gov/docs/
regulatoryreform/titleVII.pdf
---------------------------------------------------------------------------
    The Proposed OTC Act would also require the SEC and CFTC to develop 
joint rules to define the distinction between ``standardized'' and 
``customized'' derivatives. \4\ This would make SEC/CFTC harmonization 
necessary to the establishment of effective derivatives regulation.
---------------------------------------------------------------------------
     \4\ Proposed OTC Act  713(a)(2) (proposing revisions to the 
Commodity Exchange Act, 7 U.S.C. 2(j)(3)(A)).
---------------------------------------------------------------------------
    The AFL-CIO believes that the definition of a customized contract 
should be very narrowly tailored. Derivatives should not be permitted 
to trade over-the-counter simply because the counterparties have made 
minor tweaks to a standard contract. If counter-parties are genuinely 
on opposite sides of some unique risk event that exchange-trading could 
not accommodate, then they should be required to show that that is the 
case through a unique contract. The presence or absence of significant 
arms-length bargaining will be indicative of whether such uniqueness is 
genuine, or artificial.
    In a recent letter to Senators Harkin and Chambliss, Chairman 
Gensler flagged several areas of the Proposed OTC Act that he believes 
should be improved. \5\ The AFL-CIO strongly supports Chairman 
Gensler's recommendation that Congress revise the Proposed OTC Act to 
eliminate exemptions for foreign exchange swaps and forwards. We also 
strongly agree with Chairman Gensler that mandatory clearing and 
exchange trading of standardized swaps must be universally applicable 
and there should not be an exemption for counterparties that are not 
swap dealers or ``major swap participants.''
---------------------------------------------------------------------------
     \5\ Letter from Gary Gensler, Chairman of the Commodity Futures 
Trading Commission, to The Honorable Tom Harkin and The Honorable Saxby 
Chambliss, August 17, 2009, page 4, available at http://
tradeobservatory.org/library.cfm?refid=106665
---------------------------------------------------------------------------
The SEC Should Regulate Financial Markets and the CFTC Should Regulate 
        Commodities Markets
    The SEC was created in 1934, due to Congress' realization that 
``national emergencies . . . are precipitated, intensified, and 
prolonged by manipulation and sudden and unreasonable fluctuations of 
security prices and by excessive speculation on such exchanges and 
markets, and to meet such emergencies the Federal Government is put to 
such great expense as to burden the national credit.'' \6\ As a result 
of the impact instability in the financial markets had on the broader 
economy during the Great Depression, Congress gave the SEC broad 
authority to regulate financial markets activities and individuals that 
participate in the financial markets in a meaningful way. \7\
---------------------------------------------------------------------------
     \6\ 15 U.S.C.  78b.
     \7\ See generally The Securities Act of 1933 (15 USC  77a et 
seq.); The Securities Exchange Act of 1934 (15 USC  78a et seq.); The 
Investment Company Act of 1940 (15 USC  80a-1 et seq.); The Investment 
Advisers Act of 1940 (15 USC  80b-1 et seq.).
---------------------------------------------------------------------------
    As presently constituted, the CFTC has oversight not only for 
commodities such as agricultural products, metals, energy products, but 
also has come to regulate--through court and agency interpretation of 
the CEA--financial instruments, such as currency, futures on U.S. 
government debt, and security indexes. \8\
---------------------------------------------------------------------------
     \8\ 7 U.S.C.  1a(4) provides the CFTC with jurisdiction over 
agricultural products, metals, energy products, etc. See Commodity 
Futures Trading Com'n v. International Foreign Currency, Inc., 334 
F.Supp.2d 305 (E.D.N.Y. 2004), Commodity Futures Trading Com'n v. 
American Bd. of Trade, Inc., 803 F.2d 1242 (2d Cir 1986) discussing the 
CFTC's authorities with regard to currency derivatives. Since 1975, the 
CFTC has determined that all futures based on short-term and long-term 
U.S. government debt qualifies as a commodity under the CEA. See CFTC 
History, available at http://www.cftc.gov/aboutthecftc/
historyofthecftc/history--1970s.html. Other financial products 
regulated by the CFTC include security indexes, Mallen v. Merrill 
Lynch., 605 F.Supp. 1105 (N.D.Ga.1985).
---------------------------------------------------------------------------
    So long as two agencies continue to regulate the same or similar 
financial instruments, there will be opportunities for market 
participants to engage in regulatory arbitrage. As we have seen on the 
banking regulatory side and with respect to credit default swaps, such 
arbitrage can have devastating results.
    As long as the SEC and the CFTC are separate, the SEC should 
regulate all financial instruments including stocks, bonds, mutual 
funds, hedge funds, securities, securities-based swaps, securities 
indexes, and swaps that reference currencies, U.S. government debt, 
interest rates, etc. The CFTC should have authority to regulate all 
physical commodities and commodities-based derivatives.
    We recognize that the proposed Act does not in all cases follow the 
principles laid out above. To the extent financial derivatives remain 
under the jurisdiction of the CFTC, it is critical that the CFTC and 
the SEC seek the necessary statutory changes to bring the CFTC's power 
to police fraud and market manipulation in line with the SEC's powers. 
In this respect, we are heartened by the efforts by the CFTC under 
Chairman Gensler's leadership to address possible gaps in the 
Administration's proposed statutory language. A vigorous and 
coordinated approach to enforcement by both agencies can in some 
respects correct for flaws in jurisdictional design. They cannot 
correct for lack of jurisdiction or weak substantive standards of 
market conduct.
    In his letter to Senators Harkin and Chambliss, Chairman Gensler 
raised concerns about the Administration's proposal for the regulation 
of ``mixed swaps,'' or swaps whose value is based on a combination of 
assets including securities and commodities. Because the underlying 
asset will include those regulated by both the SEC and the CFTC, the 
Administration proposes that both agencies separately regulate these 
swaps in a form of ``dual regulation.'' Chairman Gensler expresses 
concern that such dual regulation will be unnecessarily confusing, and 
suggests instead that each mixed swap be assigned to one agency or the 
other, but not both. In that proposed system, the mixed swap would be 
``primarily'' deriving its economic identity from either a security or 
a commodity. \9\ Under the Chairman's view, only one agency would 
regulate any given mixed swap, depending on whether the swap was 
``primarily'' a security- or a commodity-based swap.
---------------------------------------------------------------------------
     \9\ Id.
---------------------------------------------------------------------------
    Chairman Gensler's proposal certainly has a great deal of appeal--
it's simpler, and eliminates the concern that duplicative regulation 
becomes either unnecessarily burdensome, or worse, completely 
ineffective. One could imagine a situation where each agency defers to 
the other, leaving mixed swaps dealers with free reign to develop their 
market as they see fit.
    But a proposal that focuses on the boundary between an SEC mixed 
swap and a CFTC mixed swap will run into a clear problem. There are 
swaps that are not primarily either security- or commodity-based: in 
fact, by design, they are swaps that, at the time of contract, are 
exactly 50/50, where the economic value of the SEC-type asset is 
equivalent to the economic value of the CFTC based asset. 50/50 swaps 
aren't that unusual, and Chairman Gensler's approach does not address 
what to do in those instances.
    These kinds of boundary issues become inevitable when we decide not 
to merge the two agencies. In order to prevent these problems from 
becoming loopholes, a solution must either eliminate the boundary--
e.g., the Administration's dual regulation proposal--or it must 
adequately police that boundary. One potential alternative would be to 
form a staff-level joint task force between the CFTC and the SEC to 
ensure that these 50/50 swaps--those that are neither obviously SEC-
swaps nor CFTC-swaps--would be regulated comprehensively, and 
consistently, across the system.
Anti-Fraud and Market Conduct Rules
    In considering enforcement issues for derivatives, it is critical 
to consider the appropriate level of regulation of the underlying 
assets from which these derivatives flow. Some of the strongest tools 
in the agencies' toolboxes are anti-fraud and market conduct 
enforcement. Derivatives must be held at a minimum to the same 
standards as the underlying assets. The Administration's Proposed OTC 
Derivatives Act makes important steps in this direction. However, there 
will be a continuing problem if the rules governing the underlying 
assets are too weak.
    Here the CFTC's current statutory framework is substantially weaker 
in terms of both investor protection and market oversight than the SEC. 
The Commodities Exchange Act (CEA) does not recognize insider trading 
as a violation of the law. This is a serious weakness in the context of 
mixed derivatives and both financial futures and derivatives based on 
financial futures. It also appears to be an obstacle to meaningful 
oversight of the commodities markets themselves in the light of 
allegations of market manipulation in the context of the recent oil 
price bubble.
    Similarly, the CEA has an intentionality standard for market 
manipulation, while the SEC operates under a statutory framework where 
the standard in general is recklessness. Intentionality as a standard 
for financial misconduct tends to require that the agency be able to 
read minds to enforce the law. Recklessness is the proper common 
standard.
Rules Versus Principles
    The Treasury Department's White Paper on Financial Regulatory 
Reform suggests there should be a harmonization between the SEC's more 
rules-based approach to market regulation and the CFTC's more 
principles-based approach. \10\ Any effective system of financial 
regulation requires both rules and principles. A system of principles 
alone gives no real guidance to market actors and provides too much 
leeway that can be exploited by the politically well connected. A 
system of rules alone is always gameable.
---------------------------------------------------------------------------
     \10\ Financial Regulatory Reform: A New Foundation. Department of 
the Treasury (June 17, 2009). See also http://
www.financialstability.gov/docs/regs/FinalReport_web.pdf
---------------------------------------------------------------------------
    Unfortunately, in the years prior to the financial crisis that 
began in 2007 the term ``principles based regulation'' became a code 
word for weak regulation. Perhaps the most dangerous manifestation of 
this effort was the Paulson Treasury Department's call in its financial 
reform blueprint for the weakening of the SEC's enforcement regime in 
the name of principles based regulation by requiring a merged SEC and 
CFTC to adopt the CEA's approach across the entire securities market. 
\11\
---------------------------------------------------------------------------
     \11\ http://www.treas.gov/press/releases/reports/Blueprint.pdf
---------------------------------------------------------------------------
    The SEC and the CFTC should build a strong uniform set of 
regulations for derivatives markets that blend principles and rules. 
These rules should not be built with the goal of facilitating speedy 
marketing of innovative financial products regardless of the risks to 
market participants or the system as a whole. In particular, the 
provisions of the Commodities Exchange Act that place the burden on the 
CFTC to show an exchange or clearing facilities operations are not in 
compliance with the Act's principles under a ``substantial evidence'' 
test are unacceptably weak, and if adopted in the area of derivatives 
would make effective policing of derivatives' exchanges and/or 
clearinghouses extremely difficult.
    It remains a mystery to us why ``innovation'' in finance is 
uncritically accepted as a good thing when so much of the innovation of 
the last decade turned out to be so destructive, and when so many 
commentators have pointed out that the ``innovations'' in question, 
like naked credit default swaps with no capital behind them, were well 
known to financial practitioners down through the ages and had been 
banned in our markets for good reason, in some cases during the New 
Deal and in some cases earlier.
    This approach is not a call for splitting the difference between 
strong and weak regulation. It is a call for building strong, 
consistent regulation that recognizes that the promotion of weak 
regulation under the guise of ``principles based regulation'' was a 
major contributor to the general failure of the financial regulatory 
system.
Conclusion
    The last 2 years have shown us the destructive consequences of the 
present system--destructive not only to our overall economy, but also 
to the lives and livelihoods of the men, women, and families least 
positioned to weather these storms. We have seen firsthand how 
regulatory arbitrage in the financial markets create tremendous 
systemic risks that can threaten the stability of the global economy. 
Derivatives are a primary example of how jurisdictional battles among 
regulators can result in unregulated and unstable financial markets. We 
urge you to work together to create a system that will ensure that 
nothing falls through the cracks when the SEC and the CFTC are no 
longer under your collective leadership.
         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                        FROM THOMAS DOE

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets? Also, would 
you recommend more transparency for investors:

  1.  By publicly held banks and other financial firms of off-
        balance sheet liabilities or other data?

  2.  By credit rating agencies of their ratings methodologies 
        or other matters?

  3.  By municipal issuers of their periodic financial 
        statements or other data?

  4.  By publicly held banks, securities firms and GSEs of 
        their risk management policies and practices, with 
        specificity and timeliness?

A.1. In MMA's written testimony there was extensive discussion 
regarding the issue of inadequate enforcement of financial 
disclosure by municipal issuers. The greatest inhibiting aspect 
of disclosure is the ambiguity regarding rule 15c2-12. The 
vagueness of the rule has inhibited FINRA from enforcing the 
regulation and has only ensured that investors are not provided 
with pertinent financial information, but also that taxpayers 
do not have access to updated financial information.
    As the MSRB's EMMA system approaches July 1 hegemony, 
participants' discussions over the problems with municipal 
disclosure have become more heated. Last Thursday, Moody's 
Investors Service withdrew more than a dozen local government 
ratings based on issuers' failure to provide timely financial 
or operating information. Although this does not follow a 
policy change by Moody's, it does reflect increased resources 
for surveillance and, in our opinion, is a preface to 
additional rating withdrawals in the coming months. In theory, 
if investors grow more broadly aware that bond ratings are 
vulnerable to disclosure lapses, the offending issuers will be 
forced to pay higher interest rates to borrow in the future.
    The problem: Disclosure failings undermine liquidity in 
affected bonds and have led to mistrust of issuers by investors 
and, likely, modestly higher system-wide interest rates. 
Disclosure gaps occur because the current regulation is both 
weak and evasive. Rule 15c2-12 does force primary market 
participants to require that issuers pledge to disclose future 
financial and operating information; however, there is little 
penalty to these same firms if issuers do not honor those 
pledges. The issuers themselves rarely suffer by letting 
disclosure languish. Further, firms trading bonds in the 
secondary market have little effective responsibility to ensure 
that the bonds being placed in customer accounts (and thus 
recommended) are actually in compliance with issuers' primary 
market promises. MMA has elsewhere detailed why we believe 
issuers fail to disclose as promised, but our assessment that 
they do fail, and often, is a direct product of our experience 
analyzing credits in both primary and secondary market trades.
    Recommendation: Substantive disclosure improvements do not 
require an end to the Tower Amendment, which bars the Federal 
Government from regulating State and local issuers. The loss of 
Tower would needlessly compromise State autonomy and open the 
door to incremental Federal intervention in State and local 
affairs. Instead, we advocate a market-based solution:

  1.  Congress should position a single entity as arbiter to 
        determine whether or not each issuer is in compliance 
        with their stated disclosure requirements. This arbiter 
        would likely need to be physically associated with the 
        MSRB's EMMA system (or its successor). We recommend 
        that a national issuer group control arbiter staffing 
        to reduce potential issuer/investor conflicts in the 
        future.

  2.  The arbiter would focus on regular, recurring disclosure 
        items; however, regulated market participants should be 
        required to pass along instances of non-recurring 
        disclosure violations when discovered.

  3.  The arbiter would assign two statistics to each municipal 
        Cusip. First, those issuers not currently in disclosure 
        compliance would be flagged (red, versus green). 
        Second, the arbiter would keep a database to track the 
        number or percent of days the issuer was out of 
        compliance over the last ten years. This historical 
        statistic could be called the ``disclosure compliance 
        score'' (or, ``DCS'').

  4.  Buyers evaluating primary or secondary market purchases 
        could then evaluate the issuer's current disclosure 
        flag and its historical DCS, increasing or reducing 
        their bid accordingly. Flags could be easily integrated 
        into customer portfolio statements, mutual fund 
        quarterly statements, trading inventory discussions, 
        etc.

  5.  In addition, all primary market participants 
        (underwriters, bond counsel and other legal staffs, 
        financial and swap advisors, bond insurers, and rating 
        agencies) would be associated with an aggregated DCS 
        for all issuers that they've helped bring to market in 
        the last decade. This firm-by-firm DCS reading could 
        give issuers another means to choose among potential 
        intermediaries, while giving investors some insight 
        into future disclosure compliance of first time 
        issuers. It could also help regulators discover legal 
        or financial firms whose issuer clients' record of 
        disclosure compliance has been poor.

  6.  All firms trading municipal bonds, regardless of their 
        status, would need to track how many trades, and the 
        volume of par traded, that that firm had made with 
        disclosure-flagged bonds. Registered firms could be 
        prohibited from trading in red-flagged Cusips 
        altogether. Again, this could be very important data 
        for investors evaluating with which firm to invest and 
        for firms' own risk management efforts.

  7.  New Federal regulations (e.g., the upcoming revisions to 
        2a-7, any extension of Build America Bond programs, 
        hypothetical SEC rules for financial advisors and 
        dealers, etc.) could leverage disclosure flags and DCS 
        scores in addition to other factors.

  8.  With respect to the MSRB's EMMA system, we strongly 
        recommend that Congress and/or the SEC ensure that the 
        EMMA database include all historical primary and 
        secondary market disclosure documents now being 
        archived by the four current NRMSRs. This will be a 
        critical factor for investor protection once EMMA 
        becomes the sole NRMSR, as, once that happens, the 
        current providers will lose their incentive (and 
        possibly their financial ability) to adequately 
        maintain the databases that have been painstakingly 
        collected over the last ten years. The failure to add 
        past databases will also allow the MSRB to postpone 
        real disclosure reform on the basis that more time is 
        needed to collect information before the SRO can 
        determine if lapses have actually occurred. We also 
        encourage Congress to require a formal advisory role, 
        with respect to EMMA's organization and delivery of 
        primary and secondary market disclosure items, to the 
        National Federation of Municipal Analysts (NFMA)--which 
        represents the substantial majority of EMMA's users 
        (including, we should note, both buy-side and sell-side 
        firms).

  9.  Finally, we note that we have included no recommendations 
        with respect to the content of required secondary 
        market disclosures in 15c2-12. While we believe that 
        what is now being disclosed is unsatisfactory in some 
        respects and superfluous in others, changes should be a 
        product of broad industry discussion--as they were when 
        rule 15c2-12 was created. We recommend that the MSRB 
        and SEC be required to revisit this process to make 
        regular adjustments to 15c2-12 in a fully transparent 
        and recurring fashion.

Q.2. Conflicts of Interest: Concerns about the impact of 
conflicts of interest that are not properly managed have been 
frequently raised in many contexts--regarding accountants, 
compensation consultants, credit rating agencies, and others. 
For example, Mr. Turner pointed to the conflict of the board of 
FINRA including representatives of firms that it regulates. The 
Millstein Center for Corporate Governance and Performance at 
the Yale School of Management in New Haven, CT, on March 2 
proposed an industry-wide code of professional conduct for 
proxy services that includes a ban on a vote advisor performing 
consulting work for a company about which it provides 
recommendations.
    In what ways do you see conflicts of interest affecting the 
integrity of the markets or investor protection? Are there 
conflicts affecting the securities markets and its participants 
that Congress should seek to limit or prohibit?

A.2. Witness declined to respond to written questions for the 
record.

Q.3. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the nation's economy. Please summarize your 
recommendations on the best way to oversee these instruments.

A.3. Witness declined to respond to written questions for the 
record.

Q.4. Corporate Governance--Majority Vote for Directors, Proxy 
Access, Say on Pay: The Council of Institutional Investors, 
which represents public, union and corporate pension funds with 
combined assets that exceed $3 trillion, has called for 
``meaningful investor oversight of management and boards'' and 
in a letter dated December 2, 2008, identified several 
corporate governance provisions that ``any financial markets 
regulatory reform legislation [should] include.'' Please 
explain your views on the following corporate governance 
issues:

  1.  Requiring a majority shareholder vote for directors to be 
        elected in uncontested elections;

  2.  Allowing shareowners the right to submit amendment to 
        proxy statements;

  3.  Allowing advisory shareowner votes on executive cash 
        compensation plans;

A.4. Witness declined to respond to written questions for the 
record.

Q.5. Credit Rating Agencies: Please identify any legislative or 
regulatory changes you believe are warranted to improve the 
oversight of credit rating agencies.
    In addition, I would like to ask your views on two specific 
proposals:

  1.  The Peterson Institute report on ``Reforming Financial 
        Regulation, Supervision, and Oversight'' recommended 
        reducing conflicts of interest in the major rating 
        agencies by not permitting them to perform consulting 
        activities for the firms they rate.

  2.  The G30 Report ``Financial Reform; A Framework for 
        Financial Stability'' recommended that regulators 
        should permit users of ratings to hold NRSROs 
        accountable for the quality of their work product. 
        Similarly, Professor Coffee recommended creating 
        potential legal liability for recklessness when 
        ``reasonable efforts'' have not been made to verify 
        ``essential facts relied upon by its ratings 
        methodology.''

A.5. In the past year, substantial blame has been placed on the 
rating agencies for: (1) implicit conflicts of interest in the 
issuer-pays (i.e., banker-pays) system; (2) faulty ratings; and 
(3) the facilitation of regulators' and the financial 
industry's over-reliance on ratings generally. We believe all 
these points are well made; however, the SEC has already taken 
positive strides by bolstering the regulation of rating agency 
performance. We do not believe that incremental regulation of 
the rating agencies themselves, beyond these new rules, will 
substantially benefit investor protection. Rather, we encourage 
Congress to focus on changing regulations that deal with how 
regulators and investors use ratings.

  1.  The issuer-pays system cannot be abandoned as, in 
        particular in the municipal bond market, there would 
        reasonably be insufficient investor demand to pay for, 
        and consistently maintain, a rating on each and every 
        bond. Were rating agencies no longer able to bill 
        issuers for ratings, the number and quality of ratings 
        available would likely contract, increasing the 
        informational advantage of dealers and large 
        institutional investors versus individuals and small 
        investors.

  2.  Still, any issuer-pays system has obvious potential 
        conflicts of interest, and our firm has long advised 
        our subscribers to treat rating agency ratings as sales 
        material and consider the rating agencies to be 
        effectively part of bond selling groups. We believe 
        this more adversarial framework should be employed when 
        including ratings or rating requirements in any 
        regulatory documents in the future.

  3.  To this point, we believe that Congress should create a 
        set of rating definitions (which would speak to 
        investors' expected loss--meaning a combined measure of 
        probability of default and loss if a default were to 
        occur) and require that ratings adhere to these 
        definitions if they are to be used with respect to any 
        Federal regulations (for example, Rule 2a-7). In other 
        words, the rating agencies should be able to promulgate 
        and sell ratings under any scheme of their choosing, 
        but those ratings could only be used by issuers and 
        investors for compliance with Federal regulations if 
        the rating scale's definitions match those explicitly 
        defined by Congress. This addresses what we see as an 
        enormous current problem in that regulations include 
        reference to ratings, but the rating agencies are free 
        to define those ratings to their best judgment. Thus 
        the problem in the municipal industry where municipal 
        ratings reside on a more conservative rating scale than 
        do corporate bonds (AAA corporate bonds have defaulted 
        at 10x the rate of BBB municipals) but Federal 
        regulations, such as money market fund eligibility 
        rules, use identical rating benchmarks for both. 
        Similarly, both commercial mortgage backed securities 
        and the US Treasury can be rated AAA but there are 
        obvious differences in the rating agencies' assumptions 
        about the meaning behind those ratings. The new SEC 
        rules will greatly help that entity monitor the rating 
        agencies' success in plotting individual ratings along 
        specified, expected-loss-based rating scales.

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds 
Association testified before the House Subcommittee on Capital 
Markets and said: ``MFA and its members acknowledge that at a 
minimum the hedge fund industry as a whole is of systemic 
relevance and, therefore, should be considered within the 
systemic risk regulatory framework.'' MFA supported the 
creation or designation of a ``single central systemic risk 
regulator'' that (1) has ``the authority to request and 
receive, on a confidential basis, from those entities that it 
determines . . . to be of systemic relevance, any information 
that the regulator determines is necessary or advisable to 
enable it to adequately assess potential risks to the financial 
system,'' (2) has a mandate of protection of the financial 
system, but not investor protection or market integrity and (3) 
has the authority to ensure that a failing market participant 
does not pose a risk to the entire financial system.
    Do you agree with MFA's position? Do you feel there should 
be regulation of hedge funds along these lines or otherwise?

A.6. Witness declined to respond to written questions for the 
record.

Q.7. Self-Regulatory Organizations: How do you feel the self-
regulatory securities organizations have performed during the 
current financial crisis? Are there changes that should be made 
to the self-regulatory organizations to improve their 
performance? Do you feel there is still validity in maintaining 
the self-regulatory structure or that some powers should be 
moved to the SEC or elsewhere?

A.7. The current system of SROs has failed municipal investors 
during the current financial crisis, noting:

  1.  The MSRB and FINRA have been almost entirely reactive to 
        developing crises. MSRB did not issue comments on the 
        collapse of the Auction Rate Securities (ARS) market 
        until February 19, more than a month after the failure 
        of most ARS auctions. Instead, the MSRB should have had 
        a more thorough understanding of the ARS product's 
        almost complete dependency on the: (1) ratings of the 
        bond insurers; and (2) balance sheets of dealer banks. 
        MSRB should have begun an aggressive investor education 
        program starting in August 2007 and should have 
        provided clear guidance to dealer firms over their 
        management of failed auctions.

  2.  The MSRB has chosen to pursue derivatives regulation 
        after substantial pain has already been felt by the 
        industry. Further, the MSRB's plan to regulate swap and 
        financial advisors, while likely to the benefit of the 
        industry, would have done little to arrest many of the 
        problems actually felt by municipal issuers. For 
        example, widespread derivative problems in Tennessee 
        have emanated from derivative sales by Morgan Keegan (a 
        broker/dealer already regulated by MSRB). There are 
        several other similar instances (in Wisconsin and 
        Pennsylvania and Alabama) where it has been regulated 
        firms' derivative sales practices, and not failings of 
        unregulated swap advisors, that ultimately created 
        problems for issuers and ultimately individual 
        investors.

  3.  Claiming lack of resources, FINRA has been unable to 
        proactively pursue (or, investigate without a specific 
        customer complaint to guide their actions) clear 
        evidence of broad market manipulation. We believe that 
        FINRA's funding for proactive regulation is minimized 
        by design, as their focus on specific, trade-by-trade 
        pricing violations limits their potential influence on 
        systemic market characteristics such as how bonds are 
        valued and how bonds are distributed.

  4.  Indeed, MSRB's history of avoiding the pursuit of better 
        transparency in the municipal market has exaggerated 
        dealer banks' informational advantage versus their 
        customers and individual investors. Specifically we 
        note how better information on issuers' rate and 
        counterparty exposure via derivatives and interest rate 
        swaps could have helped both individual investors and 
        the issuers themselves manage their particular 
        exposure.

  5.  The MSRB has not aggressively pursued widespread 
        instances of current disclosure failure in the 
        municipal industry. While the MSRB has worked to create 
        and rollout their EMMA system that may bring an 
        ultimate improvement to disclosure, they have avoided 
        taking any opinion or making any immediate corrective 
        actions to ongoing disclosure problems hurting 
        investors today. Further, we believe that the MSRB's 
        plans to rollout EMMA, collect information for a year, 
        and then see if disclosure is really a problem reflects 
        an intent to maintain dealers' informational advantage 
        (gained by limiting investors' access to disclosure 
        documents) for as long as possible.

  6.  And perhaps most importantly, the MSRB has largely failed 
        to educate and keep informed the macro regulators and 
        US legislature on issues involving municipal bonds. We 
        believe this is a fundamental problem with SROs in 
        that, fearing more formal regulation, they attempt to 
        shield specific details and developments from broad 
        review; thus our phrase, ``municipals are a backwater 
        by design.'' MMA was first contacted by regulators (in 
        the summer of 2007) and since that time we have 
        maintained a highly active dialogue with both 
        Congressional staffs and macro regulators. We have been 
        shocked at the lack of understanding of even the 
        rudiments of our industry, the flows of capital and 
        data, the important players and pressures. In fact, we 
        believe that, had the MSRB more actively attempted to 
        educate Washington policymakers prior to the current 
        crisis, the Federal response could have been more rapid 
        and better informed.

    Given the events of the past 18 months, I believe that 
regulation must be integrated and centralized. Because of these 
failures, it would be prudent to either move the MSRB into the 
SEC--or, at a minimum certain changes must be made to the MSRB 
structure.
    If Congress deems it necessary that a SRO is an 
inappropriate model for regulation of the municipal industry, 
the following should take place:

  1.  Create a Division of Municipal Securities that would 
        report directly to the Chairman of the SEC. Move the 
        current Office of Municipal Securities out of the 
        Division of Trading and Markets into this new Division. 
        Move all MSRB staff and its current funding structure 
        into this new Division. The municipal industry is such 
        a unique market and functions in such a different way 
        from other markets that it should be separate from 
        other markets. In creating a new division, the industry 
        would benefit from specialized staff and researchers as 
        well as having a direct line of communication with the 
        office of the Chairman.

  2.  The MSRB staff must be bolstered with more seasoned 
        municipal experts and create specific offices within 
        the Municipal division focused on: secondary markets, 
        underwriting, derivatives, accounting, disclosure, 
        ratings, and bond insurance and tax issues. 
        Compensation should and can be competitive to ensure 
        the best staff possible. Under current MSRB funding 
        structure, in 2008 the MSRB received $22.1 million in 
        revenue and in 2007 it relieved $21.4 million in 
        revenue. The Board derives revenue from primary and 
        secondary transactions that market participants pay. 
        Detailed financial statements are available on the 
        Board's Web site.

  3.  Similar to our conclusions above in the disclosure 
        responses, substantive regularly improvements do not 
        require an end to the Tower Amendment, which bars the 
        Federal Government from regulating State and local 
        issuers. The loss of Tower would needlessly compromise 
        State autonomy and open the door to incremental Federal 
        intervention in State and local affairs. Instead, we 
        advocate a market-based solution.

  4.  Create a Municipal Securities Rulemaking Advisory Board 
        (MSRAB) that will be made up of 15 ``at large'' current 
        and retired market participants. The MSRAB will produce 
        a report to Congress and the Treasury Dept. annually on 
        new trends in the market and potential regulatory 
        shortcomings. The MSRAB should have continual 
        communication with the Division of Municipals 
        Securities.

  5.  Create a SEC-FINRA enforcement coalition council whereby 
        information is shared in a fluid basis on future 
        enforcement actions.

  6.  Create regional SEC municipal offices under the Division 
        to monitor regional activities on closer basis. The 
        municipals market, more than any other market in the 
        U.S., is dominated by local politics and is quite 
        fragmented. Having staff on the ground in every major 
        region is essential to productive regulation and timely 
        enforcement.

    On the other hand, we do note that there remains strong 
industry and perhaps even issuer support for the current SRO 
structure; MMA has received multiple comments to this effect 
since our Senate testimony. Thus, while we do believe that 
integrating the MSRB's components into an independent regulator 
is the better course of action, Congress may instead choose to 
preserve the current MSRB as an SRO structure. In preserving 
the SRO, we recommend Congress do the following:

  1.  Replace the current, dealer-centric MSRB board with 
        representative members who provide independent and 
        objective insight into the various aspects of the 
        purpose of the municipal industry--the efficient and 
        effective raising of capital for municipal entities.

  2.  Require that there be frequent and regular communication 
        between the municipal regulatory network (MSRB, FINRA, 
        Treasury, SEC, and the Federal Reserve), perhaps in the 
        form of weekly or monthly committee meetings. The SEC 
        should be given full access to minutes of any 
        discussions; these minutes should be made publicly 
        available to the extent possible. A semi-annual report 
        to Congress on the status of the industry should be 
        required.

  3.  Regulate and collect real-time information on municipal 
        derivatives including interest rate swaps and credit 
        default swaps. All derivatives information should be 
        made publicly available, illustrating, among other 
        points: counterparty exposure, termination and cost 
        exposure under absolute worst case scenarios, and price 
        volatility assumptions.

    There is no question in my mind that better regulation 
comes from participants who understand the motivations of the 
participants and the environment in which market participants 
work on a daily basis. The theoretical concept or asset of the 
SRO regulatory concept is based on having knowledgeable people 
involved in the process--not bureaucrats or those susceptible 
to political pressures. However, as has been readily apparent, 
an SRO is inhibited by the time an active market participant 
can commit to a volunteer position (regardless of how well 
intended the individual) and the challenge of the participant 
to act for the industry's best interest (i.e., altruistically) 
when it may run contrary to the interests of its employer and 
one's own employment viability.
    Specific to the municipal industry, the current composition 
of the Board, with 10 of 15 spots allotted to security dealers, 
does not provide for a balanced perspective of the industry and 
participants. The board must be broad, independent and 
structure/composition must be adaptable and flexible in its 
construct to anticipate future industry change. A balance of 
board members from different constituencies of the market and 
who are predominantly, not necessarily exclusively, retired 
from active industry involvement would more likely provide 
independent counsel, industry practical knowledge and a more 
comprehensive overview being removed from day-to-day industry 
responsibilities.

Q.8. Structure of the SEC: Please share your views as to 
whether you feel that the current responsibilities and 
structure of the SEC should be changed.
    Please comment on the following specific proposals:

  1.  Giving some of the SEC's duties to a systemic risk 
        regulator or to a financial services consumer 
        protection agency;

  2.  Combining the SEC into a larger ``prudential'' financial 
        services regulator;

  3.  Adding another Federal regulators' or self-regulatory 
        organizations' powers or duties to the SEC.

A.8. Witness declined to respond to written questions for the 
record.

Q.9. SEC Staffing, Funding, and Management: The SEC has a staff 
of about 3,500 full-time employees and a budget of $900 
million. It has regulatory responsibilities with respect to 
approximately: 12,000 public companies whose securities are 
registered with it; 11,300 investment advisers; 950 mutual fund 
complexes; 5,500 broker-dealers (including 173,000 branch 
offices and 665,000 registered representatives); 600 transfer 
agents, 11 exchanges; 5 clearing agencies; 10 nationally 
recognized statistical rating organizations; SROs such as the 
Financial Industry Regulatory Authority, the Municipal 
Securities Rulemaking Board and the Public Company Accounting 
Oversight Board.
    To perform its mission effectively, do you feel that the 
SEC is appropriately staffed? funded? managed? How would you 
suggest that the Congress could improve the effectiveness of 
the SEC?

A.9. The SEC needs a mechanism to collect market information 
and input from participants so as to understand the impact both 
short and long-term regarding policy actions. My limited 
experience with the municipal division of the SEC is that there 
is an interest to understand and learn. However, the entrenched 
mechanisms that have historically inhibited timely action and 
response to consumer needs or systemic risks has reduced the 
initiative and innovation among a long standing staff. There 
would appear to be a need for new structure in order to enliven 
the current talent pool.
    The MSRB funding structure is very profitable and moving 
the MSRB into a new SEC division should pay for itself. MSRB 
annual financial statements are available on its Web site.

Q.10. MSRB's Data System: Please explain in detail why the 
Congress should consider ``End[ing] the MSRB as an SRO'' and 
``Integrat[ing] the MSRB formally and directly into a larger 
entity, possibly the Securities Exchange Commission, Treasury 
or Federal Reserve'' as you suggest in your written testimony. 
Also, what is your evaluation of the impact of the MSRB's new 
EMMA data system on investors and dealers?

A.10. In my oral and written testimony I did advocate for the 
end of the SRO era with specific reference to the MSRB. My 
advocacy comes from the direct experience of seeing:

  1.  Volunteer board members deferring decision-making and 
        becoming over-reliant on staff;

  2.  Volunteer dealer members slowing down processes to 
        inhibit the creation of regulation that would inhibit 
        current profit-making enterprises;

  3.  Anti-regulation bias among dealer community inhibited 
        innovative action;

  4.  That dealer participants, especially in larger firms, 
        were compromised in advocating regulatory changes that 
        might establish regulatory precedent which could 
        potentially reduce their employer's near-term 
        profitability because their own employment could be at 
        risk for taking such action;

  5.  An absence of representation of the wide range of 
        participants in the municipal industry has historically 
        inhibited the gathering of pertinent information for 
        appropriate regulation that would create better and 
        more informed rules and policies.

    The current structure of the SRO has resulted in the 
pockets of regulatory opacity not being addressed.
    Had the MSRB been integrated into a larger entity in a 
coordinated manner, the risks being promulgated in the 
municipal industry might have been recognized sooner--not only 
to avert the chaos which ensued over the past 18 months but 
also might have raised awareness that similar excessive risks 
were occurring in other markets which could have prompted 
earlier and more prophylactic regulatory action to mitigate the 
systemic risks which ensued.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                        FROM THOMAS DOE

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

    Would a merger or rationalization of the roles of the SEC 
and CFTC be a valuable reform, and how should that be 
accomplished?
    How is it that AIG was able to take such large positions 
that it became a threat to the entire financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
risk management, or some combination?
    How should we update our rules and guidelines to address 
the potential failure of a systematically critical firm?

A.1. Witness declined to respond to written questions for the 
record.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                      FROM LYNN E. TURNER

Q.1. Transparency: Are there additional types of disclosures 
that Congress should require securities market participants to 
make for the benefit of investors and the markets?
    Also, would you recommend more transparency for investors:

  1. LBy publicly held banks and other financial firms of off-
        balance sheet liabilities or other data?

  2. LBy credit rating agencies of their ratings methodologies 
        or other matters?

  3. LBy municipal issuers of their periodic financial 
        statements or other data?

  4. LBy publicly held banks, securities firms and GSEs of 
        their risk management policies and practices, with 
        specificity and timeliness?

A.1. Witness declined to respond to written questions for the 
record.

Q.2. Conflicts of Interest: Concerns about the impact of 
conflicts of interest that are not properly managed have been 
frequently raised in many contexts--regarding accountants, 
compensation consultants, credit rating agencies, and others. 
For example, Mr. Turner pointed to the conflict of the board of 
FINRA including representatives of firms that it regulates. The 
Millstein Center for Corporate Governance and Performance at 
the Yale School of Management in New Haven, Connecticut on 
March 2 proposed an industry-wide code of professional conduct 
for proxy services that includes a ban on a vote advisor 
performing consulting work for a company about which it 
provides recommendations.
    In what ways do you see conflicts of interest affecting the 
integrity of the markets or investor protection? Are there 
conflicts affecting the securities markets and its participants 
that Congress should seek to limit or prohibit?

A.2. Witness declined to respond to written questions for the 
record.

Q.3. Credit Default Swaps: There seems to be a consensus among 
the financial industry, government officials, and industry 
observers that bringing derivative instruments such as credit 
default swaps under increased regulatory oversight would be 
beneficial to the nation's economy. Please summarize your 
recommendations on the best way to oversee these instruments.

A.3. Witness declined to respond to written questions for the 
record.

Q.4. Corporate Governance--Majority Vote for Directors, Proxy 
Access, Say on Pay: The Council of Institutional Investors, 
which represents public, union and corporate pension funds with 
combined assets that exceed $3 trillion, has called for 
``meaningful investor oversight of management and boards'' and 
in a letter dated December 2, 2008, identified several 
corporate governance provisions that ``any financial markets 
regulatory reform legislation [should] include.'' Please 
explain your views on the following corporate governance 
issues:

  1. LRequiring a majority shareholder vote for directors to be 
        elected in uncontested elections;

  2. LAllowing shareowners the right to submit amendment to 
        proxy statements;

  3. LAllowing advisory shareowner votes on executive cash 
        compensation plans.

A.4. Witness declined to respond to written questions for the 
record.

Q.5. Credit Rating Agencies: Please identify any legislative or 
regulatory changes you believe are warranted to improve the 
oversight of credit rating agencies.
    In addition, I would like to ask your views on two specific 
proposals:

  1. LThe Peterson Institute report on ``Reforming Financial 
        Regulation, Supervision, and Oversight'' recommended 
        reducing conflicts of interest in the major rating 
        agencies by not permitting them to perform consulting 
        activities for the firms they rate.

  2. LThe G30 Report ``Financial Reform; A Framework for 
        Financial Stability'' recommended that regulators 
        should permit users of ratings to hold NRSROs 
        accountable for the quality of their work product. 
        Similarly, Professor Coffee recommended creating 
        potential legal liability for recklessness when 
        ``reasonable efforts'' have not been made to verify 
        ``essential facts relied upon by its ratings 
        methodology.''

A.5. Witness declined to respond to written questions for the 
record.

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds 
Association testified before the House Subcommittee on Capital 
Markets and said: ``MFA and its members acknowledge that at a 
minimum the hedge fund industry as a whole is of systemic 
relevance and, therefore, should be considered within the 
systemic risk regulatory framework.'' MFA supported the 
creation or designation of a ``single central systemic risk 
regulator'' that (1) has ``the authority to request and 
receive, on a confidential basis, from those entities that it 
determines . . . to be of systemic relevance, any information 
that the regulator determines is necessary or advisable to 
enable it to adequately assess potential risks to the financial 
system,'' (2) has a mandate of protection of the financial 
system, but not investor protection or market integrity and (3) 
has the authority to ensure that a failing market participant 
does not pose a risk to the entire financial system.
    Do you agree with MFA's position? Do you feel there should 
be regulation of hedge funds along these lines or otherwise?

A.6. Witness declined to respond to written questions for the 
record.

Q.7. Self-Regulatory Organizations: How do you feel the self-
regulatory securities organizations have performed during the 
current financial crisis? Are there changes that should be made 
to the self-regulatory organizations to improve their 
performance? Do you feel there is still validity in maintaining 
the self-regulatory structure or that some powers should be 
moved to the SEC or elsewhere?

A.7. Witness declined to respond to written questions for the 
record.

Q.8. Structure of the SEC: Please share your views as to 
whether you feel that the current responsibilities and 
structure of the SEC should be changed.
    Please comment on the following specific proposals:

  1. LGiving some of the SEC's duties to a systemic risk 
        regulator or to a financial services consumer 
        protection agency;

  2. LCombining the SEC into a larger ``prudential'' financial 
        services regulator;

  3. LAdding another Federal regulators' or self-regulatory 
        organizations' powers or duties to the SEC.

A.8. Witness declined to respond to written questions for the 
record.

Q.9. SEC Staffing, Funding, and Management: The SEC has a staff 
of about 3,500 full-time employees and a budget of $900 
million. It has regulatory responsibilities with respect to 
approximately: 12,000 public companies whose securities are 
registered with it; 11,300 investment advisers; 950 mutual fund 
complexes; 5,500 broker-dealers (including 173,000 branch 
offices and 665,000 registered representatives); 600 transfer 
agents, 11 exchanges; 5 clearing agencies; 10 nationally 
recognized statistical rating organizations; SROs such as the 
Financial Industry Regulatory Authority, the Municipal 
Securities Rulemaking Board and the Public Company Accounting 
Oversight Board.
    To perform its mission effectively, do you feel that the 
SEC is appropriately staffed? funded? managed? How would you 
suggest that the Congress could improve the effectiveness of 
the SEC?

A.9. Witness declined to respond to written questions for the 
record.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
                      FROM LYNN E. TURNER

Q.1. Do you all agree with Federal Reserve Board Chairman 
Bernanke's remarks today about the four key elements that 
should guide regulatory reform?

        First, we must address the problem of financial institutions 
        that are deemed too big--or perhaps too interconnected--to 
        fail. Second, we must strengthen what I will call the financial 
        infrastructure--the systems, rules, and conventions that govern 
        trading, payment, clearing, and settlement in financial 
        markets--to ensure that it will perform well under stress. 
        Third, we should review regulatory policies and accounting 
        rules to ensure that they do not induce excessive 
        procyclicality--that is, do not overly magnify the ups and 
        downs in the financial system and the economy. Finally, we 
        should consider whether the creation of an authority 
        specifically charged with monitoring and addressing systemic 
        risks would help protect the system from financial crises like 
        the one we are currently experiencing.

    Would a merger or rationalization of the roles of the SEC 
and CFTC be a valuable reform, and how should that be 
accomplished?
    How is it that AIG was able to take such large positions 
that it became a threat to the entire financial system? Was it 
a failure of regulation, a failure of a product, a failure of 
risk management, or some combination?
    How should we update our rules and guidelines to address 
the potential failure of a systematically critical firm?

A.1. Witness declined to respond to written questions for the 
record.
                                ------                                


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER
                      FROM LYNN E. TURNER

Q.1. Are you concerned that too much reliance on investor 
protection through private right of action against the credit 
ratings agencies will dramatically increase both the number of 
law suits the companies will have to deal with as well as their 
cost of doing business? Have you thought about alternative ways 
to ensure adequate investor protections that will not result in 
driving capital from the U.S. in the same way that the fear of 
litigation and costs created by Sarbanes-Oxley has resulted in 
a decline in new listings in American capital markets?

A.1. Witness declined to respond to written questions for the 
record.
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