[Senate Hearing 111-144]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-144

 
    ENHANCING INVESTOR PROTECTION AND THE REGULATION OF SECURITIES 
                            MARKETS--PART II

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

          FURTHER 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 26, 2009

                               ----------                              

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


                                                        S. Hrg. 111-144


    ENHANCING INVESTOR PROTECTION AND THE REGULATION OF SECURITIES 
                            MARKETS--PART II

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

          FURTHER 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 26, 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


                  U.S. GOVERNMENT PRINTING OFFICE
53-176                    WASHINGTON : 2009
-----------------------------------------------------------------------
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092104 Mail: Stop IDCC, Washington, DC 20402ï¿½090001


            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

                   Julie Chon, Senior Policy Adviser

                Brian Filipowich, Legislative Assistant

                Mark Oesterle, Republican Chief Counsel

                Hester Pierce, Republican Senior Counsel

                Andrew Olmem, Republican Senior 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

                              ----------                              

                        THURSDAY, MARCH 26, 2009

                                                                   Page

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

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

                               WITNESSES

Mary L. Schapiro, Chairman, Securities and Exchange Commission...     5
    Prepared statement...........................................    74
    Response to written questions of:
        Senator Menendez.........................................   247
Fred J. Joseph, President, North American Securities 
  Administrators
  Association....................................................     7
    Prepared statement...........................................    84
Richard C. Breeden, Former Chairman, Securities and Exchange 
  Commission.....................................................    33
    Prepared statement...........................................    92
Arthur Levitt, Former Chairman, Securities and Exchange 
  Commission.....................................................    34
    Prepared statement...........................................   101
Paul S. Atkins, Former Commissioner, Securities and Exchange 
  Commission.....................................................    37
    Prepared statement...........................................   104
Richard G. Ketchum, Chairman and Chief Executive Officer, 
  Financial Industry Regulatory Association......................    53
    Prepared statement...........................................   162
Ronald A. Stack, Chair, Municipal Securities Rulemaking Board....    55
    Prepared statement...........................................   166
Richard Baker, President and Chief Executive Officer, Managed 
  Funds
  Association....................................................    57
    Prepared statement...........................................   181
    Response to written questions of:
        Senator Reed.............................................   249
James Chanos, Chairman, Coalition of Private Investment Companies    59
    Prepared statement...........................................   187
    Response to written questions of:
        Senator Reed.............................................   254
Barbara Roper, Director of Investor Protection, Consumer 
  Federation of America..........................................    61
    Prepared statement...........................................   195
David G. Tittsworth, Executive Director and Executive Vice 
  President, Investment Adviser Association......................    62
    Prepared statement...........................................   216
Rita M. Bolger, Senior Vice President and Associate General 
  Counsel, Global Regulatory Affairs, Standard & Poor's..........    64
    Prepared statement...........................................   228
    Response to written questions of:
        Senator Reed.............................................   277
Daniel Curry, President, DBRS, Inc...............................    66
    Prepared statement...........................................   243
    Response to written questions of:
        Senator Reed.............................................   277

                                 (iii)

 
    ENHANCING INVESTOR PROTECTION AND THE REGULATION OF SECURITIES 
                            MARKETS--PART II

                              ----------                              


                        THURSDAY, MARCH 26, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 9:36 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. Good morning. The Committee will come to 
order. Let me welcome my colleagues who are here, as well as 
our witnesses. We have a very busy morning today. We have got a 
long list of very distinguished witnesses to appear before us 
this morning on the subject matter of enhancing investor 
protection and the regulation of securities markets. This is 
the ninth--is it the ninth or tenth?--on the general matter of 
the modernization of Federal regulations and the second very 
specific hearing on the securities industry itself.
    There is an awful lot of ground to cover here. We have 
three panels this morning, the first, of course, involving Mary 
Schapiro, the Chairman of the Securities and Exchange 
Commission, and Fred Joseph, who is the President of North 
American Securities Administrators Association.
    A second panel of witnesses who have been before this 
Committee on numerous occasions, of course, the previous 
Chairs--I see Mr. Breeden is here already this morning, and 
Arthur Levitt and others, along with Paul Atkins, who will be 
testifying about their experience, background, how this all 
emerged, and their thoughts on how we move forward.
    And then a third panel of witnesses who will give us some 
very current experiences they are going through and ideas and 
thoughts as to how we ought to proceed. So I appreciate their 
testimony.
    What I am going to do is have opening statements by just 
Senator Shelby and myself, although Senator Warner is here, and 
as long as no one else shows up, you can make an opening 
statement, because I worry about if we have everybody show up, 
we will be here until midnight tonight.
    [Laughter.]
    Senator Shelby. Governor Warner--he is used to those 
opening statements.
    Chairman Dodd. Yes, I know. Well, he was a good Governor 
and he is a good Senator. We welcome him to this Committee.
    Then I am going to ask my colleagues--we are going to have 
one round on the first panel. As much as there are many 
questions, obviously, we have for both of you, but if we end up 
with too many rounds, we will never get to the second and third 
panels, and colleagues have busy schedules as well, as do our 
witnesses. So we will cut it off after one round.
    Then we will go to the second panel, which I will leave a 
little more open, given the backgrounds of our witnesses, and 
the third panel.
    With that, let me share some opening comments and then turn 
to Senator Shelby, and then we will go right to our witnesses 
this morning.
    Today, the Committee meets, as I said, for our second 
hearing to examine the securities market regulation, the ninth 
hearing on this general matter of modernization of Federal 
regulations. This hearing is to discuss how investors and our 
entire financial system are protected, or lack of protection, 
in the future from the kind of activities that led to the 
current crisis. This hearing is one of a series, as I 
mentioned, of nine we have already convened to modernize the 
overall regulatory framework and to rebuild our financial 
system. And I saw this morning the headlines of our local 
newspaper here, the direction that the Secretary of the 
Treasury is heading. I welcome that. This is all within about 
60 days of this administration coming to office. We will not 
have all the time this morning to go over that. This Committee 
will be meeting at the request of the Treasury tomorrow with 
Democrats and Republicans to listen to some of these thoughts. 
It is not a formal hearing. We will have one of those. But 
given the time constraints and the fact that the administration 
is heading overseas to the meeting coming up with the G-20, we 
thought it would be worthwhile to have at least a briefing as 
to where this thing is heading. So we welcome that and are 
excited over the fact that they are going to be proposing some 
thoughts in this area as well.
    We are also very excited to have two witnesses who are not 
only former Chairmen of the SEC but also, I might add, 
residents of my own State as well, having Arthur Levitt and 
Richard Breeden with us.
    From the outset, I have argued that our financial system is 
not really in need of reform but modernization, that truly 
protecting consumers and investors in the decades to come will 
require a vast overhaul of our financial architecture that 
recognizes the extraordinary transformation that has occurred 
over the last quarter of a century, and it is extraordinary. 
And nowhere has that transformation been clearer than in the 
area of securities, which have come to dominate our financial 
system, now representing 80 percent--80 percent--of all 
financial assets in the United States.
    With pension funds, the proliferation of 401(k)s and the 
like, today half of all households in the United States are 
invested in some way in the securities markets. As Federal 
Reserve Governor Dan Tarullo said at our last hearing on this 
subject matter, ``The source of systemic risk in our financial 
system has, to some considerable extent, migrated from 
traditional banking activities to markets over the last 20 or 
25 years.''
    In essence, as the assets of our financial system have 
shifted from banking deposits to securities, so too have the 
dangers posed to our economy as a whole. We need regulators 
with the expertise, tools, and resources to regulate this new 
type of financial system.
    At our last hearing on this subject, this Committee heard 
about the need to watch for trends that could threaten the 
safety of our financial system. Our witnesses had different 
views on what regulatory body should perform that function. 
Some felt it should be given to a special commission made up of 
the heads of existing agencies. Others have argued for a new 
agency or to give that authority to an existing regulator.
    As I have said, given the regulatory failures we saw in the 
lead-up to this crisis, I have concerns, and I think many of my 
colleagues have also expressed, about this authority residing 
exclusively within one body. And I re-express those views this 
morning.
    For instance, we have seen problems with the regulated bank 
holding companies where they have not been well regulated at 
the holding company level. And while there are many aspects to 
our financial system, systemic risk itself has many parts as 
well. One is the regulation of practices and products which 
pose systemic risk, from subprime mortgages to credit default 
swaps, and that is why I remain intrigued by the idea of a 
council approach to address this aspect of systemic risk. And I 
know our previous witnesses Paul Stevens with the Investment 
Company Institute and Damon Silvers with the AFL-CIO have both 
recommended this type of concept.
    Of course, systemic risk is only one issue which we are 
examining. At our last hearing on this subject matter, we heard 
how we could increase transparency by addressing the risks 
posed by derivatives. We heard ways to improve the performance 
of credit rating agencies, who failed the American people 
terribly, by requiring them to verify the information they used 
to make those ratings. And, more recently, Secretary of 
Treasury Geithner has proposed the creation of a resolution 
mechanism for systemically important nonbank financial 
institutions, and I will be very interested in hearing from 
you, Chairman Schapiro, on that subject matter, what your 
thoughts are and the role the SEC should play.
    In providing this authority to the FDIC, I am pleased that 
they have recognized the need to ensure that powerful new tools 
do not all reside, again, with any single agency.
    These are all ideas that deserve careful examination, which 
we will engage in here at this Committee. Today's diverse 
panel, including representatives from hedge funds, credit 
rating agencies, retail investors, industry self-regulatory 
organizations, paints a very vivid picture of the numerous 
issues facing the securities markets at this moment.
    The goals of modernization are clear, in my view: 
consistent regulation across our financial architecture with 
strong cops on the beat in every neighborhood; checks and 
balances to ensure our regulators and the institutions that 
oversee them are held accountable; and transparency so that 
consumers and investors are never in the dark about the risks 
they will be taking on.
    The time has come for a new era of responsibility in 
financial services. That begins with the rebuilding of our 21st 
century financial architecture from the bottom up, with the 
consumer clearly in our minds in the forefront. It begins with 
the work of this Committee, and, again, this is now almost the 
tenth hearing on the subject matter. Senator Shelby and I and 
our colleagues here are determined to play a constructive and 
positive role as we help shape this debate in the coming weeks.
    With that, let me turn to Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    I look forward to hearing from our witnesses today. I am 
particularly interested in hearing from SEC Chairman Schapiro 
about the steps that she is taking to address the agency's 
recent regulatory failures. This includes the disappearance of 
the investment banks, the SEC's largest regulated entities 
there; the systemically devastating failures by the credit 
rating agencies that enjoy the SEC's implicit seal of approval; 
and the Madoff fraud. I believe that changes in the way the 
agency is managed and how its resources are used will be of 
utmost importance in getting the SEC back on the right track.
    The insights of former SEC Chairmen and Commissioners, 
State securities regulators, and self-regulatory organizations 
will also be useful in determining what changes may be needed. 
For that reason, I am pleased that we have representatives of 
each of these groups here today. Only by hearing a wide range 
of perspectives and by digging deep inside these agencies and 
failed financial institutions will we be able to fully 
understand how we got into this crisis, how we can get out of 
it, and how we can prevent them in the future.
    Mr. Chairman, I think we are on the right road here 
breaking all this down into the various parts, and I commend 
you for that.
    Chairman Dodd. Thank you very much.
    I only see a couple of our colleagues, and I know that 
Senator Corker likes to give long opening statements.
    [Laughter.]
    Chairman Dodd. So I am going to presume we are going to 
pass and get right to our witnesses. All right. Senator Tester, 
any quick comments?
    Senator Tester. Well, since Senator Corker is here, I want 
to give a long opening statement.
    [Laughter.]
    Senator Tester. I pass.
    Chairman Dodd. Well, again, Chairman Schapiro and Mr. 
Joseph, we thank you for coming before the Committee, and let 
me just say to my colleagues and witnesses--I always say this, 
but it needs to be said--that any supporting documents and 
information you think would be helpful in expanding your 
answers to questions or comments or full opening statements my 
colleagues would like to make will be included in the record as 
we go forward. And we will leave the record open for several 
days because invariably there will be additional questions I 
think my colleagues would like to ask, and we will leave that 
record open and ask you to respond as quickly as possible.
    With that, Chairman Schapiro, we welcome you before the 
Committee again.

            STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN,
               SECURITIES AND EXCHANGE COMMISSION

    Ms. Schapiro. Thank you very much, Chairman Dodd, Ranking 
Member Shelby, and Members of the Committee. I appreciate the 
opportunity to testify as we face a critical juncture in the 
history of our Nation's financial markets. It is a particular 
pleasure to appear with Fred Joseph, Securities Commissioner 
from the State of Colorado and the head of NASAA.
    I am testifying today on behalf of the Commission as a 
whole. The Commission agrees that our goal is to improve the 
financial regulatory system, that we will work constructively 
to that end, and that we are all fully committed to the mission 
of the SEC. In light of the recent economic events and their 
impact on the American people, I believe this Committee's focus 
on investor protection and securities regulation as part of a 
reconsideration of the financial regulatory regime is timely 
and critically important.
    I strongly support the view that there is a need for 
systemwide consideration of risks to the financial system and 
for the creation of mechanisms to reduce and avert systemic 
risks. I am equally convinced that regulatory reform must be 
accomplished without compromising the integrity of our capital 
markets or the protection of investors. This is the SEC's core 
mission, and we believe that an independent agency with this 
singular focus is an essential element of an effective 
financial regulatory regime.
    I believe that three general principles should feature 
prominently in regulatory reform. The first is that an 
integrated capital markets regulator that focuses on investor 
protection is indispensable to restoring investor trust and 
confidence, which is in turn indispensable to the recovery of 
our economy; second, that regulator must be independent; and 
third, a strong and investor-focused capital markets regulator 
complements the role of a systemic risk regulator, resulting in 
a more effective oversight regime.
    The SEC's regulation of the Nation's capital markets 
involves an integrated set of functions that promote the 
efficiency, competition, and fairness of our markets for the 
benefit of investors; through the regulation of the exchanges, 
clearing agencies, and transfer agents that provide the 
infrastructure that makes our markets work at lightning speed, 
with remarkable efficiency, and at low cost to investors; 
through the provision of accurate, meaningful, and timely 
corporate information which allows investors to allocate 
capital efficiently; through the independence of expert 
accounting standard setters to ensure that the primary focus in 
standard setting is investors reading financials, not the 
companies preparing them; through the rules that ensure that 
mutual and money market funds which hold over $9 trillion of 
assets are operated for the benefit of investors and only 
investors; through the oversight of 5,500 broker-dealers and 
over 11,000 investment advisers to whom investors turn for 
guidance when accessing our capital markets; and, finally, 
through enforcement, done aggressively and without fear or 
favor.
    Each of the SEC's core functions interacts with the others. 
As an aggregated set, they provide for strong capital markets 
oversight. Take any function away, and the investor protection 
mission suffers. If the functions are disaggregated, capital 
markets oversight becomes diluted and investors suffer.
    As we look to the future of securities regulation, we 
believe that independence is an essential attribute of a 
capital market's regulator. Congress created the SEC to be the 
investor's advocate, and Congress did so precisely so that we 
can champion those who otherwise would not have a champion and, 
when necessary, take on the most powerful interests in the 
country. Regulatory reform must guarantee that independence in 
the future.
    Finally, the SEC, as a strong and independent capital 
markets regulator, will work cooperatively to support the 
mission of systemic risk regulation, whether it is accomplished 
through the designation of a single entity to monitor and 
control risk or through a college of regulators approach.
    When I returned to the SEC as Chairman in January, I 
appreciated the need to act swiftly to help restore investor 
confidence in our markets and in the SEC. In less than 2 
months, we have instituted important reforms to reinvigorate 
our enforcement program, better train our examination staff, 
and improve our handling of tips and complaints. To address 
short selling, the Commission will consider proposals early 
next month to reinstate the uptick rule. And on April 15th, the 
Commission will hold a public roundtable on possible credit 
rating agency reforms.
    This spring, I will ask the Commission to consider 
proposals to strengthen money market funds through improvements 
to credit quality, maturity, and liquidity standards; improve 
investor access to public company proxies; and significantly 
enhance controls over the safekeeping of investor assets.
    But we cannot do everything alone, and this crisis 
highlights several pressing needs. I expect to ask for the 
Committee's help with legislation that would require 
registration of investment advisers who advise hedge funds, and 
likely of the hedge funds themselves; legislation to break down 
statutory barriers between broker-dealers and investment 
advisers, and to fill other gaps in regulatory oversight, 
including those related to credit default swaps and municipal 
securities, an area that has far too long needed more robust 
oversight.
    Every day when I go to work, I am committed to putting the 
SEC on track to serve as a forceful regulator for the benefit 
of America's investors. Today, the SEC's core mission of 
capital markets oversight and investor protection is as 
fundamentally important as it ever was, and I am fully 
committed to ensuring that the SEC carries out that job in the 
most effective way it can.
    Thank you again for the opportunity to share the SEC's 
views. We very much look forward to working with the Committee 
on any financial reform efforts in the months ahead, and I, of 
course, would be pleased to answer any questions.
    Chairman Dodd. Thank you very much, Chairman Schapiro.
    Mr. Joseph, thank you very much for being with us.

         STATEMENT OF FRED J. JOSEPH, PRESIDENT, NORTH
         AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION

    Mr. Joseph. Thank you, Mr. Chairman. Chairman Dodd, Ranking 
Member Shelby, and Members of the Committee, I am Fred Joseph, 
Colorado Securities Commissioner and President of the North 
American Securities Administrators Association--NASAA. I am 
honored to be here today to discuss legislative and regulatory 
changes that are most relevant to Main Street Americans who are 
looking to regulators and lawmakers to help them rebuild and 
safeguard their financial security.
    In November 2008, NASAA released its Core Principles for 
Regulatory Reform in Financial Services and subsequently issued 
a pro-investor legislative agenda for the 111th Congress. Today 
I would like to highlight the recommendations that we feel are 
most vital to sound regulatory reform and strong investor 
protection.
    NASAA's top legislative priority is to protect investors by 
preserving State securities regulatory and enforcement 
authority over those who offer investment advice and sell 
securities to their residents. Just one look at our enforcement 
data shows the effectiveness of State securities regulation. 
Last year in Colorado alone, my office conducted investigations 
that led to 246 enforcement actions, resulting in $3 million 
ordered to be returned to investors and 434 years of prison 
time for fraudsters. And just last month, a Ponzi scheme 
investigation launched by my office resulted in a prison 
sentence of 132 years for the main perpetrator.
    And yet, over a number of years there have been calls for 
preemption of State regulation and enforcement. The National 
Securities Markets Improvement Act of 1996, NSMIA, preempted 
much of the States' regulatory authority for securities traded 
in national markets. Although it left State antifraud 
enforcement largely intact, it limited the States' ability to 
address fraud in its earliest stages before massive losses have 
been inflicted on investors.
    An example of this is in the area of private offerings 
under Rule 506 of Regulation D. These offerings enjoy an 
exemption from registration under Federal securities law, so 
they receive virtually no regulatory scrutiny. As a result, we 
have observed a significant rise in the number of offerings 
made pursuant to Rule 506 that are later discovered to be 
fraudulent.
    Although Congress preserved the States' authority to take 
enforcement actions for fraud, this power is no substitute for 
a State's ability to scrutinize the offerings for signs of 
potential abuse and to ensure that disclosure is adequate 
before harm is done to investors. NASAA believes the time has 
come for Congress to reinstate State regulatory oversight of 
all Rule 506 offerings.
    Next, the Madoff case illustrates the horrific consequences 
we face when an investment adviser's illegal activity goes 
undetected and unchecked for an extended period. NASAA 
recommends two changes to enhance the States' role in policing 
investment advisers. First, the SEC should expand the class of 
IAs that are subject to State registration and oversight. In 
NSMIA, Congress provided that the States would regulate IAs 
with up to $25 million in assets under management, while the 
SEC would regulate the larger IAs. Congress further intended 
that the SEC would periodically review this allocation of 
authority and adjust it appropriately. The time is now for the 
$25 million ``assets under management'' test to be increased 
possibly to $100 million.
    Congress should also consider enhancing the States' 
enforcement authority over large IAs. Currently, a State can 
only take enforcement action against a federally registered 
investment adviser if it finds evidence of fraud. This 
authority should be broadened to encompass any violations under 
State law, including dishonest and unethical practices. This 
enhancement will not interfere with the SEC's exclusive 
authority to register and oversee the activities of large IAs.
    NASAA also urges Congress to apply the fiduciary duty to 
all financial professionals who give investment advice 
regarding securities--broker-dealers and investment advisers 
alike. This step will enhance investor protection, eliminate 
confusion, and even promote regulatory fairness by establishing 
conduct standards according to the nature of the services 
provided and not the licensing status of the provider.
    The fiduciary duty is the obligation to place a client's 
interest first, to eliminate any conflicts of interest, and to 
make full and fair disclosure to clients. We recommend that 
Congress ratify the highest standard of care. For all financial 
professionals, the interests of the clients must come first at 
all times.
    Many observers believe that private actions are the 
principal means of redress for victims of securities fraud, but 
they also play an indispensable role in deterring fraud and 
complementing the enforcement efforts of Government regulators 
and prosecutors. The problem is that Congress and the U.S. 
Supreme Court have restricted the ability of private plaintiffs 
to seek redress in court for securities fraud. These 
restrictions have not only reduced the compensation available 
to those who have been the victims of securities fraud, but 
they have also weakened a powerful deterrent against misconduct 
in our financial markets. Removing excessive restrictions on 
access to the courts would not only provide just compensation 
for investors, it would also benefit regulators by restoring a 
powerful deterrent against fraud and abuse--that is, the threat 
of civil liability.
    In conclusion, State securities regulators believe that 
enhancing our securities laws and regulations and ensuring they 
are being vigorously enforced is the key to restoring investor 
confidence in our markets. NASAA and its members are committed 
to working with the Committee to ensure that the Nation's 
financial services regulatory regime undergoes the important 
changes that are necessary to enhance Main Street investor 
protection, which State securities regulators have provided for 
nearly 100 years.
    Thank you very much.
    Chairman Dodd. Thank you very much, Mr. Joseph. We 
appreciate that very much. We will begin with the first round, 
and I will ask the clerk to keep an eye on this clock here so 
we make sure we get to everybody and move along with as many 
witnesses we have.
    Madam Chairman, thank you again for being with us here this 
morning. Lehman Brothers, Financial Products Division, AIG, 
among others, I guess, you have heard Secretary Geithner and 
Fed Chairman Bernanke propose the creation of a resolution 
mechanism for nonbank entities as a way to move things forward. 
Obviously, you are talking about an area in which the SEC plays 
a very critical role. So, one, I would be interested to know 
whether or not you were consulted on this at all. We have 
talked about the Treasury Secretary and the Chairman of the 
Federal Reserve, but given the fact we are talking about 
entities that would normally fall under the jurisdiction of the 
SEC or the State regulators, were you at all consulted by the 
Treasury and the Fed? What role do you think the SEC should 
play in this resolution mechanism given the oversight and 
regulator responsibilities? And let me take advantage of the 
moment as well to ask you, if you would, to comment on the 
reports of the regulatory changes that Secretary Geithner has 
mentioned this morning. In fact, I will ask both of you to do 
that, but let me begin with Chairman Schapiro.
    Ms. Schapiro. Thank you, Mr. Chairman. I would say broadly 
and quite generally there was consultation with respect to the 
concept of filling the gaps in the existing resolution regime, 
but really very little conversation about what that would look 
like and what the legislative proposal ultimately would 
propose.
    We clearly have gaps in our resolution regime for large 
financial institutions. SIPC obviously handles the unwinding 
and the liquidation of a broker-dealer. FDIC is empowered to 
handle the unwinding or the resolution of a bank, but we have 
bank holding companies and other large financial institutions 
for which there really is no organized resolution regime. And I 
do think that that was an issue, clearly an issue with AIG, but 
also an issue with Lehman Brothers and other institutions.
    So I fully support the concept of closing the gap in 
resolution regimes so that we have a more coherent approach. 
Whether that ultimately rolls SIPC, over which the SEC has 
authority, into it or it works to be highly coordinated and 
cooperative with an entity like SIPC I think is something we 
should probably discuss as this legislation moves forward.
    Chairman Dodd. Let me just say on that point, before we 
move to the second question, whether they have consulted with 
you or not, I would hope that you would demand to be consulted 
on this. This is something where clearly this is--you are going 
to have a resolution of these entities here, given the role of 
the SEC in the regulation of them and the oversight of them. 
And I am very much supportive of the idea of having a 
resolution mechanism. I do not want to suggest I am not. But it 
seems to me you have got to be involved in this.
    Ms. Schapiro. There is actually no question but that we 
have to be involved in this. The SEC has an enormously 
important role to play here as the expert. But, again, as I 
said in my opening statement, as the advocate for the investor 
whose funds are in potentially multiple components of a large 
financial firm, and most particularly, of course, the broker-
dealer, and our concern will always be the protection of 
investors' assets in the broker-dealers.
    So I am not known for being shy. I have no intention of 
being shy.
    Chairman Dodd. Kick down the door, if you have to.
    Ms. Schapiro. I will kick down the door.
    Chairman Dodd. Mr. Joseph--let me have you respond to this 
quickly, and then I want to get back to this--and do not take a 
long time on the second part of that question, but I would be 
interested in your general reaction to what you have heard this 
morning from Treasury and others on the modernization.
    Ms. Schapiro. With respect to a systemic risk regulator?
    Chairman Dodd. Yes.
    Ms. Schapiro. Again, the devil is in the details on this 
one for sure, and my concern is that in the creation of a 
systemic risk regulator we do not create a monolithic entity 
that supplants the important functions that are served by 
multiple other agencies and most especially, in my view, the 
Securities and Exchange Commission and our role as a regulator 
of the capital markets with a focus, again, solely on investors 
and investor protection.
    So while I support the concept of either a systemic 
regulator or a college of regulators--which I think is a 
concept you have talked about; I know there is at least one 
bill proposed that would create that sort of a mechanism, and I 
think it is well worth exploring because I think multiple 
regulators bring a lot to the table and multiple perspectives.
    Nonetheless, whichever way we end up going, I think there 
is value to a view across the markets of large or rapidly 
increasing exposures that can threaten the health of the 
financial system. I think there is an important focus on 
evaluation of risk management procedures within large firms. I 
think there are certain prudential standards that ought to be 
established for very important systemic institutions. And I 
think a risk regulator can help the appropriate resolution 
authority in their functions.
    But I think what is really important is that while we try 
to create a mechanism like this, that we do not try to supplant 
the very important functions that are engaged in by agencies 
like the SEC in the regulation of markets, clearance and 
settlement systems, brokerage firms, mutual funds where 
Americans entrust their savings and so forth.
    Chairman Dodd. Let me just say, my time is up here, and, 
again, I think Senator Shelby and I are both very determined to 
work very closely together on this, so I would not want any of 
my statements to be taken as a final conclusion on this. But as 
we talk about a systemic risk regulator and a prudential 
regulator, my own view is we put that together. I get somewhat 
uneasy about consolidation of a lot of this. It looks great on 
a sheet of paper in terms of doing the efficiencies of it. But 
I for one feel very strongly, at least at this point, that the 
SEC and the function of the SEC ought not to be so incorporated 
in something that it ends up diminishing the role of the 
Securities and Exchange Commission in investor confidence, 
investor confidence, investor confidence.
    Ms. Schapiro. I completely agree with you. My fear is that 
a systemic risk regulator and systemic risk concerns will 
always trump investor protection. And given the structure of 
our markets and the broad participation of the public in our 
markets, that would be a terrible result.
    Chairman Dodd. We are interested in your thoughts and views 
on this as well, but I would not want the moment to pass 
without expressing my reservations about moving a lot of boxes 
around and consolidating things and assuming you are getting 
something better because you have got fewer boxes.
    Ms. Schapiro. Thank you.
    Chairman Dodd. In fact, the goal is that consumer, that 
investor, that shareholder, that user of the system, what is in 
their interest? You begin there.
    Senator Shelby.
    Senator Shelby. Thank you, Mr. Chairman.
    Picking up on the area that Senator Dodd was in, Chairman 
Schapiro, the SEC's Consolidated Supervised Entity Program, I 
believe was not a success. What role, if any, should the SEC--
you are the Chairwoman of the SEC--play in prudential 
supervision?
    Ms. Schapiro. I think it is----
    Senator Shelby. Can you bring the microphone up closer, 
please?
    Ms. Schapiro. Sure. I am sorry. Is that better?
    Senator Shelby. Yes.
    Ms. Schapiro. I think the SEC's Consolidated Supervised 
Entity Program was not a success. I think that is a fair 
evaluation. It has been replaced now because we obviously still 
have very important oversight of brokerage firms that have 
financial and operational issues that need the close 
supervision of the SEC, and it has been replaced by an Office 
of Broker-Dealer Risk Management.
    Nonetheless, our focus on the broker-dealer is very 
important and it is well ingrained in the SEC. But you can't 
effectively oversee the broker-dealer and its operations if you 
don't also have the ability to understand what is going on in a 
holding company or an affiliate, including overseas affiliates, 
whose activities can very, very directly impact the broker-
dealer and the safekeeping of customer assets at that broker-
dealer.
    So my view is that we have responsibility for brokerage 
firms, but we also have to have what we call a touch at the 
holding company level and at the affiliate level to understand 
risk management, exposures, leverage, and other issues that 
have implications for the broker-dealer's health.
    Senator Shelby. You have announced plans to consider 
reinstating the uptick rule, or a variation of the rule, at an 
open meeting next month. A lot of economic analysis was done 
before the rule was eliminated in 2007. How are you 
incorporating economic analysis into the decision about 
whether, and if so, how to reinstate an uptick rule?
    Ms. Schapiro. Senator, you are absolutely right. We are 
going to consider at an April 8 Commission meeting proposing to 
reinstate the uptick rule, or a bid test, or a circuit breaker, 
or some combination of those as a mechanism for controlling 
short selling to some extent. We are obviously acutely aware of 
the tremendous interest in this issue on both sides. Economic 
analysis did play a very important role in the elimination of 
the uptick test and we would expect that our economists at the 
SEC are looking at data now in the context of the changes in 
the markets to understand what the impact of an uptick rule 
might be, and I would expect that we will make data available, 
to the extent we can, to independent economists to do some 
analysis, as well.
    We will also hold in conjunction with the open meeting 
where we will consider the uptick test a public roundtable 
where we will solicit views more broadly about not just the 
uptick test, but other potential Governors on short selling.
    Senator Shelby. The SEC's examination function used to be 
integrated into each of the rulemaking divisions. Over 10 years 
ago, it was split off into a separate office. Some people have 
argued that this structure creates a dangerous wall between 
those who write the rules and those who monitor how firms are 
implementing them. Are you at the SEC reviewing this structure 
and how it continues to make sense, especially in light of the 
Madoff-Stanford financial and market timing scandals?
    Ms. Schapiro. Yes, Senator, we are. I have only been on 
board about 2 months, not quite 2 months, and----
    Senator Shelby. I know that.
    Ms. Schapiro. ----and reviewing the structure of the agency 
broadly is high on my list of things to get done. It is really 
critically important that we have an examination staff that has 
the tools and the skill sets to do a more effective job, the 
most effective job possible, but that is also linked back to 
the policymaking parts of the organization so that they can 
inform policymaking and they can also inform the Commission 
about areas where we may need to take further action. So I am 
looking very broadly at the structure of the entire agency and, 
of course, OC is a component of that.
    Senator Shelby. You have also noted that the SEC may ask 
Congress for a statutory mandate that hedge fund advisors 
register. Would your request also extend to venture capital and 
private equity advisors, and how would the influx of new 
advisors affect the frequency with which advisors get 
inspected?
    Ms. Schapiro. Well, it is a terrific question because right 
now, we have something on the nature of 400 examiners to cover 
11,300 advisors and more than 8,000 mutual funds. So without 
additional resources, we could not make, even given the 
authority to regulate hedge funds, we couldn't make that a 
reality in a very effective way.
    Senator Shelby. How much money are you going to need there? 
I know this is an Appropriations Committee question, but I am 
also on that committee.
    Ms. Schapiro. We are working on that analysis right now and 
will be happy to provide it to the Committee as soon as 
possible.
    Senator Shelby. OK.
    Ms. Schapiro. Also, it is important, though, that in 
addition to resources, we need to have the skill sets that are 
appropriate in order to do an effective job with hedge fund 
regulation.
    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Dodd. Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman. Thank you for 
holding the hearing, and thank you to the witnesses for being 
here today.
    My first question deals with executive compensation. It has 
become clear that something is out of whack with executive 
compensation. I think we all believe that people should be 
rewarded for good performance. That is not the problem. But 
what we have seen in many instances, that has enraged 
Americans, is a ``heads, I win, tails, you lose'' system, in 
which executives are rewarded for flash-in-the-pan short-term 
gains, or even worse, rewarded richly when the company does 
poorly and the shareholders have been hammered. I think that is 
what most confounds people--bad performance, higher salary.
    Corporate boards are supposed to keep an eye on 
compensation. They are supposed to keep it aligned with 
shareholder interests. Lately, they seem to have more interest 
in keeping the CEOs and top management happy than in carrying 
out their fiduciary responsibilities, so I think we have to 
address that. We have learned a lot about this in the last 
while.
    Last year, when he was a Senator, President Obama sponsored 
an advisory say on pay proposal. I think we have to look at 
this. I am for it. But for say on pay to have teeth, it seems 
pretty clear it requires shareholders to have a stronger voice 
in regard to corporate management. This obviously means 
shareholders need to have a real voice in the election of 
directors. Right now, given the fact it is so hard to get 
access to the proxy materials for nonmanagement shareholders, 
this isn't true, so I was encouraged to hear in your testimony 
you don't believe the SEC has gone far enough in this area.
    First, how are you proceeding to correct this, and do you 
agree with me that, in conjunction, real proxy access along 
with say on pay would have some real impact on compensation 
practices and on enhanced board responsibility more generally?
    Ms. Schapiro. Senator, I agree with everything you have 
said----
    Senator Schumer. Oh, well maybe we should stop right now.
    [Laughter.]
    Ms. Schapiro. I could stop right there in the interest of 
time.
    Let me say quickly, I think there has been a lot of effort 
to link pay to performance, but there has been a nonsuccessful 
effort to link pay to risk taking and that is a responsibility 
for boards, to understand the appetite for risk within the 
organization and to control it, and one way to control it is 
through linkage to compensation practices for senior 
management.
    We will move ahead this spring to propose greater access to 
the proxy for shareholders as a mechanism both to empower 
shareholders, who are, in fact, the owners of the corporation, 
but also as a mechanism to help provide greater discipline with 
respect to compensation and risk taking.
    Senator Schumer. Thank you, and I look forward to working 
with you on this area. I think we need to move forward.
    Second is enforcement funds. We know--everyone knows about 
the Madoff case, but it is emblematic of a broader trend of 
fraud that I believe is going to be uncovered in the aftermath 
of this financial crisis. Back in the S&L crisis, I helped push 
a law that would get special prosecutors, FBI agents, and bank 
examiners to go after that fraud. Mr. Breeden is shaking his 
head because we worked together on that. And we need to do that 
again, particularly now. If you saw yesterday's newspaper, the 
administration, correctly, doesn't want to reduce antiterrorism 
efforts in the Justice Department, but that squeezes new needs, 
such as financial investigators.
    In conjunction with my colleagues on this Committee, we are 
trying to increase the SEC enforcement budget. I proposed 
legislation to do that with Senator Shelby, which we are going 
to try to do in the Appropriations Committee. Can you give us a 
sense of what improvements you could make with a stronger 
enforcement budget?
    Ms. Schapiro. I would be happy to, and we----
    Senator Schumer. Or an increased budget in general, too.
    Ms. Schapiro. We would be grateful recipients of an 
increased budget and particularly an increased enforcement 
budget. We have a new Enforcement Director beginning on Monday. 
He spent 11 years as a prosecutor and head of the Securities 
and Commodities Fraud Task Force in the Southern District of 
New York. He is coming in with a renewed commitment to the 
SEC's focus on bringing the most important cases, the most 
meaningful cases, in the quickest time possible in order to 
protect investors more effectively.
    We are also looking at technology improvements to support 
our enforcement and examination staff. The SEC's technology is 
light years behind Wall Street, and frankly, light years behind 
everybody else.
    Senator Schumer. OK.
    Ms. Schapiro. We have enhanced our training programs. We 
have a number of people who are now taking the Certified Fraud 
Examiner Program, as well as enhancing dramatically our 
internal training programs. And we are actively seeking new 
skill sets, including in financial analysis, forensic 
accounting, trading, and other areas, so that we are better 
able to keep up with what is going on and what the fraudsters 
are up to.
    Senator Schumer. Thank you. So I see you need the money.
    Could I ask one more, Mr. Chairman? Quickly, just on 
derivatives clearing. For a while, I have been advocating that 
derivatives ought to be traded whenever they can be--some are 
very complicated and there is no market--in either a 
clearinghouse, or for me, preferably, an exchange. I know that 
this morning, Secretary Geithner is going to mention that in 
his testimony, at least as I understand it, on the House side.
    What steps is the SEC encouraging to take to encourage the 
use of central counterparties? Do you have the authority to 
require clearing of certain types of derivatives now? If you 
don't, is it the kind of authority that you want, and if not, 
what other kinds of authority do you need?
    Ms. Schapiro. I believe that----
    Senator Schumer. Do you agree with the general thrust?
    Ms. Schapiro. Yes. CDS should be centrally cleared. We do 
not have the authority right now to require that. We have 
facilitated the approval of three central counterparties for 
CDS clearing that we have done jointly with the Fed and with 
the Commodities Futures Trading Commission and we would 
strongly recommend that Congress require central clearing of 
CDS. I am not a big believer in voluntary regulation and I 
think that this is an area where we need authority.
    Senator Schumer. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Did I hear you say in response to Senator Schumer on the 
way on pay that you are inclined to be supportive of that in 
terms of shareholder----
    Ms. Schapiro. I do support say on pay, the advisory vote by 
shareholders of pay, yes.
    Chairman Dodd. Good. Thank you for that.
    And let me just say, too, as I turn to Senator Corker, 
there are some wonderful people who work at your organization 
and I wouldn't want our comments to talk about needs and 
resources and so forth to be reflective of how many of us feel 
about how hard working people are at the SEC. They need the 
tools, as Senator Schumer points out, the resources and so 
forth there, but it is not for lack of determination of good 
people who want to do a good job, and I think that needs to be 
said. It can't be said often enough.
    Ms. Schapiro. I appreciate that very much.
    Chairman Dodd. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and thank you all 
for being here and for your testimony.
    I just, in looking at my BlackBerry a second, would recite 
a quote from Secretary Geithner this morning on the other side 
of the Capitol. We have a moment now where there is broad-based 
will to change things that people did not want to change in the 
past.
    I am getting a little feeling of nervousness just about the 
pace at which change is taking place. Typically, when you move 
in crisis, you end up with not having a cause-neutral solution, 
OK. I would just say to you, if you are going to be kicking the 
door down, the kicking is good right now. I mean, you are going 
to miss an opportunity if that doesn't happen very quickly, and 
I would just ask your opinion of some of the resolution 
authority concepts that were laid out in the last 24 hours.
    It feels to me like a codification of TARP. The very powers 
that the Treasury has now under TARP, it seems to me they are 
codifying under this proposal they have put in place, which 
allows them to not only take companies down, but to decide to 
invest in companies. I just wonder if you have any thoughts 
there and does that concern you in any way.
    Ms. Schapiro. It does concern me. I think any time we write 
blind check legislation, as I sometimes call it, we have to be 
very conscious of the fact that we could set in motion a 
complete rewrite of the regulatory regime without perhaps truly 
intending to do that. So I think it is really critically 
important the Congress stay deeply involved in this discussion 
and this debate and set the parameters.
    So, for example, the definition of a systemically important 
institution is absolutely essential, and if it is very, very 
broadly defined, that resolution regime or the systemic risk 
regulator could usurp the functions of multiple other 
regulators, and as you know, my concern is also usurp the 
importance of investor protection and capital markets 
regulation in doing so.
    So I think it is really an area where Congress needs to 
stay involved so that we don't end up with such broad 
legislation that we define the regulatory regime without the 
input of the broadest number of perspectives and without really 
careful thought to what the implications are to the other 
functions that are important in financial regulation.
    Senator Corker. Mr. Chairman, I think we have seen that 
TARP was set up for an intended purpose and we have moved into 
industrial policy. The last administration did that. This 
administration looks like it is going to move more deeply into 
industrial policy. And it seems to me that what the Secretary 
has outlined this morning truly gives them the ability to move 
into any sector of our economy that they choose that they 
decide might be systemically putting our economy at risk, and I 
think we should heed Ms. Schapiro's comments here. This is a 
fearful time. The public is concerned, and lots of time bad 
things happen legislatively as a result of people being 
concerned.
    Let me ask you this. Do you agree or disagree that hedge 
funds, derivatives, private equity ought to be regulated?
    Ms. Schapiro. I do not disagree. I believe they should be 
regulated.
    Senator Corker. And to follow up on Mr. Schumer's comment--
and obviously, how they are regulated makes a huge difference, 
would you not agree?
    Ms. Schapiro. Absolutely.
    Senator Corker. I mean, we could, in fact, I guess, run all 
three of those enterprises to other places if we regulate them 
inappropriately, is that correct?
    Ms. Schapiro. That is right, so we need to be sensitive to 
the fact that a hedge fund is not a mutual fund, and we need to 
understand the differences in how those investment vehicles 
work and tailor the regulation appropriately.
    Senator Corker. And we still want private equity to take 
risk, right?
    Ms. Schapiro. Absolutely.
    Senator Corker. I know there is not time right now. I would 
love to hear your thoughts on how you regulate private equity 
in such a way as to allow them to continue to take risks, which 
is what we want them to do, and yet be somewhat under their 
hood. So maybe you will answer that a little bit later.
    I want to ask you one last thing, because time is so short. 
We have so many panel members. Credit default swaps, I think we 
all understand some of the problems that have occurred. There 
have been people that have advocated that credit default swaps 
are like off-track betting if you don't have any skin in the 
game. And so I would love to hear your thoughts as to whether 
credit default swaps should only be used when you have some 
collateral that you are actually insuring against, or whether 
you ought to be able just to make bets with no collateral.
    Ms. Schapiro. It is a terrific question and it is one where 
there are very strongly held views on both sides, whether there 
should be skin in the game in the sense that you have an 
insurable interest before you engage in a credit default swap. 
We don't have an agency perspective on that. I think it is 
actually an issue very much worth exploring as a mechanism to 
control some of the risk in the system.
    I can't tell you I am sophisticated enough to know all of 
the implications of requiring an insurable interest before 
engaging in a credit default swap and exactly how you would 
define that. But I think it is an issue that is worthy of 
consideration.
    Senator Corker. Well, my time is up, but my sense is that 
you feel like the Treasury's proposal, as outlined in the last 
24 hours, could be very much a power grab, is that correct?
    Ms. Schapiro. I certainly wouldn't use those words----
    Senator Corker. But I am using them, and I would love to 
have a yes or no on that.
    Chairman Dodd. Nice try, Senator.
    [Laughter.]
    Ms. Schapiro. I think the devil--I believe the devil is in 
the details. I believe it is really important we understand 
what it is exactly that we are proposing to do and what the 
implications are for the regulatory regime and for investors 
broadly.
    Chairman Dodd. Thank you, Senator.
    Let me just say, too, to my colleague from Tennessee, whose 
judgment and counsel I take very seriously, as well, this 
Committee will be very involved as we listen to the proposal on 
the resolution mechanism. I said I am generally supportive of 
the idea of having some sort of a resolution mechanism. What 
shape that takes and how it is organized and structured is 
something this Committee will be deeply involved in, and so----
    Senator Corker. I sure hope so. The way things have laid 
out, Mr. Chairman, I would rather be Treasury Secretary than 
chairman of the universe, so I hope we will be involved.
    Chairman Dodd. Well, be careful what you wish for.
    Senator Warner.
    Senator Warner. Better than chairman of the universe? That 
is a high standard.
    Well, thank you, Mr. Chairman. I know my time is short, but 
I would like to echo what my colleague said. In the Chairman's 
response to the skin in the game question about credit default 
swaps, I know there are a number of other arguments on the 
other side. I would like to hear out those arguments because it 
does seem to me that from at least a broader-based societal 
standpoint, the outside risk and the downside risk that we as a 
society, in effect, have taken on by these nonskin in the game 
offside bets, we are sure seeing the downside of that.
    I would like to come at this, maybe look at it from the top 
and maybe from the bottom in one of the questions, bottom up, 
and you having served in the role of FINRA. I understand the 
need for self-regulatory organizations in light of the limited 
resources you have at the SEC to have the oversight on the 
number of institutions you have to cover, but we had a previous 
hearing here a month or so back on the Madoff schedule and it 
seemed where they were passing responsibility representatives 
from the SEC and FINRA about where boundaries ended and how far 
you could go and at what points the operator of an institution 
could, by simply defining that this was off-limits, could stop 
investigations.
    Have you looked through your overview, Chairman Schapiro? 
Have you looked at, kind of a fresh eye look at all of the SROs 
and what their role and function should be going forward?
    Ms. Schapiro. We have not yet. That is something we will 
do, because I think it is very important. The SEC is 
responsible for about 30,000 regulated entities, including 
about 12,000 public companies. We have a staff of 3,600 people. 
We have got to have the ability to leverage third parties in 
order to do our job, which is not to say in any way that we 
would ever abdicate our responsibility or delegate our 
responsibility away. But whether it is accounting firms or 
SROs, the PCAOB or other entities, we need the ability to 
utilize them to help us get our jobs done.
    I think what the Madoff matter points out to me that I 
think is something we need to focus on, and I alluded to in my 
oral testimony and in more detail in the written, is that we do 
have doubts in the regulatory regime and a particular area of 
concern, and Fred Joseph raised this, as well, is the different 
standards of care and the different regulatory regimes that 
govern investment advisors and broker-dealers when they are 
providing largely the same service, and investors clearly don't 
understand that there is either a different standard of care or 
a different regulatory regime in place.
    Those are the kind of gaps that we absolutely need to fill 
and we need to do so from the perspective of the investor so 
that they are getting uniform protections and standard of care 
and regulatory oversight regardless of what the title is of the 
person who is offering them financial services, and that is an 
area where I think we need to be very focused.
    Senator Warner. I would love to come back and pursue that 
later, but I have got two other areas and my time is short.
    One is, following up on Senator Schumer's comments, and I 
was appreciative of your comments that the Chairman brought 
out, as well, on say on pay. But I do think that at some point, 
this Committee also needs to take a look at corporate 
governance. I believe a lot of good things may have come out of 
Sarbanes-Oxley. One of the challenging things that came out of 
Sarbanes-Oxley is I think it is even tougher to get good 
quality board members to serve on public companies. I would 
actually believe that one of the unintended consequences of 
Sarbanes-Oxley may be that chairmen of companies end up getting 
even more captured board members because so few folks, other 
than maybe their friends, would want to serve on a public board 
at this point.
    I have explored the option of looking at institutional 
investors, could we create an effective cadre of qualified 
potential board members so that we really could look at the 
issue of how we bring some real independence and broader-based 
oversight on corporate governance, and I just wonder if you had 
any kind of initial thoughts----
    Ms. Schapiro. We would love to work with you on that. We 
are engaged right now in a pretty complete review of corporate 
governance issues at the SEC, everything from linking--
disclosure concerning pay and its linkage to risk taking, risk 
disclosure more generally, qualifications of board members, and 
access to the proxy as a way to try to facilitate more 
independent boards that are more responsive to shareholders, 
and my view is we will take all good ideas and put them into 
the mix and see if we can come up with a system that works 
better for U.S. shareholders than the one we have----
    Senator Warner. I do think we need something to make sure 
the board members don't get captured as quickly and often as 
they do.
    One last question. I know my time is up, but this could be 
perhaps an easier one. I know you are going to deal with the 
uptick rule, but I wonder, as well, if you are looking in terms 
of short selling at some type of real-time disclosure component 
for short sales so that the market could know on a real-time 
basis the position of the number of shorts.
    Ms. Schapiro. We are, as you point out correctly, talking 
about the uptick rule at an April 8 Commission meeting. We are 
looking at a wide range of possibilities and disclosure is 
certainly one of them with respect to short selling, hard 
borrow, just the broad panoply of possibilities in this area. 
The one that is most advanced is the possibility of reinstating 
the uptick rule at this point.
    Senator Warner. Thank you. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Just on that last point Senator Warner has raised, as well, 
I wonder if you will also look at margin requirements. The 
difference between exposing weakness, which short selling does 
and has very great value, versus speculation, which has been, I 
think--you know, people have talked about mark-to-market. The 
quickest thing you might do about mark-to-market is get this 
uptick rule in place, in my view, and then look at the margin 
requirements as Richard Breeden talked about.
    Ms. Schapiro. Yes, it is in former Chairman Breeden's 
testimony.
    Chairman Dodd. Yes. Senator Johanns.
    Senator Johanns. Thank you, Mr. Chairman, and let me just 
say to the Chairman and Ranking Member, this is another 
excellent hearing.
    If I could, I would like to focus our attention in my 
limited time on Mr. Madoff and his Ponzi scheme, and I will 
offer an observation to start out with, and I don't suggest 
this in a necessarily critical way, but I am very skeptical, 
and I think there is reason for that skepticism. I hear your 
need for more people, more money, more staff, the vast 
regulatory responsibility you have. But I look back on the 
Madoff case and there is, I think, a fair amount we know today. 
There is a fair amount we probably don't know because of the 
ongoing investigation that we will learn as time goes on.
    But you have a gentleman out there, for lack of better 
terminology, I will call him a whistleblower, who I think 
pretty effectively blew the whistle, and having been in your 
position as a cabinet member and having regulatory 
responsibilities also, I read through that information that he 
provided to you folks and, boy, I would liken it to dropping a 
grenade in the Secretary's office. I mean, it is explosive. It 
sets up the possibility that everybody's investment is at risk, 
if not literally disappearing.
    And I put myself in that position and I think about, boy, I 
would have had the Inspector General, the Department of 
Justice, I mean, anybody I could have reached out to and 
grabbed onto to help me deal with that issue, and yet we went 
along here and now today we learn that maybe a billion dollars 
will be recovered out of some $65 billion.
    Now, I am very mindful of the ongoing investigation. I 
don't want to interfere with that. I certainly understand that. 
But what I want to start to understand is what went wrong, 
because if we don't understand what went wrong, then we can't 
be very effective in designing a regulatory framework that 
protects the consumer. What assurance can we have as the 
Committee that when the next whistleblower shows up, it will be 
different because of some action we have taken as the U.S. 
Senate or as the Congress to try to deal with these issues? So 
help me start to understand that.
    Ms. Schapiro. I would be happy to, and let me say very 
clearly that I don't lay the blame for the SEC's failure to 
respond appropriately to the Madoff to the whistleblower's 
information provided to the agency at the feet of a lack of 
resources. As you rightly point out, a fairly complete set of 
information was provided over a period of years to the agency 
and wasn't follows up on appropriately. So in this instance--we 
do have resource issues. In this instance, I am not sure we can 
blame resource issues.
    The Inspector General, as you correctly point out, is 
investigating, and that is going to take a number of additional 
months. My view is I need to run this agency in the meantime 
and I am not really anxious to wait four or five additional 
months to find out what went wrong and then start to fix our 
problems, because as you also point out correctly, we can't fix 
it if we don't understand how we failed.
    My belief is that there are multiple things that 
contributed to the agency's failure to act and there are a 
number of things that we can do and have started to do in 
response. One is that we have a stovepiped approach within the 
Securities and Exchange Commission, where information is not 
freely shared across offices and among departments and 
divisions the way it ought to be and the way that you would 
hope for in an agency that was really operating efficiently.
    We have very disparate processes for handling the between 
700,000 and a million-and-a-half tips and whistleblower 
complaints that come into the agency on an annual basis and we 
don't have all the right skill sets. So that information may 
well have landed with somebody who didn't understand at all 
what they were looking at, and because the culture isn't 
normally one of sharing information easily, it didn't get sent 
necessarily to the right place.
    Those are all things that we can do something about. We 
have engaged the Center for Enterprise Modernization to come in 
and review all of our processes for handling those 700,000 tips 
and complaints and helping us build the technology that will 
allow us to mine those that are most productive. We will come 
back to this Committee and ask for whistleblower legislation 
that will allow us to compensate people who bring us fully 
formed, well documented instances of abuse or fraud that we can 
then pursue from a law enforcement perspective. We are bringing 
in new skill sets and people with the ability to look and 
understand the data that they are looking at.
    And finally, it is the job of the leaders of the agency, 
myself, most especially, to try to break down the walls that 
exist between departments and divisions so that sharing 
information and viewing ourselves as engaged in a common 
enterprise is the way we approach our work, not as divisions 
competing sometimes with each other.
    So we have a lot to do in this area. I am fully committed 
to fixing every problem that we have as best as I possibly can. 
I have only been there 2 months. I think we have gotten a lot 
of things started, but it is going to take time and effort to 
refocus the efforts and the energies of the agency on 
protecting investors from exactly this kind of conduct.
    I will say that in the last couple of months, the Ponzi 
scheme TRO machine has been fired up and you will not see a 
week go by where we are not bringing Federal court cases 
against Ponzi scheme operators and trying to stop them at a 
much, much earlier point in time.
    Senator Johanns. I appreciate the candor of the answer. I 
think you acknowledge there were some things here that just 
simply were missed.
    My time is up. Here is what I would ask for--because this 
is going to unravel over time. The investigation will continue, 
but at some point it will conclude. My hope is that when there 
is a full and complete picture and we can have an open and 
candid discussion about what the investigation showed, et 
cetera, that we do that. We owe that to the people who have 
lost so much. And so I hope you will work with the Chairman and 
the Ranking Member and the Committee Members to help us just 
nail this thing down in terms of what happened and why it is 
not going to happen in the future.
    Ms. Schapiro. I completely agree that the Congress, as our 
oversight body, is entitled to understand that, and the 
American public is entitled as well.
    Senator Johanns. Great. Thank you.
    Chairman Dodd. Let me just say in that regard, too, Jack 
Reed and Senator Bunning are the Chair and Ranking Member of 
the subcommittee dealing with securities. And today is an 
abbreviated session with the Chairperson of the SEC, but I 
commit to my colleagues this will be an ongoing conversation 
both formally and informally. We will find means by which we 
can pursue these matters, and certainly as Chairman Schapiro 
knows, we have made some requests which the SEC--in fact, the 
Chairwoman indicated to me this morning--will be getting back 
to us immediately on some requests the Committee has made 
regarding this matter, and we welcome that very much. It is 
very much in line with what the Senator has requested this 
morning.
    With that, Senator Tester.
    Senator Tester. Thank you, Mr. Chairman, Ranking Member 
Shelby. I appreciate the hearing. Thank you both for being 
here.
    This is a question for both Chairwoman Schapiro and Mr. 
Joseph. I had conversations around the State, as I am sure we 
all have, with constituents, regulators, and finance 
professionals in Montana, and there is pretty much unanimous 
consent that one of the biggest, if not the biggest, threat to 
our economy right now is a lack of confidence in the 
marketplace. Families fear their retirement accounts and all 
their investments are not as safe as they once were. What do 
you feel in your individual capacities is the most critical 
step that we can take to restore consumer/customer confidence? 
You will both get a chance, so go ahead.
    Ms. Schapiro. You know, there are so many pieces to 
restoring investor confidence. From the perspective of the SEC, 
we really have to show a single-minded commitment to putting 
investors first in every single thing we do. That means 
aggressive enforcement so that investors understand that there 
is a penalty and a price to pay for abusing investor trust. It 
means ensuring that the corporate disclosure that investors get 
so they can make rational decisions about how to allocate their 
capital, whether to buy a stock or to buy a mutual fund, is 
absolutely honest and transparent and readily available to 
them.
    It is ensuring that post the reserve fund ``breaking the 
buck'' and scaring everybody about the resilience of money 
market funds, that we understand those issues and that we move 
quickly to enhance the liquidity and quality of paper that is 
held in money market funds.
    For us, it is really doing what we do every single day, but 
with the single-minded focus on investors and ensuring that our 
efforts are urgent and aggressive. And beyond that, I think 
obviously the economic stabilization programs need to play out. 
People need to see credit flowing again. They need to have 
faith that the people that they are dealing with are going to 
be honest, and enforcement is obviously a huge component of 
ensuring that.
    Senator Tester. Thank you.
    Mr. Joseph.
    Mr. Joseph. Thank you, Senator. I agree with the Chairman. 
Her comments are right on. And you are correct, the whole 
system--the entire financial system--is built on trust and 
confidence. And at the moment I think that is a little bit 
shaky. If people do not believe they are on a level playing 
field, and if that does not happen, obviously they are not 
going to invest.
    I agree that we need to focus on investor protection. I 
believe we need to be certain that the people who are licensed 
to sell securities are adequately prepared and qualified to do 
so. The securities that they are selling, for example, the Reg. 
D Rule 506 offerings, need more regulatory scrutiny; otherwise, 
in some cases it is just pure gambling.
    Senator Dodd also pointed out that in some cases it is 
speculation. Senator Dodd, I would say it is speculation at 
best and gambling at worst in some cases.
    Last, we need to enforce, and enforce strongly. And I 
believe the SEC and the States must continue on in that role, 
and we take our roles very seriously.
    Senator Tester. Thank you. One quick comment before I get 
to my next question. Chairwoman Schapiro, I appreciate your 
consideration of the uptick rule. There is a bill that Senator 
Isakson, Senator Kaufman, and myself are on to reintroduce it, 
and I think it could help, reinstituting that rule that was 
taken away after 8 years. I appreciate you taking that up.
    I want to talk just very briefly, because I have only got a 
minute left, about the power of a monolithic regulatory scheme 
versus a patchwork scheme that we have now of regulation that, 
quite frankly--and I think it was your predecessor who said 
that there was no regulation in some of these financial 
instruments, and it is one of the reasons we are at this point, 
at least from my perspective.
    There seemed to be a lack of consistency with the patchwork 
scheme because of gaps that inherently open up. Then on the 
other side of the coin--and I do not want to put words in your 
mouth--you talked about one agency could get too powerful, and 
I agree with that, too.
    So how do we solve the problem? How do we solve the problem 
of gaps and people saying, well, I really do not have authority 
to regulate this, it is somebody else's authority, and they are 
saying the same thing and things fall through the cracks?
    Ms. Schapiro. I think it is critically important that we 
fill the gaps, first and foremost. We will have overlap, and I 
think that does create some tension among regulators. But as 
compared to gaps, that is a pretty manageable process, and 
sometimes the creative tension that evolves between banking and 
securities regulators actually results in a positive.
    But as we identify those areas of the financial system that 
have not been subject to regulation--hedge funds, credit 
default swaps, other kinds of pooled investment vehicles--it is 
important that we decide that if they are important to investor 
protection, if they are important to the financial system, that 
they be brought under the Federal regulatory umbrella with the 
support, obviously, in multiple areas of State regulators as 
well, and that those gaps basically be filled by a functional 
regulator.
    I think there is also a role for a systemic risk regulator, 
again, whether it is done by an individual institution that has 
responsibility for monitoring exposures and working on 
prudential regulatory standards and working with a resolution 
regime or with a college of regulators, there has to be 
heightened sensitivity to these components of the financial 
system that have not been regulated.
    Senator Tester. In an ideal system, you are right. But what 
happens when you have a lack of resources? How anxious are you 
to jump on some other regulatory financial mechanism out there 
if you can say, well, gosh, this really is not my job anyway, 
and I am limited in financial resources, we will let somebody 
else take care of it?
    Ms. Schapiro. It is really our responsibility, and we 
should not be in these roles if we are not willing to come to 
Congress and say this is a problem, we need your help, we need 
legislation, we need resources.
    Senator Tester. Thank you.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Senator Martinez.
    Senator Martinez. Thank you, Mr. Chairman.
    Madam Chairwoman, I wanted to follow up on a question that 
Senator Johanns had asked regarding the Madoff situation, and 
that is not really where I was going, but I heard your 
response, and it sparked the old lawyer in me. I just wanted to 
ask, when you said that if not resources, it was not resources 
that prevented the SEC from more aggressively pursuing the 
Madoff matter, then you went into a series of more technical 
issues involved in that. But if it was not resources, that goes 
to some other motivation. What do you attribute that to?
    Ms. Schapiro. What I intended to say is that I do not lay 
the problems with Madoff solely at the foot of a lack of 
resources. The information came into the agency over a period 
of years. It is not clear to me yet--and we have, obviously, an 
Inspector General review ongoing right now--whether it was 
people who received the information did not understand the 
import of it and, therefore, did not pursue it, or they did not 
send it to the right people who could understand it and analyze 
the data that was contained therein.
    We have very disparate processes throughout the agency 
around the country in all of our offices for how we handle the 
massive amounts of data that come into the agency. Whether it 
fell through the cracks or somebody just did not understand 
what they were doing, I cannot--I do not know. I would tell----
    Senator Martinez. So you do not know at this point. You are 
still undergoing an investigation. You have not reached a 
conclusion.
    Ms. Schapiro. No.
    Senator Martinez. You just do not think it was a lack of 
resources as such. It was more about either an understanding of 
it or an unwillingness to understand it or it just did not get 
to the right person.
    Ms. Schapiro. It is one of those things, and my view is 
that we will fix all of those things, on the assumption that it 
is one of those things that has caused the agency not to pursue 
that information when it came in the door.
    Senator Martinez. The issue I really wanted to get to is 
the issue of systemic risk. I know there has been some 
commentary from the Secretary of the Treasury about this as 
part of this new regulatory situation, and I wondered if you 
could define for us how you view systemic risk.
    In the old days of, you know, Fannie and Freddie concerns, 
obviously their size was a concern, and view them by size alone 
as perhaps posing a systemic risk. I think that has been proven 
all too much to be true. And also their capital requirements 
were fairly thin, which I think also made them, again, a 
systemic risk.
    How do you define what is the systemic risk that we need to 
be looking for?
    Ms. Schapiro. That is probably the $64,000 question, 
because I think how you define it matters very much in how we 
ultimately structure any kind of a systemic risk regulator. 
Certainly, size would be a component. Relationship to other 
important financial institutions within our economy or----
    Senator Martinez. Interlink between those?
    Ms. Schapiro. Interdependency or interlinkage; the amount 
of leverage. I think it matters very much how we define it, 
because there are a lot of criteria that can go to this issue, 
and how we define it will define how we regulate it. And 
whether we have a monolithic approach, a college of regulators 
approach, or a functional approach with some kind of overlay of 
systemic risk oversight that monitors exposures, perhaps 
requires the reduction of leverage, requires other prudential 
capital or other standards to be put in place, those 
definitions matter greatly.
    Senator Martinez. How do you think we will come to a 
definition? Is this something that the Secretary of the 
Treasury is going to define for us? Or is that part of what 
we----
    Ms. Schapiro. Well, I hope the Congress will be very much 
engaged in coming to that definition and that the other 
regulatory agencies that have profound responsibilities for 
components of the financial regulatory system will be engaged 
in that process as well.
    Chairman Dodd. Let me say something. We had a witness the 
other day that said something that I think was very important. 
I think we talk about this in the singular, and I think that is 
sometimes where we are narrowing ourselves. He called it 
``systemic risks.'' And I think that is a more appropriate 
wording, because there are--there are numerous risks. It could 
be the size of the operation, the practices and products of 
the--there are a lot of systemic risks that we ought to be 
looking at. Hence, one of the reasons why I am gravitating 
toward this college idea or commission idea rather than a 
single regulator idea, so that we have the ability to 
understand the risks that are posed to our system in a sense.
    I do not know if you agree with that.
    Ms. Schapiro. I do agree with that. I think there are many, 
many small risks that, accumulated, become systemically 
threatening, and so I think----
    Chairman Dodd. I did not mean to interrupt. I apologize.
    Senator Martinez. No, that is fine. I appreciate it.
    Ms. Schapiro. ----the definition process is very, very 
difficult here.
    Senator Martinez. But as a result of having a regulator in 
place that would be strong enough to then monitor these 
entities that we will have defined, we will then be able, going 
forward, to probably have a better handle on this. How do we at 
this point regulate those entities that appear to be 
systemically risky or provide systemic risks? Is there anything 
we can do at the moment going forward prior to a regulatory 
system being redeveloped?
    Ms. Schapiro. Well, what I think we have seen develop over 
the last year is a bit of a patchwork and an ad hoc approach to 
dealing with institutions like Lehman Brothers and Bear Stearns 
and obviously, as is playing out very much right, AIG where it 
is an effort on the part of multiple regulators to use whatever 
tools they have available to them to try to reduce the risk or 
resolve the issues with respect to particular institutions.
    Senator Martinez. But is there a coordinating--I know my 
time is up. But is there a coordinating point, is there 
someone--I mean, in other words, it seems to me that with AIG, 
you know--is it Treasury?
    Ms. Schapiro. It has largely evolved to be the Treasury 
working most closely with the Federal Reserve, in some 
instances with the FDIC, in some instances with the SEC.
    Senator Martinez. But that is my concern, that it is not 
clear to me when something like bonuses go out the door--which 
may, by the way, be perfectly a legal obligation that the 
company had. But there does not seem to be a clear 
understanding of who was at the end of the day providing the 
oversight that would have known precisely what was happening. 
And we are talking so many billions of dollars that it seems to 
me that needs to be defined before we get to a more permanent 
regulator.
    Ms. Schapiro. I agree.
    Chairman Dodd. Thank you very much.
    Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    Madam Chairlady, I appreciate your statement, particularly 
where you said if there ever was a time when investors needed 
and deserved a strong voice and a forceful advocate in the 
Federal Government, that time is now. And you went on to make a 
series of positive statements that I think are very powerful, 
and I appreciate that.
    In pursuit of those statements and in pursuit of what I 
asked you during your confirmation process, could you tell me 
what since your confirmation--and I understand it has been 
about 2 months or so--what steps you have taken within the 
Securities and Exchange Commission to increase enforcement and 
investor protections?
    Ms. Schapiro. I am happy to do that. We have announced the 
appointment of a new enforcement Director who begins on Monday, 
a long-time Federal prosecutor who also ran the Commodities and 
Securities Task Force in the Southern District of New York. We 
have retained the Center for Enterprise Modernization to help 
us overhaul tips and complaints as they come into the agency so 
that we can have a better handle on and pursue those tips and 
complaints that are most likely to produce important investor 
protection enforcement cases for the agency.
    I ended the penalty pilot program which required that the 
Commission's enforcement staff pre-negotiate with the 
Commission before they could suggest a fine against a public 
company. We have speeded up dramatically the process which 
authorizes the staff to issue subpoenas in enforcement 
investigations.
    We have instituted new training programs. Our hiring now is 
focused on bringing in people with new skill sets that are in 
forensic accounting, financial analysis, and trading and 
operations. We are working on our technology. We have a long 
way to go there. And we have been very fortunate to have 
sufficient resources this year to actually do some hiring in 
the enforcement program, which had declined, as you may know, 
by about 5 or 6 percent over the last couple of years.
    So we have a new sense of urgency, and we have started to 
put into place tools that I think will really result in much 
more aggressive, much faster enforcement.
    Senator Menendez. Well, I appreciate that you were ready 
for my question.
    Ms. Schapiro. I remember the confirmation hearing.
    Senator Menendez. And I am happy to hear your answer, to be 
very honest with you, so I appreciate your progress there.
    You know, I have told some of those in the investor 
community that you have only been there 2 months and give it 
time. Some of them are worried that you will not take the 
tougher steps that are necessary, and particularly on proxy 
access. I saw that you mentioned that in your statement. I 
think Senator Schumer asked you a question on this, and I 
appreciate what you said.
    I just want to visit with you on that issue. Is this 
something that you still remain committed to offering 
investors, a path to nominate their own candidates for board 
seats on company proxy ballots? And if so, give us a sense of 
your timeline for addressing what is a very important investor 
issue.
    Ms. Schapiro. I remain very much committed to that, and it 
is my expectation that--I believe we are tentatively scheduled, 
the Commission, to consider this issue in May--if not May, 
June, but certainly in the first half of this year.
    Senator Menendez. Let me ask you one other question. Have 
you had the chance to look at the question that many in the 
Enforcement Division of the SEC move on to be employed by Wall 
Street firms? And there is some concern that there may be a 
conflict of interest there. Is that a revolving door, or is 
that something that you feel is OK?
    Ms. Schapiro. It is a revolving door. We talked about this 
at my confirmation hearing, and I made a commitment to talk 
with the bank regulators who actually have in place some 
limitations on their examination staff's ability to move freely 
from the agency to an entity that was otherwise examined by the 
agency.
    My counterbalancing concern is that I want to attract the 
best and the brightest people to the SEC, and if I make it too 
hard for them to leave, I may not get them in the first place. 
So from my perspective, it is a balancing act, but it is 
something that I continue to be committed to looking at and 
hopefully will get to before terribly long.
    Senator Menendez. Finally, let me ask you, in light of the 
recent intense pressure from financial services lobbyists on 
accounting standard setters over fair value accounting, what 
will you and the Commission do to ensure that accounting 
standard setters remain independent so that they can fulfill 
their mission of serving the needs of investors rather than the 
short-term interests of some of the industry?
    Ms. Schapiro. Well, I completely agree that that is a 
critical function for the SEC to help protect the independence 
of FASB and the accounting standard setters. And I understand 
there is tremendous emotion and concern about fair value 
accounting right now and any impact that it may be having. But 
our guiding light on this is that investors have told us that 
fair value accounting is important to them. It is important to 
their understanding of financial statements and their 
confidence in the honesty of those statements, and that is 
critical for them to make decisions about the allocation of 
capital.
    So we will continue to be vocal proponents of the 
independence of FASB. I think it is one of the tremendous 
strengths of our corporate disclosure system, which is 
unsurpassed in the world, and largely as a result of having an 
independent, highly expert body that sets accounting standards.
    Senator Menendez. All right. Well, so far so good. Thank 
you, Madam Chairlady.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Bennett.
    Senator Bennett. Thank you very much, Mr. Chairman, and, 
Madam Chairman, Mr. Joseph, we welcome you here and appreciate 
your public service and the efforts that you are doing, and 
yours, Mr. Joseph, is public service too, even though you are 
not on the Federal payroll.
    Mr. Joseph. Senator, I am here for you.
    Senator Bennett. We are grateful for people who serve who 
are not on the Federal payroll.
    Madam Chairman, you talked about balance, and as I listened 
to all of this, I think balance is a word we need to keep very 
much in front of us--the balance to get the good people and at 
the same time try to keep our eye on potential conflict of 
interest.
    In times of crisis, the impulse is always to go absolutely 
in the direction of protection against everything else, and the 
ultimate protection of investors to make sure that they do not 
lose any money would be to shut down the market, because as 
long as there is no market, nobody is going to lose anything. 
And, obviously, we do not want to do that because it is the 
power of the American market that has allowed entrepreneurs to 
make America not only very profitable but truly unique.
    I have done business around the world. I have owned 
businesses in other countries and done business with companies 
from other countries. And the American entrepreneurial spirit 
is indeed unique and the driving force, I think, behind our 
long-term prosperity.
    So striking the balance between regulation that will find 
the Bernie Madoffs and get rid of them, which the public 
clearly needs to do, and allowing the markets to work is, I 
think, philosophically your biggest challenge.
    Ms. Schapiro. I could not agree more.
    Senator Bennett. Do you want to respond to that? Have you 
had any late-night thoughts in a quiet room about that? Or have 
you been so overwhelmed with the details you have not gotten 
around to thinking about it?
    Ms. Schapiro. It is a question we confront really every 
single day, in small issues and large. How do we keep the 
balance right? How do we do exactly as you say, assure the 
protection of investors, the integrity of the marketplace, but 
not regulate everything within an inch of its life so that we 
do not have any more innovation and we do not have any more 
opportunity for people with great ideas to bring them to the 
marketplace?
    I do not have any wisdom, certainly no more wisdom than you 
have on this. I just think it is something we have to think 
about as we approach every single issue. And it is one reason I 
like very much to have a broad and diverse group of people 
within the agency and on my personal staff to consult with me 
on issues, because they bring those different perspectives and 
they will tell me to slow down, not to get caught up in the 
moment, and think about the implications of each and every 
thing we are doing. And I hope we will bring that very 
deliberative process to all of the issues--which is not to say 
we will not have lots of disagreements with different 
constituencies, but we will always try to get the balance 
right.
    Senator Bennett. That is my concern, one of my concerns 
with respect to the proposals that we have before us to 
restructure our whole regulatory system. Systemic risk, let us 
give that to the Fed; safety and soundness, let us give that to 
FDIC; and then transparency and business practices, let us give 
that to the SEC, and you will all see to it that there is no 
problem of any kind anywhere else.
    I was a new Member of this Committee right after the RTC 
circumstance, and there was an overreaction to the question of 
making sure every institution is safe and sound. I remember 
sitting in this room as Members of this Committee were beating 
up bankers about you are not making enough loans, you are not 
making any money available to people. And the reaction of the 
bankers was: Are you kidding? What we have just been through 
where we were beaten up for being too open in making money 
available to people who went out and lost it? You are darn 
right we are not making any loans because the regulators will 
kill us if we do. We are threatening safety and soundness if we 
make loans.
    You are now in an atmosphere very similar to that 
atmosphere where the populist reaction to things is shut 
everybody down, and my only concern is that if we overreact and 
do shut everybody down, we make the recession longer, we hurt 
the country, and all of the rest of it.
    One last quick comment. I understand before I came in you 
did speak about the uptick rule and looking at the locator. You 
and I have had these conversations. I am very grateful to you 
that you have now gone public with our private conversations 
because I still believe the issue of naked short selling is a 
genuine issue that too many people have said for too long does 
not really exist, and if it does, it does not really matter 
because it is really very small. And to those investors who 
have seen their companies destroyed as a result of it, it is a 
big deal.
    Mr. Joseph, did you want to comment on the short-selling 
thing? You looked expectant there, and I did not want to cut 
you off.
    Mr. Joseph. No, I agree, Senator. Naked short selling 
should be curtailed, period, end of story.
    Senator Bennett. Good. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you, Senator Bennett.
    I would note before I turn to Senator Bayh, I think Senator 
Corker raised the issue, we have as well, that sense of balance 
is critical. I have been here as a Member of this Committee--
not as Chair of the Committee but as a Member of this 
Committee--during those periods we talk about. And there can be 
an exuberance of the moment, overreactions. Someone once said 
to me, to pick up on your point, why have we done as well as we 
have? Putting aside, obviously, the recent crisis we are in. We 
are very good. This country has been very good, very creative 
at creating wealth. But, second, and as importantly, it has 
been safe, that if you park your resources here, your hard-
earned money, that the system and structure are safe. You may 
lose. There is no guarantee of winning. But you do not have to 
worry about your system. It is pretty good. We have lost that 
reputation. And it is striking that balance about being 
creative and imaginative and creating wealth and being safe. 
And it is not always easy to strike that perfect balance that 
we talk about, but that is the goal. If we lose that reputation 
of being a safe place to be because we have a system in place 
that will not allow fraud and deceit and deception to occur, 
and simultaneously to encourage the kind of imagination and 
thoughtfulness that goes into wealth creation is a challenge. 
Always will be a challenge. We are not going to resolve it. I 
think one of the things--we are raising expectations maybe 
here, that somehow we are going to take care of every and all 
problems that will ever happen again. We are not. There is 
someone out there right now imagining how they can circumvent 
this system. And the job of this Committee, this Congress, and 
succeeding ones will be to be vigilant as these new ideas 
emerge to make sure they just do not end up in the marketplace 
without someone putting the brakes on and saying: What are you 
doing with this? What does it really do? And what are the 
implications of it and what risk does it pose?
    I appreciate the Senator from Utah raising that sense of 
balance. It is important. Senator Corker raised it earlier, and 
I agree with him.
    Senator Bayh.
    Senator Bayh. Thank you, Mr. Chairman, and thanks to both 
of you.
    Chairman Schapiro, I have two questions. One we discussed 
in my office prior to your confirmation and it relates to the 
importance of accurate information for investors making 
decisions and for markets to function, and that implicates the 
role of the rating agencies, which is what I would like to ask 
you about. With the benefit of hindsight, it appears that many 
of the more exotic instruments were rated too highly. The 
ratings were not adjusted in a timely manner. And some have 
raised questions about the way in which the rating agencies are 
compensated for making their ratings, paid by the issuers of 
the securities as opposed to those who purchased them or by the 
government itself.
    I would like to ask you, do you have any thoughts or can we 
take any additional steps to promote accurate ratings of 
financial instruments so that investors can make decisions in 
accordance with their risk tolerance and not be unpleasantly 
surprised by buying AAA-rated instruments that turn out to be 
anything but?
    Ms. Schapiro. I think accurate information is absolutely 
the lifeblood of our markets, and whether it is corporate 
disclosure or ratings, they are incredibly important to 
investors.
    The SEC over the last couple of years, since Congress gave 
it authority in the Credit Rating Reform Act in 2006, has done 
a number of things to try to bolster the regulatory regime 
around rating agencies. I am not sure that we have gone far 
enough, and on April 15, we are actually holding a roundtable 
to discuss further rating agency reform. We will have rating 
agencies there to talk about what went wrong and why. We will 
have large users of ratings, institutional and other investors 
to talk about it. And we will have people there who are going 
to talk about some of the more creative ideas we have heard 
about how to change the model of issuer pays to try to 
alleviate some of the conflicts of interest, and there have 
been some very creative ideas expressed.
    So we expect to have a very public day-long session talking 
about all of these issues, the goal of which is to inform the 
Commission's next steps with respect to either rulemaking or 
the potential to come back and ask the Committee for further 
legislation.
    Senator Bayh. I would encourage you in this direction. I 
mean, a big part of what we are trying to do now is to 
reinstall confidence in a whole number of ways, and if people 
simply don't believe the information they are receiving, if 
they think they are buying instruments that are AAA-rated and 
they turn out to be anything but that, what are they to do 
going forward in terms of making decisions? It really 
undermines confidence, and so I look forward to getting the 
benefit of your further input on that. I would really encourage 
you to focus on that.
    Second, and my final question has to do with, in addition 
to accurate information making markets function efficiently, 
incentives are important in terms of human behavior. And I 
think again, with the benefit of hindsight, we can see that a 
lot of the incentives for people who are running publicly held 
companies promoted short-term decisionmaking and there was a 
decoupling of the potential rewards of running risks and 
bearing the full consequences of those risks, which does lead 
to skewed decisionmaking, let us just put it that way.
    I mean, for example, executives at some firms levered up 
highly. If the thing held together--and they ran significant 
risks--if it held together for just a year or two, they became 
fabulously wealthy, could take some of the chips off the table. 
And then if the wheels came off, well, it was the shareholders 
who ended up holding the bag. So, I mean, there was a 
decoupling. There was short-term decisionmaking as opposed to 
long-term decisionmaking and a decoupling of risk and the 
consequences of running those risks, which perverts the kind of 
decisions that are made.
    So my question to you, in terms of the incentives that 
exist, what can we do to promote long-term decisionmaking and 
real adding of value as opposed to this sort of short-term 
gambling mentality that took hold there for a period of time 
and has now come back to haunt us?
    Ms. Schapiro. I think there are really multiple avenues for 
us to pursue in that regard. One is much better disclosure 
about how risk is tied to compensation. We talked a lot about 
compensation for performance, but noticeably absent has been a 
real discussion about how compensation has been tied to risk 
taking and the implications of that.
    Senator Bayh. Well, if I could just interject, I mean, it 
is tied in some cases to short-term performance, which then 
comes back to haunt us----
    Ms. Schapiro. Right.
    Senator Bayh. ----because short-term can fluctuate up and 
down.
    Ms. Schapiro. Exactly right, and risk taking reveals itself 
over the longer run, and so the compensation decisions need to 
be tied to that longer-run perspective. I think, also, we need 
better disclosure of risk of holding certain financial 
instruments and just generally better risk disclosure for 
investors.
    And finally, and the piece we talked about a bit is the 
ability of shareholders to influence more directly who serves 
on corporate boards and tying the responsibility of boards. 
Board compensation clearly resides there, but making boards 
explain how they closed the circle with risk taking and 
compensation. But giving investors greater access to 
determining who sits on corporate boards is an important 
component of that, as well.
    Senator Bayh. Thank you, Madam Chairman.
    Mr. Joseph, I hope you don't feel slighted that my time has 
run out, but I thank you for being here, as well. Thank you.
    Chairman Dodd. Senator Bayh, thank you very, very much, and 
let me thank both of you.
    Mr. Joseph, let me just tell you, we have got a series of 
questions to submit to you, because obviously what--and some of 
your proposals raise issues, as well, regarding resources and 
tools. There is a valuable role to be played by the States. In 
fact, as you point out in your opening statement, because you 
are as close to the investor community as you are at that 
level, it provides an avenue for people to be able to express 
themselves and bring matters to the public attention. So we see 
a real value in what you do. I think we all have some questions 
about various proposals and raising from 25 to 100 million and 
so forth, what that involves. Obviously, the compatibility, as 
well, between the SEC and the States are very important.
    I regret we didn't get to spend more time with you, but 
obviously having a Chairperson here obviously focused a lot of 
attention on these current issues before us. So we will submit 
some questions to you and look forward to having you back 
before the Committee, as well.
    Mr. Joseph. Thank you, Mr. Chairman.
    Chairman Dodd. And Madam Chair, we thank you very much.
    Ms. Schapiro. Thank you.
    Chairman Dodd. As you have heard, we have got a lot of 
interest in the subject matter, so we will have you back up 
formally and informally, as well.
    Ms. Schapiro. Thank you.
    Chairman Dodd. Let me quickly invite our next panel, and 
they have been very patient and had the benefit of sitting and 
listening to all of this, as well, so they may want to add some 
addendums to their own testimony.
    But I am very honored and pleased to present three 
witnesses who are very familiar with this Committee, have been 
before us, some of us here on the Committee over the years.
    Richard Breeden served as Chairman of the Securities and 
Exchange Commission between 1989 and 1993. In July of 2002, Mr. 
Breeden was appointed to act as the corporate monitor of 
WorldCom on behalf of the U.S. District Court overseeing the 
case involving history's largest corporate fraud and largest 
bankruptcy.
    Arthur Levitt, Junior, is the 25th and longest serving 
Chairman of the SEC, from 1993 to 2001. As Chairman, he created 
the Office of Investor Education and Assistance, established a 
Web site which allowed the public free and easy access to 
corporate filings and investor education materials.
    Both Chairmen assisted our work, by the way, in Sarbanes-
Oxley, going back, and I know both these individuals very, very 
well. If you needed to have examples, if you wanted to just 
say, give me an example of good public servants, I offer up the 
names of Arthur Levitt and Richard Breeden and a look at their 
work would define, I think, what has been remarkable public 
service, and successful in the private world, as well. So you 
bring a wonderful wealth of experience from both sides of the 
equation. You heard Senator Bennett use the word ``balance'' 
and others talk about how we strike those balances of wealth 
creation and having safe and sound financial institutions and a 
regulatory process.
    Paul Atkins is the former Commissioner of the Securities 
and Exchange Commission. He served from 2002 to 2008, and we 
thank you very much, as well, for joining us and we thank you 
for your service on the Commission during those years.
    I guess we begin on a seniority basis here. By seniority, I 
guess you were the earliest serving, Mr. Breeden, so unless you 
have worked out something else, we will begin with you and then 
move right down the line. Thank you all very much, and thank 
you for your patience in listening to the first panel.

 STATEMENT OF RICHARD C. BREEDEN, FORMER CHAIRMAN, SECURITIES 
                    AND EXCHANGE COMMISSION

    Mr. Breeden. Thank you very much, Chairman Dodd, Ranking 
Member Shelby, and Members of the Committee, for the 
opportunity to offer my views on enhancing investor protection 
and improving financial regulation. These are really, really 
critical subjects and it is a great pleasure to have a chance 
to be back before this important Committee.
    I was privileged to serve as SEC Chairman from 1989 to 
1993. My views here today reflect that experience at the SEC as 
well as my White House service in 1989, when we had to craft 
legislation to deal with an earlier banking crisis, that 
involving the savings and loans. In subsequent years, my firm 
has worked on the restructuring of many, many companies that 
encountered financial difficulties, most notably WorldCom in 
the 2002 to 2005 range. Today, I am an investor and my fund 
manages approximately $1.5 billion in equity investments in the 
United States and Europe on behalf of some of the Nation's 
largest pension plans.
    By any conceivable yardstick, our Nation's financial 
regulatory programs have not worked adequately to protect our 
economy, our investors, or our taxpayers. In little more than a 
year, U.S. equities have lost more than $7 trillion in value. 
Investors in financial firms that either failed or needed a 
government rescue have alone lost about $1 trillion in equity. 
These are colossal losses without any precedent since the Great 
Depression.
    After the greatest investor losses in history, I believe 
passionately that we need to refocus and rededicate ourselves 
to putting investor interests at the top of the public policy 
priority list. We have badly shattered investor confidence at a 
time when we have never needed private savings and capital 
formation more. There is much work to be done to restore trust, 
and I must say, in the public policy debates, we seem to worry 
endlessly about the banks that created this mess and I believe 
we need to focus a little more on the investors who are key for 
the future to get us out of it.
    Many people today are pointing at gaps in the regulatory 
structure, including systemic regulatory authority. But the Fed 
has always worried about systemic risk. I remember back in the 
Bush task force back in 1982 to 1985, the Fed talking about its 
role as the lender of last resort and that it worried about 
systemic risk. And they have been doing that and we still had a 
global banking crisis.
    The problems like the housing bubble, the massive leverage 
in the banks, the shaky lending practices and subprime 
mortgages, those things weren't hidden. They were in plain 
sight, except for the swaps market, where I agree with the 
previous witnesses that there is a need for extending oversight 
and jurisdiction. But for the most part, the banking and 
securities regulators did have tools to address many of the 
abusive practices but often didn't use their powers forcefully 
enough.
    Creating a systemic or super-regulator, in my view, is a 
giant camel's nose under the tent. It is a big, big step toward 
industrial planning, toward central planning of the economy, 
and I think the very first thing that creating a systemic 
regulator will do is to create systemic risk. I fear very much 
that if you are not extremely helpful, we will have more ``too 
big to fail,'' more moral hazard, and more bailouts, and that 
is not a healthy path for us to move forward.
    I am very concerned that we not shift the burden of running 
regulated businesses in a sound and healthy manner from 
management and the boards of directors that are supposed to do 
that. Unfortunately, in the wake of this crisis, we have seen 
boards of directors that failed miserably to control risk 
taking, excessive leverage, compensation without correlation to 
performance, misleading accounting and disclosure, overstated 
asset values, failure to perform due diligence before giant 
acquisitions. These and other factors are things that boards 
are supposed to control. But over and over again in the big 
failures, the boards at AIG, Fannie Mae, Lehman Brothers, 
CitiGroup, Bank of America, Wachovia, WAMU, in those cases, 
boards were not doing an adequate job.
    So my view is that we need to step back as part of this 
process and look and say, why are boards not doing what we need 
them to do? I think one of the important answers is that we 
have too much entrenchment of board members, too many staggered 
boards, too many super voting shares, too many self-
perpetuating nominating committees, and a very, very high cost 
to run a proxy contest to try and replace directors who are not 
doing their jobs.
    So I think one of the important things that Congress can 
look at, and I hope you will look at in the future, is to enact 
a shareholder voting rights and proxy access act that would 
deal with proxy access, uninstructed votes by brokers, which is 
corporate ballot stuffing, majority vote for all directors 
every year, one share, one vote. There are a number of things 
where if we give a little more democracy to corporate 
shareholders, we can bring a little more discipline to 
misbehavior in corporations and not put quite so much on the 
idea that some super uber-regulator somewhere is going to save 
us from all these problems.
    Thank you very much.
    Chairman Dodd. Thank you.
    Mr. Levitt.

  STATEMENT OF ARTHUR LEVITT, FORMER CHAIRMAN, SECURITIES AND 
                      EXCHANGE COMMISSION

    Mr. Levitt. Thank you, Chairman Dodd and Ranking Member 
Shelby, for the opportunity to appear before the Committee this 
morning. Thank you for your kind words. It is good to be back 
with former friends and colleagues.
    When I last appeared before this Committee, I focused my 
remarks on the main causes of the crisis we are in and the 
significant role played by deregulation. Today, I would like to 
focus on the prime victim of deregulation, investors. Their 
confidence in fair, open, and efficient markets has been badly 
damaged, and not surprisingly, our markets have suffered.
    Above all the issues you now face, whether it is public 
fury over bonus payments or the excesses of companies receiving 
taxpayer assistance, there is none more important than investor 
confidence. The public may demand that you act over some 
momentary scandal, but you mustn't give in to bouts of populist 
activism. Your goal is to serve the public not by reacting to 
public anger, but by focusing on a system of regulation which 
treats all market actors the same under the law, without regard 
to their position or their status.
    Many are suggesting we should reimpose Glass-Steagall 
rules. For six decades, those rules kept the Nation's 
commercial banks away from the kinds of risky activities of 
investment banks. While it would be impossible to turn back the 
clock and reimpose Glass-Steagall, I think we can borrow from 
some of the principles and apply them to today's environment. 
The principles ensured are regulation's need to match the 
market action. Entities engaged in trading securities should be 
regulated as securities firms, while entities taking deposits 
and holding loans to maturity should be regulated as depository 
banks. Regulation, I think, is not one-size-fits-all.
    Accounting standards must be consistent. The mere mention 
of accounting can make the mind wander, but accounting is the 
foundation of our financial system. Under no circumstances 
should accounting standards be changed to suit the momentary 
needs of market participants. This is why mark-to-the-market 
accounting should not be suspended under any condition.
    The proper role of a securities regulator is to be the 
guardian of capital markets. Of course, there is an inherent 
tension at times between securities regulators and banking 
supervisors. But under no circumstances should securities 
regulators, especially those at the SEC, be subordinated. You 
must fund them appropriately, give them the legal tools they 
need, and hold them accountable to enforce the laws you write.
    And finally, all such reforms are best done in a 
complementary, systemic way. You can't do regulation piecemeal.
    Allow me to illustrate how these principles can be put to 
work in specific regulatory and policy reforms. First, some 
have suggested that you create a super-regulator. I suggest you 
take a diverse approach using the existing strengths of our 
existing regulatory agencies. For example, the Federal Reserve 
is a banking supervisor. It has a deep and ingrained culture 
that is oriented toward the safety and soundness of our banking 
system.
    Ultimately, the only solution to the tension is to live 
with it. when I was at the SEC, there was tension between 
banking regulators and securities regulators all the time. 
While this was frustrating for the regulators and the financial 
institutions themselves, I think it served the overall purposes 
of reducing systemic risk. Regulatory overlap is not only 
inevitable, I think it may be desirable.
    Second, mark-to-the-market or fair value standards should 
not be suspended. Any effort that seeks to shield investors 
from understanding risk profiles of individual banks would, I 
believe, be a mistake and contribute greatly to systemic risk. 
The Chairman of the Federal Reserve, the heads of the major 
accounting firms maintain that maintenance of mark-to-the-
market standards is essential.
    Third, this Committee and other policymakers seek to 
mitigate systemic risk. I suggest promoting transparency and 
information discovery across multiple markets, specifically 
credit rating agencies, municipal bond issuers, and hedge 
funds. For years, credit rating agencies have been able to use 
legal defenses to keep the SEC from inspecting their operations 
even though they dispense investment advice and sit at a 
critical nexus of financial information and risk. In addition, 
these rating agencies operate with significant protections from 
private rights of actions. These protections need to be 
reconsidered.
    In the same manner, the SEC should have a far greater role 
in regulating the municipal bond market, which consists of 
State and local government securities. Since the New York City 
crisis of 1975, this market has grown to a size and complexity 
few anticipated. It is a ticking time bomb. The amount of 
corruption, the amount of abuse, the amount of pain caused to 
municipal workers and will be caused to municipal workers in an 
environment that is almost totally unregulated is a national 
scandal.
    Because of the Tower amendment, many participants, 
insurers, rating agencies, financial advisors, underwriters, 
hedge funds, money managers, and even some issuers have abused 
the protection granted by Congress from SEC regulation. Through 
multiple scandals and investment debacles hurting taxpayers, we 
know self-regulation by bankers and brokers through the 
Municipal Services Rulemaking Board simple does not work. We 
must level the playing field between the corporate and 
municipal markets, address all the risks to the financial 
system.
    In addition, I would also recommend amending the Investment 
Advisers Act to give the SEC the right to oversee specific 
areas of the hedge fund industry and other pockets of shadow 
markets. These steps would require over-the-counter derivatives 
market reform, the outcome of which would be the regulation by 
the SEC of all credit and securities derivatives. To make this 
regulation possible and efficient, it would make sense, as my 
predecessor, Chairman Breeden, has said so often, to combine 
the resources and responsibilities of the SEC and CFTC. Under 
no condition should the SEC lose any of its current regulatory 
authority. The Commission is the best friend investors have.
    The resulting regulatory structure would be flexible, 
effective in identifying potential systemic risk and supportive 
of financial innovations and investor choices. Most 
importantly, these measures would help restore investor 
confidence by making sure rules are enforced equally and 
investors are protected from fraud and outright abuse.
    As we have seen in the debate over mark-to-market 
accounting rules, there will be strong critics of a strong and 
consistent regulatory structure, but someone must think of the 
greater good. That is why this Committee must draw on its 
heritage of setting aside partisanship and the concerns of 
those with single interests and affirm the rights of investors 
whose confidence will determine the health of our markets, our 
economy, and ultimately our Nation.
    Thank you.
    Chairman Dodd. Thank you very much, Mr. Levitt. We thank 
you for being here.
    Mr. Atkins, we welcome you to the Committee.

 STATEMENT OF PAUL S. ATKINS, FORMER COMMISSIONER, SECURITIES 
                    AND EXCHANGE COMMISSION

    Mr. Atkins. Thank you very much, Chairman Dodd, Ranking 
Member Shelby, and Members of the Committee, for inviting me 
here today to the hearing. It is a great honor for me to be 
here today, and especially appearing today with two great 
public servants whom I know very well and admire.
    This Committee has had a long history of careful study and 
analysis of matters relating to the financial markets and the 
financial services industry, and as you have already heard in 
your hearings, there are multiple, complex, and interrelated 
causes to the current situation in global financial markets. I 
believe that these causes are more than the competence or 
incompetence of individuals in particular roles, but have more 
to do with fundamental principles of organizational behavior 
and incentives.
    Your topic for today is rather broad, so I would like to 
touch on a few specific items that go to the heart of an agency 
that I know very well, the Securities and Exchange Commission.
    With respect to the subject of regulatory reform----
    Chairman Dodd. Mr. Atkins, can you pull that microphone a 
little closer to you?
    Mr. Atkins. I am sorry.
    Chairman Dodd. Thank you very much. I appreciate it.
    Mr. Atkins. With respect to the subject of regulatory 
reform, your hearings have so far been a very good start and I 
would suggest that you ask some very hard questions in 
subsequent hearings. For example, why was the SEC in the course 
of the last dozen years or so has the SEC experienced such 
catastrophic failures in basically every one of its four 
competencies--rulemaking, filing review, enforcement, and 
examinations? What led to the failures of the SEC and other 
regulatory agencies, both in the United States and globally, to 
discern the increasing risk to financial institutions under 
their jurisdiction? What led the failures at financial 
institutions to recognize the inadequacy of their own risk 
management systems and strategy in time to avert a collapse? 
How did so many investors get lulled into complacency and not 
adequately do their own due diligence? What is the proper role 
of credit rating agencies, and has regulation, in fact, 
fostered an oligopoly by recognizing the opinions of a few as 
being more privileged than those of the rest?
    These are hard questions, and if there are to be changes to 
the Federal securities laws, I think they need to be made 
carefully through a robust analysis of the costs and benefits 
of various potential actions and how those actions might affect 
human behavior in the market.
    The current situation is certainly no time to wing it or to 
act on gut instincts because investors ultimately pay for 
regulation. And if Congress doesn't get it right, severe 
consequences could be in store for the U.S. Once on the books, 
laws, especially in this area, seem to be very hard to change 
and unintended consequences live on.
    Prior to the recent crisis, the subject of regulatory 
balance was being discussed. Senator Schumer, Mayor Bloomberg, 
the U.S. Chamber of Commerce, and others cited many reasons why 
the U.S. as a marketplace was not so competitive. In fact, in 
2006, the value of Rule 144A unregistered offerings in the U.S. 
for the first time exceeded that of public offerings. 2006 
seems like a long time ago, but it still is very much a valid 
concern, especially once the global financial system recovers.
    The worrisome thing to me is that if care is not taken to 
have solid analysis, the wrong lessons may be gleaned from this 
latest crisis and that will ultimately hurt investors. It takes 
a long time, as I said, to change legislation in this area. So 
what we need is an analysis to determine how we can effectively 
and efficiently promote honesty and transparency in our markets 
and ensure that criminality is not tolerated.
    For example, I disagree with the assertion that 
deregulation in the past four, eight, ten, or what have you 
years has led to the current problems in the financial markets. 
One can hardly say that the past eight to 10 years have been 
deregulatory with the adoption of new laws and rules, such as 
Sarbanes-Oxley. More regulation for regulation's sake is not 
the answer What we need is smarter regulation.
    The global crisis has primarily affected regulated versus 
nonregulated entities all around the world, not just in the 
supposedly deregulatory United States. The question is, how did 
so many regulators around the world operating under vastly 
different regimes with differing powers and differing 
requirements all get it wrong? Indeed, how did so many firms 
with some of the best minds in the business get it wrong?
    During the past dozen years, the SEC has experienced 
catastrophic operational failures in its four core functions of 
filing review, rulemaking, enforcement, and examinations. 
ENRON's corporate filings were not reviewed for years in the 
1990s. Tips were not pursued regarding Bernie Madoff and 
regarding the late trading of mutual funds in 2003. It took 
literally an Act of Congress led by this Committee to get 
transparency and a reformed SEC process with respect to credit 
rating agencies.
    These mistakes, I think, were a long time in the making and 
were caused by failures of the system of senior staff 
management. First, management applied faulty motivational and 
review criteria, and second, since resources are always 
limited, there is an opportunity cost in choosing to spend time 
and resources on one thing because then, of course, there is 
less time and less resources to spend on other things.
    With respect to opportunity costs, I believe that the SEC, 
especially in the years 2003 to 2005, was distracted by 
controversial, divisive rulemaking that lacked any grounding in 
cost-benefit analysis during this very crucial period right 
when many instruments, like CDOs and CDSs, took off and 
established their trajectory. Because these rules and the 
arguments for them were ultimately invalidated by the courts 
after both long litigation and much distraction for the agency 
and the industry, a lot of essential time was wasted.
    Because life is full of choices, if you devote resources to 
one thing, you have less to devote to another, and the one risk 
that you haven't focused on just may blow up in your face. That 
is, in fact, exactly what happened to the SEC, and it was 
really through back office processes and documentation that 
weren't attended to that led to the current crisis.
    There are other things that I would be happy to talk about 
that I put into my written testimony. With respect to that, I 
have mentioned in my written testimony an article on 
enforcement and the processes at SEC. I ask that I be able to 
submit that for the record.
    Chairman Dodd. Consider that done. That will be certainly 
true of both Mr. Breeden and Mr. Levitt, as well, any 
additional comments and thoughts.
    And obviously, I have already had conversations with 
Richard Breeden and Arthur Levitt and I expect I will have a 
lot more in the coming weeks, and we invite, Senator Shelby and 
I and Members of the Committee, as we work our way through 
this, and we are very conscious, both Senator Shelby and I are, 
of the importance of the matter and how well we handle this. So 
we are very interested in getting as much counsel and advice, 
particularly from people who have been through this and been 
around over the years to watch a lot of what is occurring.
    Let me ask you, if I can, to start out with, to get the 
panel's views on two proposals from the current administration, 
the proposal to establish a resolution authority of nonbank 
institutions. And I would also like to ask you to comment on 
the public-private plan to purchase toxic assets. You have all 
got tremendous experience in this area as well and a little 
afield.
    The first regarding the resolution authority, and it was 
the first question I raised with Chairwoman Schapiro. Arthur 
Levitt noted, and I quote, that regulation needs to match 
market action, and that if an entity is engaged in trading 
securities, it should be a regulated securities firm. And that 
is certainly almost a self-evident statement, but nonetheless, 
deserves being repeated.
    So, obviously, it begs the question, if we are going to 
have a resolution operation of nonbanks, to what extent, then, 
are we going to involve the agency or agencies that are 
bringing the most expertise and background to the issues so 
they would have some ability to manage that kind of an event? 
Then, second, what should the role of the securities regulator 
be in the orderly resolution of these securities entities.
    And, then, I would like you to describe, if you could, 
briefly, what features are necessary in the public-private plan 
to protect taxpayers and restore public confidence in the 
banking system. It seems to me--I think, like many, my general 
reaction to this, with all of its shortcomings, is an idea that 
I think they needed to pursue. Whether or not this is exactly 
right or not, I do not know; time will tell. But I like the 
thrust of it, it seems to me, because I hear the view that 
unless you get rid of these assets, this is going to continue 
to clog up the system and the credit freeze will continue. And 
then the only answer, seems to me, is to pour capital back in 
institutions, and we have just run out of patience and 
resources to do that. So you have to try something else to move 
this along.
    While there are questions, legitimately, about what 
valuation will be on these, whether or not sellers will sell, 
buyers will buy, it seems not trying to do something like this 
is a far greater mistake, in my view, than trying something.
    So at least my general reaction is a positive one. That 
does not mean I am buying into every dotted I and crossed T, 
but I would be very interested, given all your background and 
experience, to comment on that as well.
    So, Richard, do you want to start?
    Mr. Breeden. Yes, sir. Let me start with the resolution 
question. There is an old saying that you cannot really have 
Christianity without the devil, and capitalism does not work if 
you do not have failures. I mean, we have a competitive system, 
and some people win and some people lose. And if we close the 
door--one of the things that has traditionally been one of the 
greatest strengths of the U.S. economy has been Chapter 11 and 
our willingness to let companies fail and then restructure 
them.
    I went through the largest one in history of this country, 
WorldCom, where we took a company that had $35 billion a year 
in revenues, 75,000 employees, a mere $85 billion worth of 
missing assets, and all kinds of problems, a catalog longer 
than anybody could dream of, and over a 3-year period, we 
restructured it. It came out of bankruptcy with 66,000 
employees still there, the business in tact. And what it was 
worth when it went down, probably three or 400 million, was 
eventually sold for 12 billion, and creditors came out with a 
very good recovery. If you can fix WorldCom, you can fix 
anything.
    Our problem in the financial space--so I think when you 
talk about nonfinancial institutions, airlines, car companies, 
whatever, bankruptcy is there. It is a good workable structure. 
And we have a problem that we seem to have policymakers who 
either do not understand it or are afraid to use it. And that 
is why we have the courts and they can restructure companies; 
it is a very, very good thing.
    In the financial world, we have been afraid to use it. And 
one of the thing I suggested in my testimony was that Congress 
think about something like the national securities surveillance 
courts you have created, over in the terrorism side; create a 
court composed of senior judges who have actually handled big, 
multi-billion dollar collapses and restructuring, and have 
expedited processes so that an AIG could--that there would be a 
structure to handle it.
    Throwing it into bureaucracies, whether it is the Treasury 
or the Fed, to me is the wrong approach because you are going 
to get ad hoc decisions. And, frankly, part of the reason we 
had so much panic in the market, loss of confidence, last fall 
was that every Sunday night you would get out of the blue a 
decision coming out of one of the administrative agencies about 
how they were handling Fannie Mae and Freddie Mac, Bear 
Stearns, Lehman Brothers and so on. And every one of them was 
different. There was no consistency.
    One of them preferred stock to be wiped out, the next one 
to be protected. One of them the debt is OK; the next one, it 
would be wiped out. And there was no real way to predict it. 
And when investors cannot predict what is going to happen, then 
you are not going to lend credit because you cannot make a 
sensible decision.
    So I think the rule of law is a very, very healthy thing in 
the resolution area. And creating a court aimed at handling 
large financial institution failures, with lots of input from 
the Fed and the Treasury and SEC, but where it is done in a 
judicial context, would be very helpful.
    Mr. Chairman, we had failure of Drexel Burnham when I was 
at SEC, and we also had a restructuring of Solomon Brothers, 
two of the largest securities firms of the time.
    Drexel had a regulated broker-dealer and its holding 
company was off doing everything under the sun. When they got 
in trouble, we seized the broker-dealer, we sold it to 
PaineWebber, and we took the unregulated holding company and we 
sent them down to the local bankruptcy court. And they spent 
the next three to 4 years sorting it out, and it was just fine. 
The market was not interrupted in any way.
    The same technique could have been used at AIG. You could 
have taken the regulated insurance companies, sold them to 
other companies instead of sitting there with them, and put the 
unregulated activities, swaps or anything else, put them into a 
bankruptcy proceeding and wind them down. And that would be a 
much better mechanism for dealing with all the issues that come 
along.
    So I think the topic of having a resolution mechanism that 
works for a big financial institution is a good topic, but I 
would urge that we spend a little more time looking at the 
range of alternatives rather than just throwing them into the 
Treasury Department, where I am not sure they have the 
institutional knowledge to make good decisions.
    Chairman Dodd. Let me jump--Arthur Levitt and Mr. Atkins, 
quickly, on this subject matter.
    Mr. Levitt. Generally speaking, I associate myself with 
Richard's views, although in this case, because of the nature 
of the crisis is so different than it was at the time of Drexel 
Burnham or elsewhere, morphing over into economic Darwinism I 
think is a mistake.
    We are operating in a polarized environment, highly 
polarized. And because of that, the notion of these public-
private partnerships will be met with a measure of skepticism 
in terms of what the government may extract once more from any 
private sector entity that wants to deal with the bureaucracy.
    I agree that the approach has to be more comprehensive, 
less at the edges, more directly, in terms of determining who 
is going to make it and who is not going to make it. And the 
notion of adding bureaucratic layers of control and judgment 
and dispensation I think will slow the process and slow the 
eventual outcome.
    Chairman Dodd. Let me just ask you--because, Richard, you 
were one of the architects of the Resolution Trust Corporation 
in the 1980s. And there, there was--being a bit of a devil's 
advocate. Certainly your approach is interesting, but there, 
there was the creation and it did work. We did not get 
everything back, but we got a lot back, and your idea had great 
value and merit.
    Given Arthur's point here, this is arguably a time when the 
tentacles are far more far reaching in many ways. The issues 
are not sort of stovepiped, not that they were then either, but 
nonetheless.
    Is that a change of view? If you had to go back to the 
1980s, would you be sitting here offering something different 
than what you suggested at the time?
    Mr. Breeden. Thank you, Mr. Chairman. I have thought a lot 
about our experiences, creating the RTC and dealing with the 
savings and loan crisis as I have watched the current crisis 
unfold.
    In a nutshell, our philosophy back then was no bailouts but 
fast funerals, and it worked pretty darn well.
    Chairman Dodd. That is an Irish expression.
    Mr. Breeden. It worked pretty darn well.
    There is similarity in the public-private partnership, that 
the Treasury is trying to establish for the troubled assets, 
and the RTC. RTC was an entity that just stripped all the 
assets out of everything that failed and then repackaged them 
and tried to sell them back out to the market as quickly as you 
possibly can. These assets do not get better when they are 
owned by the government; get them back in private hands where 
they can be managed effectively.
    I think that is what Treasury's public-private partnership 
is trying to do without creating an agency, if you will, to do 
it. And I think it will work. They are on the right path. I 
have not looked at all the details of it. It is critical that 
you have price exposure, that you let people bid on these 
packages, that they not be directed to individual purchasers. 
It is important that you have transparency. And the key to all 
of it is that--and the big difference between the current plan 
is we were dealing with debt institutions. They were closed, 
and then we took the assets out and repackaged them.
    Chairman Dodd. Right.
    Mr. Breeden. So they did not care what price they got 
because they were not in existence anymore. We, on the other 
hand, would sell assets to maximize recovery for the taxpayers, 
and we got a lot of it back.
    The whole--this plan, one of the critical issues will be, 
at what price will a bank, that is still doing business, that 
is carrying stuff on its books at 60, that maybe is worth 15, 
are they going to be willing to sell it into one of these 
public-private partnerships----
    Chairman Dodd. I agree.
    Mr. Breeden. ----that is at a realistic price.
    Mr. Levitt. That is absolutely critical. And in a 
globalized electronic market, the margin of error is so much 
narrower than it has ever been in the history of commerce. A 
mistake now is measured in milliseconds.
    Chairman Dodd. Right. But let me ask--I mean, I agree with 
that. And I am going to turn to Senator Shelby.
    I agree with that. I think it is a very good point, not 
Madoff enough. Everyone is wondering whether there will be 
buyers. I think the issue is whether or not there will be 
sellers. That is really going to be the issue, will you sell.
    I am just imagining this. And, again, I am just listening 
to some folks, and we have a panel coming up who can maybe shed 
some more light on this.
    My guess is if you are a board of a bank, and you are 
sitting there, and someone is saying, we think this thing is 
worth more than what they are offering, my reaction might be, 
you know what, get rid of this stuff; let's move along. The 
credit markets are not going to open up until we get this 
unclogged. And while you may be right, and I am sure it is 
worth more than what they are offering here, let's move along.
    I have to believe that thinking may have some influence on 
the decision of sellers to move the product along. I know it 
affects balance sheets, though. But the larger good here is, 
get this moving. So I do not know whether that is going to be 
the case or not, but that is the counter argument I have heard 
about whether or not sellers will sell.
    I do not mean to dwell on all of this, but it is an 
interesting point.
    Let me turn to Senator Shelby. I have taken way too much 
time.
    Senator Shelby. Thank you.
    Mr. Breeden, you were chairman of the SEC from 1989 to 
1993. Mr. Levitt, you were chairman of the SEC from 1993 to 
2001. We know Mr. Atkins was a commissioner there for some 8 
years, I believe it was.
    In looking back at your time at the SEC, what could each of 
you have done differently that would have helped to prevent the 
roots of the current crisis from growing?
    Mr. Breeden? You were there a while back, I know that.
    Mr. Breeden. We did everything we could, and I suppose you 
can always do more----
    Senator Shelby. Sure.
    Mr. Breeden. ----to maintain market discipline. I have a 
deep faith that continues to this very day, that markets do a 
better job disciplining risk than bureaucrats do. So I did not 
want the SEC trying to figure out if Drexel Burnham would say--
should stay in business or not. I wanted the market to decide 
that.
    We tried to draw the line and make clear that too big to 
fail did not include the securities industry; that if you 
extended credit to a securities firm, do it on the basis of 
their creditworthiness because we were not going to bail you 
out if you got it wrong.
    I wish we had established that principle more clearly, 
because to the extent that anybody out there thought Lehman 
Brothers or Bear Sterns were inside a taxpayer protection 
umbrella that would have allowed them to borrow more money, get 
more credit than their own balance sheet warranted--and I think 
we get into so many problems of distortion in the marketplace. 
You saw it with Fannie and Freddie, you see it with any area 
where you have moral hazard where people are thinking, well, I 
can lend money here because if it goes wrong, taxpayers, the 
government, will somehow step in and bail it out.
    We did the right things when I was there to try and make 
sure we drew the line and said, in the securities industry, you 
are on your own, but I suppose we could have done it better.
    Senator Shelby. Mr. Levitt.
    Mr. Levitt. A day does not go by when I do not think about 
this very question. The first mistake I made was not pressing 
harder for an immediate resolution of the issue of expensing 
stock options. We are now entering a decade or transparency, 
where every rule, every regulation, every judgment will be 
judged by the metric of how transparent it is. That was a case 
in point.
    Second was maybe the most important issue of all. There 
came a time when the chairwoman of the CFTC came to the 
President's Working Group and said, it is time to regulate 
swaps. Alan Greenspan, Bob Rubin and others said, that is 
impossible. You cannot do it. We have trillions of dollars of 
outstanding contracts. It is the wrong thing to do; do not do 
it.
    I went along with it. I went along with it without taking 
the additional step of saying, wait a second. Maybe we have 
those contracts out there. Let's grandfather them, and going 
forward, let's regulate them, mandate them to go on an 
exchange, give them transparency. I did not call for a mandated 
central clearing facility, and that was a mistake that I will 
regret as long as I think about these things.
    Senator Shelby. But there is nothing like transparency in 
anything, is there?
    Mr. Levitt. Absolutely.
    Senator Shelby. And confidence to bring trust back to the 
market.
    Mr. Levitt. Essential.
    Senator Shelby. Essential.
    Mr. Atkins.
    Mr. Atkins. Thank you, Senator Shelby. You know that 
commissioners can be literally the fifth wheel at the SEC, 
but----
    Senator Shelby. But you are part of the system.
    Mr. Atkins. Definitely, and I tried to ring the gong down 
through the years.
    I think one thing is that the SEC probably became a little 
bit too focused on the equity markets and, to a lesser extent, 
the options markets, and did not pay enough attention to the 
debt side, including as Chairman Levitt was just talking about, 
munis. And the real question is do the equity markets still 
function as the primary price discovery mechanism because a lot 
of that has shifted to the debt side. So I think there needs to 
be new types of skill sets at the SEC.
    Second was maybe not speaking out more loudly and often 
about some of the backoffice and documentation issues for CDOs 
and the CDSs down through the years.
    Then, finally, with respect to the enforcement program at 
the SEC, I think what has happened over the years is that the 
senior staff has tendeding to chase headlines rather than to 
look at real cases that hurt real investors, Ponzi schemes and 
stock manipulations, really disparaging them as ``slip and 
fall''--or unimportant--cases.
    Senator Shelby. Mr. Breeden, you know, as well as everybody 
does, the Federal Reserve is not only the central bank but it 
is the regulator of our holding companies, our largest banks. I 
believe myself that they have utterly failed as a regulator, 
utterly, because most of our Wall Street banks that got in 
trouble, and some of them are in trouble today, still, were 
regulated by the Federal Reserve. So that causes me great 
heartburn when we start talking about the Federal Reserve as 
the systemic risk regulator, you know, the all powerful thing.
    Explain your concerns about having the Fed serve in the 
role as a systemic regulator.
    Mr. Breeden. Well, Senator, I think this is a terribly 
important subject, and I really hope people stop and think 
about this. The Fed does, as lender of last resort--and I hope 
we will always have a central bank, not the world's largest 
hedge fund, over at the Federal Reserve. But as lender of last 
resort, well, you can only cram so many--every time the Fed 
buys everybody else's broken assets, you are not really fixing 
those assets, you are just moving them over to the Federal 
Reserve. And there are limits to how you do that.
    Senator Shelby. They seem to be keeping a lot of them too 
long.
    Mr. Breeden. Well, they do not get more valuable as you 
hold them.
    Senator Shelby. I know.
    Mr. Breeden. So this lender of last resort role has always 
given the Fed a stature and an importance in the system, and it 
is quite genuine; central banks do play a critical role. But 
their primary role is, of course, monetary policies, stability 
of the currency, and you will always pick Fed chairmen and Fed 
Governors to get good economists who will do that role well.
    Regulation is kind of off on the side. Who really runs 
regulation in the Fed, I am not sure anybody ever really knows.
    Senator Shelby. Maybe they did not have anybody running it.
    Mr. Breeden. Well, bottom line, there is probably $800 
billion in equity losses at Citicorp, B of A, WaMu, Wachovia, 
all institutions, which, as you point out, were regulated by 
the Fed.
    So the idea that we are now going to add to their plate GE 
and IBM and General Motors and every other--United 
Technologies, and anybody else who makes something important--
well, they make elevators, and elevators is certainly 
systemically important; we cannot get around without them. Who 
knows what ends up in that----
    Chairman Dodd. Just be careful of the names you use here, 
you are throwing out.
    Mr. Breeden. Well, I thought you might notice, Mr. 
Chairman.
    So I worry you are creeping very far into industrial 
policy. And I go back to my comment earlier. You cannot stop 
everybody from failing. You have to have a mechanism where the 
people who were unsuccessful get taken over and replaced by 
people who are successful.
    So the farther we go into saying the Fed will oversee 
everybody big in the economy--their expertise is looking at 
banks, not other kinds of firms. So you are putting people who 
do not have the experience and do not have the expertise in 
charge of regulating people, and you will get bad regulation. 
You will have the illusion of regulation, but maybe not the 
successful outcome.
    Senator Shelby. You said their expertise was looking at 
banks. Now, that is very debatable today----
    Mr. Breeden. At best.
    Senator Shelby. ----because if they are the regulators I 
said earlier, and they are, of our holding companies, and our 
banks, so many of our big banks failed under their supervision, 
that says a lot to me about the Fed's inadequacies.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Warner.
    Senator Warner. Thank you, Mr. Chairman. I think Senator 
Shelby asked a very good question in terms of what mistakes 
were made, and I appreciate the candor of the witnesses.
    I do think that one of the things Mr. Atkins said that 
struck home to me, as somebody who has been around the markets 
for some time, is over the last 10, 15-plus years, the enormous 
focus on the equity side as opposed to the debt side. And as 
the debt side got more and more complicated, I think it even 
got, perhaps, less focused. So I think a very valid point.
    Following up on the chairman's comment as well, about 
whether we are going to have willing sellers, I do think there 
is--and I know you have had these meetings, Senator Shelby. 
Senator Corker has had these meetings as well where you have 
got the hedge fund community saying everything is melting down 
and the banks saying, no, we are actually fine. Maybe the 
stress test will give us, if they are applied with some rigor, 
some winnowing out process and push those who fall below into 
this sales procedure.
    I have just got word that the Budget Committee is, which I 
am on, is in the markup. So let me just ask a question and not 
be able to stay for the answer. But I would like to start with 
Chairman Levitt, I guess.
    Earlier, we had Chairman Schapiro in, and we were asking 
about say on pay. I would be curious to have you and your 
colleagues' comments on say on pay. And I would also love to 
hear just your more general comments. Nobody thinks we are 
going to unscramble the eggs post-Glass-Steagall, but I would 
like your comments about what should be some of the underlying 
principles.
    Should we acknowledge that all institutions are going to be 
able to do all things on a going-forward basis, and what 
challenges and opportunities does that present us in terms of a 
new regulatory structure?
    Again, my apologies to the Members that I have to go down 
and vote in this markup.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator Warner.
    Senator Corker.
    Senator Warner. There was a question there, Mr. Chairman.
    Senator Shelby. Oh. I see. I thought you were walking out, 
so I apologize.
    Mr. Levitt. With respect to say on pay, what I would say 
about this, this sounds like an easy call. How can you be 
against it? And I am not. But I think it is simplistic. It can 
be a check the box kind of mentality, which businesses can 
easily incorporate and just move on.
    I urge any legislation to allocate to the SEC the 
responsibility of defining exactly what that means under what 
circumstances, how it is done, how far down it goes, what the 
details should be, what the explanation should be, what the 
history should be. Not simply pass a rule because, I assure 
you, it looks differently than if you refine it in a way that I 
think the Commission should be charged with doing.
    Mr. Breeden. Just on say on pay, real briefly, I am 
chairman of the Board of H&R Block, and we put say on pay in 
voluntarily last year. It works fine. It is good to let 
shareholders express their views. If they do not like your pay 
policies, then you ought to find out about it sooner rather 
than later. And we did the same thing at Zale Corporation, 
where I am on the board. We put it in voluntarily. I think the 
American business community has been resisting something that 
is simple, easy and an appropriate step to take.
    I share Arthur's concern that say on pay alone is not going 
to fix our compensation problems. You really have to have some 
ability--if compensation committees do outrageous things--and 
we have all seen examples of profligate compensation that can 
get seriously out of whack. You have to go beyond that and have 
either majority voting every year where shareholders can try 
and withhold votes or voting against members of a compensation 
committee. And, ultimately, you have to have the threat that if 
boards do not do a good job managing compensation policy, that 
they could be replaced. And until you do that, an advisory vote 
that just every year says you are doing a terrible job is not 
going to solve the problem.
    Chairman Dodd. Yes. Well said.
    Mr. Atkins. With respect to say on pay, I am an advocate 
for federalism. I think that Congress needs to be, or should 
be, a little bit leery of wading into this issue. We do not 
have a Federal corporate code or anything like that. I think 
once you start wading into it, the question becomes, where do 
you stop? And, maybe Congress should concentrate, like you did 
in Sarbanes-Oxley, on empowering the SROs, the stock exchanges 
and others, and then maybe leave it to the states to do what 
they deem appropriate--states acting and the shareholders 
acting within the ambit of the state laws and regulations as 
best suits the individual situation.
    Chairman Dodd. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman. I think this 
testimony you all have given I think has been outstanding this 
morning.
    I could not agree more with you, Mr. Breeden, about the 
boards. I think there is a lot of reforms that need to take 
place to strengthen boards' responsibility to oversee and to 
give, I think, shareholders some powers that they now do not 
have. We have had numbers of conversations regarding that. I 
could not agree more.
    Mr. Levitt, it is amazing to me, this fascination where 
somehow another changing accounting rule actually changes the 
status of an entity. While I do think there should be some 
degree of judgment, which I know the SEC ruled upon, anyway, 
several months ago--it has not had the uptick from the public 
accounting entities yet. But I think your comments are right-
on. And it is amazing to me that people would think that an 
accounting rule would actually change the actual status of an 
entity, but I thank you for that.
    Then, Mr. Chairman, I do think the seller issue you talked 
about is real. I think the securities will fly out the door 
because they have already been marked to market, and people 
sort of know what--they have marked them down realistically. I 
think on the whole loans or the assets, we are going to have a 
serious problem. And I think that piece has got to be worked 
through. And, certainly, if those assets are sold below where 
they are--of course, there is a different set of accounting 
standards that go there. We are talking about, in combination 
with the stress test, additional capital going into these 
entities, right? And it could be coordinated in a way that I 
think could be very helpful.
    But let me go back to Mr. Breeden. You mentioned having 
this special court to deal with some of these complex entities. 
And then on the other hand, there is the whole issue of 
protecting citizens for those that are not ready to go into 
that. So a resolution entity of some kind may be necessary, 
even if you had a structure for entities to move into Chapter 
11.
    Is that true or false?
    Mr. Breeden. Senator, I would say if you had the right 
Chapter 11 mechanism, you would not need an intermediate step. 
Companies would operate as long as they could get the liquidity 
and the credit to operate. If they got to a point where they 
could not, bang, you would make a filing that--like Chapter 11 
does, you stop the ability of people to shut an entity down 
while it goes through this reorganization process.
    So I do not think you would need an agency as a sort of 
warming tent for a special court. I think if you did it right, 
that court would be able to do things earlier. And one of the 
problems with Chapter 11 and financial institutions is it is 
loaded under current law toward liquidation, and that is what I 
think you have got to fix.
    Mr. Levitt. I would like to add one point to that, and it 
goes to the general tone of all of this testimony. Whether we 
have a court, whether we have a resolution, whether we have new 
rules, and whether we have a systemic regulator, do not under 
any circumstances allow that to diminish the investor 
protections offered by the SEC. The consequence of that kind of 
action, no matter how nice it sounds, not matter how pretty its 
dressing may look, would be to turn that agency into a Betty 
Crocker kind of agency, which does nice things for investors, 
but has no bite, has no power, has no authority. It just stands 
up there as an empty symbol. That is the danger of creating 
these systems of oversight and systemic risk and whatever it is 
that you call it. Do not allow investors to be hurt by this 
process.
    Senator Corker. Thank you very much. Let me move on. This 
economic Darwinism that Mr. Levitt referred to earlier, we 
see--I think we are going to have a task force report on the 
automotive industry that is going to come out, and they are 
going to lay out what futuristic things need to occur.
    Does the fact that debtor in possession financing is 
difficult to get today, does that in any way affect your view 
of economic Darwinism, if you will?
    Mr. Breeden. Senator, I----
    Senator Corker. Meaning that if somebody goes into Chapter 
11--under the WorldCom scenario, you had the ability to finance 
assets that were of value. There are people that I think would 
argue very strongly, and probably have a great point as we see 
what is happening, that there is not financing available for 
that kind of thing. Does that in any way affect your thoughts 
on entities like that?
    Mr. Breeden. Senator, I think you have put your finger on a 
terribly important issue, the availability of debtor in 
possession financing, and that is an area where a resolution 
authority might be able to--finding liquidity for those 
facilities, particularly if you suddenly need a giant one to 
deal with an AIG or something of that magnitude, would be an 
area that could conceivably be very helpful in working out with 
the Federal Reserve what form of public-private financing, if 
we are having inadequate liquidity in debtor in possession 
financing, Because without that, reorganization does not work.
    You know, Arthur was being a little critical of my economic 
Darwinism, but I am really unrepentant on that. If companies 
fail, you need to let them fail, and you need to let them be 
replaced by people who do a better job of managing. It does not 
mean that they will disappear from the face of the Earth. What 
we call Bank of America today really was once North Carolina 
National Bank. And a lot of other banks failed, and they got 
put together, and it grew and grew.
    Well, you can put these institutions together by 
acquisitions, and you can also take them apart by divesting 
things, making them smaller and more manageable, and arguably 
you sometimes make companies a lot better and a lot more 
valuable when they get back to a more manageable focus and 
size.
    So you do need the DIP financing. That is a critical role--
--
    Senator Corker. So you would advocate then potentially, 
instead of all the activism that we have had through Treasury 
and TARP and certainly now a Treasury Secretary, it appears, 
who wants to codify TARP, you would actually argue instead that 
we consider as a body creating a debt in possession financing 
mechanism that would allow people to go into an orderly Chapter 
11 and have the ability to finance out in lieu of that. Is that 
what you are arguing?
    Mr. Breeden. You have done a better job than I could of 
articulating that, but I think that coupled with having the 
ultimate decisions not made by a Cabinet Secretary but made by 
somebody wearing a black robe, I think having the courts be 
involved--because then you have the ability to deal with 
contracts for bonuses and to deal with the fact that the entity 
has more obligations than it has money to pay for them. And so 
they all need to be restructured, and doing that through the 
rule of law rather than every Sunday night somebody in an 
administrative agency makes a decision and announces it, if it 
stuns the market, I really like the protections as an investor. 
I like the protection knowing if I make an investment, what 
rights do I have, and who is going to back them up, and that 
that is going to be done through the judicial system 
ultimately.
    So I would marry up your suggestion of a DIP financing 
facility, if you will, with the judicial oversight, and I think 
we would then have something that would be very workable.
    Senator Corker. Mr. Chairman, I know my time is up. I want 
to say that Mr. Breeden's opening comments to me were pretty 
clairvoyant and somewhat chilling in light of what we see 
happening. We have this Trojan horse. You know, it looks really 
pretty and it sounds really pretty, and I am talking about the 
systemic regulator being an entity.
    Chairman Dodd. That is not going to happen.
    Senator Corker. I know that you, for what it is worth, have 
looked at--I know you talked with Susan Collins the other day 
about something she has put forth. I have to tell you, based on 
what I sense and feel, I think it would be one of the worst 
mistakes we could possibly make to put in one person's hands 
that ability. I do think very quickly we would move into 
industrial policy issues, things way beyond--I mean, we will 
never define properly systemic risk. I mean, it could move into 
all kinds of things, like WorldCom or other things.
    I thank you for pursuing that route. I see Senator Shelby 
nodding. But I hope we will resist any move--any move--that 
gives anybody that kind of power and basically renders almost 
every other entity in Government useless.
    Chairman Dodd. One of the things we learned, going back in 
Richard Breeden's day, is that you cannot have the regulator in 
a sense also be responsible for the resolution of these 
matters. What I said the other day is an entity that only talks 
to itself is dangerous in a sense when you get to these 
matters. And so that is why I, for one--again, I want to make 
it clear as well. I have not written anything, I have not--I am 
just listening, as we all are, to these various ideas and what 
make sense. And I like Richard Breeden's idea of this one, 
whether or not you can do this kind of a thing, but I agree 
with him the notion of getting--so you get resolution. I mean, 
the whole idea of calling it resolution is to get to a 
resolution on these matters.
    Mr. Breeden. Absolutely, Mr. Chairman.
    Chairman Dodd. And so we need to think carefully how we do 
it, but I agree with you, Senator, that this has got to be one 
that is thought out and has balance to it. These are 
complicated institutions today, either by design or 
acquiescence, and so, therefore, to look at them and how you 
unwind requires a lot more eyes on this than would come from 
one single entity. The danger of doing that seems to me to only 
complicate the problem to some degree. So I think we sort of 
agree on that.
    I just want to make--and we have got to go to that. Jack 
Reed has shown up who has done a terrific job as the Chairman 
of the subcommittee on Securities, and I invoked your name 
earlier without your permission, and that is, there is a lot of 
interest in Chairman Schapiro's testimony today and suggested 
that maybe the subcommittee would continue, formally or 
informally, following up the conversations with the SEC.
    I wanted to mention a subject matter, and just because it 
has come to my attention, and that is, this resetting or 
repricing of options. I have been reading some stories about 
how, obviously, with the decline in the price of various 
stocks, where options were taken on them, on the assumption, of 
course, their value would continue to increase--and it has done 
exactly the opposite. But whether or not certain people at a 
certain level are resetting the option at the lower price at 
the expense of shareholders who do not have that same ability 
raises some serious issues, in my view. And I was going to 
raise it with Jack, may draft a letter, in fact, to the SEC and 
others to find out what is going on with this. Again, I am 
reading news reports about it, so I want to be careful about 
suggesting something is absolutely the case. But, nonetheless, 
it is disturbing to me that that may be happening. And so we 
may want to look at that. We will draft something along those 
lines and get some answers very quickly.
    I do not know if you have seen anything like that. I do not 
know if either of our witnesses have seen any reports on the 
resetting of options at a certain level. Have you seen this as 
well?
    Mr. Levitt. Through the years, this is part of the 
compensation issue, and it is something----
    Chairman Dodd. Well, it is huge. You go from something that 
was $100 and it moves to $5 or $10 more, that is value. If you 
are going from $100 down to $10 and all of a sudden that stock 
goes to $20, and you have reset it at $10 for a handful of 
people, that makes some of these other issues pale by 
comparison.
    Mr. Levitt. Some companies have set and reset and reset and 
reset and reset again.
    Chairman Dodd. Well, I do not know how my colleagues feel, 
but it is something we ought to look at.
    Senator Shelby. Absolutely.
    Mr. Breeden. Mr. Chairman, it is another area where having 
large shareholders being able to be on the board--I guarantee 
that in companies where our fund sits on the board of 
directors, there will be no repricing of options. And, you 
know, shareholders are the ones who are hurt by that because 
nobody repriced for us the cost of our shares. And so 
management, yes, going forward there may be new options granted 
each year at different prices.
    Chairman Dodd. That is another matter.
    Mr. Breeden. But it is really a terrible abuse when people 
go back and reprice from the past. It was an incentive to make 
the stock worth more, grow value for the shareholders, and 
really, you are jumping off the train and saying I am going to 
go give myself a special deal. That is a very serious problem.
    Chairman Dodd. Well, I am hearing sort of----
    Mr. Atkins. One note of caution there is that this issue is 
not just a monolithic type of thing. Every company is 
different. Every situation might be different. I think you will 
probably hear that if you write the letter to the SEC. The 
response will be in various situations, it sometimes might be 
justifiable and the shareholders might have approved it.
    Chairman Dodd. Well, again, it is certainly worthy of quick 
examination because this is the kind of thing that, again, in a 
week or two from now we will pick up our newspapers and 
discover that this has gone on and no one has paid attention to 
it. It will pale--if you think you had a furor over what 
happened last week, watch this one. And so let me just use this 
forum as an opportunity to send a message, before we get a 
letter written, that someone ought to be looking at it 
immediately, and I would like to hear back what steps, if any, 
are being taken to deal with it. They will respond accordingly, 
and maybe we will get some people in front of us to talk about 
it. And you are right, there may be different circumstances. I 
am not trying to have a sweeping statement here, but, 
nonetheless, you are hearing from witnesses and others, this is 
troubling, to put it mildly. So we will take a look at it.
    Anyway, we are going to keep the questions open. We could 
have you here virtually all day, the three of you, and it is so 
valuable. I cannot thank you enough for appearing this morning, 
and we will submit some additional questions. There is an awful 
lot to ask you. We are just doing the securities field. There 
are a number of issues. I appreciate, by the way, Arthur, your 
comment on the muni issue, the bond issue. This is very 
important. Your language was very strong. In our private 
conversations, you have expressed this to me as well. And 
certainly this Committee will take a look at it, a completely 
very unregulated area and one that poses some real risks, and I 
appreciate you bringing that point up.
    Mr. Levitt. Thank you.
    Chairman Dodd. With that, this panel will be excused, and 
we thank you for coming.
    I am going to introduce the next panel, and I am going to 
thank them for their testimony in advance. I want to thank Jack 
Reed for his willingness to chair. I am not going to be here 
for all of this. I will be here for a few minutes of it, 
anyway, but let me begin and I will introduce them.
    Richard Ketchum is the Chairman and CEO of FINRA. He is 
also Chairman of the World Federation of the Exchanges' 
Regulatory Committee.
    Ronald Stack has served on the Municipal Securities 
Rulemaking Board since 2006 and is Managing Director of 
Barclays Capital, with responsibility for the firm's national 
public sector investment banking effort.
    Richard Baker is President and Chief Executive Officer of 
the Managed Funds Association, a former colleague of ours, 
served in the other body, previously a member of the U.S.--as I 
mentioned, a member of the House of Representatives, Chairman 
of the subcommittee on Capital Markets for 12 years.
    Jim Chanos is Chairman of the Coalition of Private 
Investment Companies. Mr. Chanos is also President of Kynikos 
Associates, a New York private investment management company.
    Barbara Roper is the Director of Investment Protection for 
the Consumer Federation of America.
    David Tittsworth is the Executive Director and Executive 
Vice President of the Investment Adviser Association.
    Dan Curry is the President of DBRS' U.S. affiliate. 
Previously he spent 22 years at Moody's Investor Service.
    And Rita Bolger, our last witness, is the Senior Vice 
President of Global Regulatory Affairs, Associate General 
Counsel for Standard & Poor's, and has served as the head of 
Global Regulatory Affairs.
    Senator Shelby. Mr. Chairman, can I say something?
    Chairman Dodd. Yes, you certainly may. Let me thank all of 
you, and we are packing you in here. I apologize. I hope you 
found this morning interesting. At least you have been sitting 
here and listening to the Chairmen of the Securities and 
Exchange Commission and then our last panel, so I am sure you 
would have been paying very close attention had you not been 
asked to be here. But having you in the room, I kept on looking 
out to see how you were reacting to some of the things that 
were being said. I saw some commonality of interest being 
expressed on certain matters and some dismay at others, I 
guess, along the way. So I was watching the nodding heads along 
the process.
    Let me turn to Senator Shelby for some comments quickly, 
and then we will get to our panel and ask you to share some 
thoughts with us on the subject matter before us.
    Senator Shelby. Mr. Chairman, I appreciate these hearings 
that you are putting together, and, gosh, we could be here all 
week and learn a heck of a lot.
    I have reviewed this testimony of the third panel. A very, 
very impressive panel. A lot of you I know. And all of your 
testimony is interesting.
    Jim Chanos' testimony I think goes right to the heart of a 
lot of things of what is wrong, and I think we ought to pay 
particular attention to that.
    The reason I am bringing this up, I, too, have got a 
luncheon I have got to speak at. You know, I am not leaving 
yet, but I might miss some of you. But I want to thank you, 
like Senator Dodd did, for your contribution. And as we go 
through this trying to find out what went wrong and trying to 
do what should be right in the future, I think we are going to 
be very careful and very comprehensive.
    Chairman Dodd. I thank you for that. Richard Baker, a 
former colleague. You got to be on this side of the dais and 
now that side of the dais. For 12 years you were on this side, 
so I have gotten to know Richard very, very well, and he does a 
fine job on behalf of the people he represents as well. And Jim 
Chanos I know, and like all of us here, many of you we know and 
worked with in the past at various times. So we thank you for 
coming before us.
    Jack, any opening comments you want to make?
    Senator Reed. No.
    Chairman Dodd. Well, let us get right to it. Again, we will 
just hear from Mr. Ketchum. We thank you. We will take your 
full testimony, if you will try and move along.

 STATEMENT OF RICHARD G. KETCHUM, CHAIRMAN AND CHIEF EXECUTIVE 
       OFFICER, FINANCIAL INDUSTRY REGULATORY ASSOCIATION

    Mr. Ketchum. Chairman Dodd, thank you, and it was a morning 
well spent, so it was good to be here.
    Chairman Dodd. Thank you.
    Mr. Ketchum. Chairman Dodd, Ranking Member Shelby, and 
Members of the Committee, I am Richard Ketchum, Chairman and 
CEO of the Financial Industry Regulatory Authority, or FINRA. 
On behalf of FINRA, I would like to thank you for the 
opportunity to testify, and I commend you, Mr. Chairman, for 
having today's hearing on the critically important topic of 
reforming our regulatory structure for financial services.
    As someone who has spent the great majority of my career as 
a regulator, dedicated to protecting investors and improving 
market integrity, I am deeply troubled by our system's recent 
failures. The credit crisis and scandals of the last year have 
painfully demonstrated how the gaps in our current fragmented 
regulatory system can allow significant activity and misconduct 
to occur outside the view and reach of regulators. FINRA shares 
this Committee's commitment to identifying these gaps and 
weaknesses and improving the system for investors.
    Let me briefly talk about FINRA and our regulatory role.
    FINRA regulates the practices of nearly 4,900 securities 
firms and more than 650,000 registered securities 
representatives. As an independent regulatory organization, 
FINRA provides the first line of oversight for broker-dealers. 
FINRA augments and deepens the reach of the Federal securities 
laws with detailed and enforceable ethical rules and a host of 
comprehensive regulatory oversight programs. We have a robust 
and comprehensive examination program with dedicated resources 
of more than 1,000 employees. FINRA has the ability to bring 
enforcement actions against firms and their employees who 
violate the rules.
    Mr. Chairman, as I said earlier, the topic of today's 
hearing is critical. The failures that have rocked our 
financial system have laid bare the regulatory gaps that must 
be fixed if investors are to have the confidence to re-enter 
the markets. Our current system of financial regulation leads 
to an environment where investors are left without consistent 
and effective protections when dealing with financial 
professionals. At the very least, our system should require 
that every person who provides financial advice and sells a 
financial product be licensed and tested for competence, that 
advertising for products not be misleading; that every product 
marketed to an investor is appropriate for that particular 
investor; and that comprehensive disclosure exists for services 
and products.
    I would like to highlight the regulatory gap that, in our 
view, is among the most glaring examples of what needs to be 
addressed--the disparity between oversight regimes for broker-
dealers and investment advisers.
    The lack of a comprehensive, investor-level examination 
program for investment advisers impacts the level of protection 
for every person that entrusts funds to an adviser. In fact, 
the Madoff Ponzi scheme highlighted what can happen when a 
regulator like FINRA has only free rein to see one side of the 
business.
    Let me be clear. I mention this example not because FINRA 
is sanguine with its role in the Madoff tragedy. Any regulator 
who had any responsibility for oversight for Madoff must accept 
accountability and search diligently for lessons learned. But 
the way to identify fraud, just as with sales practice abuse, 
is not through the fog of jurisdictional restrictions. 
Fragmented regulation provides opportunities to those who would 
cynically game the system to do so at great harm to investors, 
and it must be changed.
    The regulatory regime for investment advisers should be 
expanded to include an additional component of oversight by an 
independent regulatory organization, similar to that which 
exists for broker-dealers. The SEC and State securities 
regulators play vital roles in overseeing both broker-dealers 
and investment advisers, and they should continue to do so. But 
it is clear that dedicating more resources to regular and 
vigorous examination and day-to-day oversight of investment 
advisers could improve investor protection for their customers, 
just as it has for customers of broker-dealers.
    Broker-dealers are subject to rules established and 
enforced by FINRA that pertain to safety of customer cash and 
assets, advertising, sales practices, limitations on 
compensation, and financial responsibility. FINRA ensures firms 
are following the rules with a comprehensive exam and 
enforcement regime. Simply put, FINRA believes that the kind of 
additional protections provided to investors through its model 
are essential.
    Does that mean FINRA should be given that role for 
investment advisers? That question must ultimately be answered 
by Congress and the SEC, but we do believe FINRA is uniquely 
positioned from a regulatory standpoint to build an oversight 
program quickly and efficiently.
    In FINRA's view, the best oversight system for investment 
advisers would be one that is tailored to fit their services 
and role in the market, starting with the requirements that are 
currently in place for advisory activity. Simply exporting in 
wholesale fashion the broker-dealer rulebook or current 
governance would not make sense.
    We stand ready to work with Congress and the SEC to find 
solutions that fill the gaps in our current regulatory system 
and create a regulatory environment that works properly for all 
investors.
    Thank you, Mr. Chairman. I would be happy to answer any 
questions.
    Chairman Dodd. Thank you very much, and we will look 
forward to some questions for you, too.
    Mr. Stack.

   STATEMENT OF RONALD A. STACK, CHAIR, MUNICIPAL SECURITIES 
                        RULEMAKING BOARD

    Mr. Stack. Thank you very much. Good morning, Chairman 
Dodd, Ranking Member Shelby, and Members of the Committee. I am 
Ronald Stack, Chair of the Municipal Securities Rulemaking 
Board. By way of background, I have been involved in the 
municipal market since 1975 when I was a member of the staff of 
Governor Hugh Carey during the New York City fiscal crisis.
    I am pleased today to testify on behalf of the MSRB at the 
Committee's second hearing on Enhancing Investor Protection and 
the Regulation of the Securities Markets.
    The MSRB was created by the Congress in 1975 to write rules 
for municipal securities dealers, at that time many of whom 
were unregulated, unsupervised, and not even registered by the 
SEC. Our mission was set in statute, and it remains clear and 
unambiguous, and that is, to protect the investing public and 
to promote a fair and efficient market for municipal 
securities. This is a $2.7 trillion municipal market, and it is 
fundamental to financing our Nation's infrastructure. Indeed, 
over 55,000 entities issue $400 billion in municipal securities 
each year. We are absolutely committed to preserving municipal 
access to capital, the municipal market's integrity, and 
investor protection. This is our mission, this is our 
commitment.
    We believe one of the important ways to protect investors 
and preserve market integrity is through a culture of 
transparency, one that makes information available to all. 
Historically, access to public disclosure about municipal bonds 
has been hindered by a severely fragmented disclosure system 
that was cobbled together over the years. This system did not 
promote public access to disclosure documents, and it did 
nothing to shine a light on the disclosure practices of 
issuers, good or bad. So what have we done?
    The MSRB has developed a comprehensive Web site that is 
transforming municipal disclosure and transparency for all 
investors, large and small, institutional and retail. It is 
called the Electronic Municipal Market Access system, which we 
call it EMMA, and it is so advanced that we believe it exceeds 
disclosure systems for any other fixed-income market, and that 
includes corporate bonds. With EMMA, all investors have free 
access on the Web to an incredible amount of information about 
municipal securities.
    We have had real-time trading information up since 2005. We 
have added official statements and information about auction 
rates. Starting next week, we will add information about 
variable rates, and finally, in July of this year, pursuant to 
a rule amendment that was passed by the SEC in December, we 
will be including what is called ``continuing disclosure 
filings,'' which are up-to-date material changes from bond 
issuers.
    Our new system of making continuing disclosure available 
easily and on the Web will be a vast improvement over the 
current system. EMMA will serve as a red flag for poor 
disclosure by issuers, just as it reveals good disclosure 
practices.
    But good, timely dissemination of disclosure is only one of 
our myriad responsibilities. We require municipal securities 
dealers to observe the highest professional standards in their 
dealings with investors: full disclosure, suitability, fair 
pricing. We are the only Federal regulator that has 
successfully implemented a ban on ``pay to play.'' If you are a 
municipal securities professional, you cannot do business with 
an issuer if you have contributed to one of its officials. We 
test professionals' qualifications and we require them to take 
continuing education courses. We have a complete set of rules 
regulating municipal dealers that we constantly review, modify, 
and change as necessary. And I emphasize all of our rules are 
sent out for comment and then are subject to strict review and 
approval by the SEC itself.
    Unfortunately, we continue to read reports--and I think 
this is something which I think Chairman Levitt was referring 
to--about other municipal market participants who engage in 
``pay to play'' and similar activities. Some are alleged and 
some are still under investigation, but whatever the outcome, 
the market suffers from an appearance problem, and that is not 
good for the muni market or for any market.
    Earlier this year, we wrote to you and your colleagues in 
the House Financial Services Committee about the potential for 
regulation of some or all of these other market participants. 
They serve critical roles in many of the complex financing and 
related derivative transactions that have become commonplace. 
They advise State and local governments, big and small, on how 
to structure a bond issue, how to sell it, how to market it, 
what type of securities to sell, how to invest bond proceeds, 
whether to use swaps or other related derivatives.
    We believe these and other similar market participants 
should be registered with the SEC and regulated by the MSRB 
with rules similar to those already applied to dealers. Many of 
these people are fiduciaries, and they should be subject to the 
standards of professional conduct. ``Pay to play'' should be 
prohibited, just like it was prohibited for dealers by the MSRB 
in 1994.
    I want to emphasize that I know many of these participants, 
and many of the individuals are ethical and well qualified, 
but, unfortunately, not all of them are and activities of a few 
can taint the entire market if not by fact, by appearance. That 
is something we cannot afford, especially in the current 
crisis.
    During this time of stress, it is crucial that we have 
clear guideposts and that investor confidence in the municipal 
securities market is not undermined by questionable practices.
    Also, as Treasury seeks to find solutions to assist the 
municipal bond market through the crisis, ensuring that all 
market participants adhere to the highest professional 
standards is essential.
    The MSRB looks forward to working with the Committee, as 
well as other regulators and market participants, to ensure 
that the level of investor protection provided in the municipal 
market is second to none.
    Senators, thank you for inviting the MSRB to participate in 
this very important hearing.
    Chairman Dodd. Thank you very much, Mr. Stack.
    Richard Baker, we welcome you to the Committee.

   STATEMENT OF RICHARD BAKER, PRESIDENT AND CHIEF EXECUTIVE 
               OFFICER, MANAGED FUNDS ASSOCIATION

    Mr. Baker. Thank you, Mr. Chairman, Ranking Member Shelby, 
Members. I am indeed delighted to be back after the prohibited 
period from my engagement with policymakers, and for the record 
to reflect, I did not engage anyone during the prohibited 
period. It is delightful to be here today.
    The MFA represents a majority of the world's largest hedge 
funds and is the primary advocate for sound business practices 
for industry professionals. We appreciate the opportunity to be 
invited and to comment today about the systemic risk concerns, 
and we are committed to being a constructive participant in the 
discussion going forward.
    Hedge funds do provide liquidity and price discovery to 
markets, capital to companies to allow them to grow or turn 
their businesses around, and sophisticated risk management 
tools for investors such as pensions, to allow them to meet 
their obligations.
    To perform these market functions, we require sound 
counterparties and stable market structures. The current lack 
of certainty regarding financial conditions of major financial 
institutions has limited the effectiveness of the stabilization 
efforts, and this uncertainty inhibits investors' willingness 
to put their capital at risk or transact with these firms.
    The relative size and scope of the industry helps explain 
why we believe hedge funds do not pose significant systemic 
risk despite the current market environment. With an estimated 
$1.5 trillion under management, the hedge fund industry is 
significantly smaller than the $9.4 million mutual fund 
industry or the $13.8 trillion banking industry.
    Because many hedge funds use little or no leverage, 
contrary to many public comments, their losses did not pose the 
same potential systemic concerns that losses at more highly 
leveraged institutions presented. One recent study found that 
26.9 percent of hedge funds do not deploy leverage at all, and 
a recent 2009 report by the FSA, the Financial Services 
Authority, indicated that the leverage of hedge funds was, on 
average, less than 3:1.
    Mr. Chairman, the hedge fund industry was not the root 
cause of the ongoing difficulties in our financial markets, but 
we have a shared interest with all other market participants in 
re-establishing a sound financial system. To that end, 
restoration of stability can be accomplished through a careful, 
deliberate approach toward the goal of a smart financial 
regulatory construct, one which would include investor 
protections as well as a systemic risk analysis.
    Smart regulation means improving the overall functioning of 
the financial system through appropriate, effective, and 
efficient regulation, while encouraging adoption of industry 
best practices which promote efficient capital markets, 
integrity, investor protections, and enabling better monitoring 
of potential systemic risk events.
    We believe that a single systemic risk organization--and I 
have not been absent during the preceding discussions. I would 
merely want to point out that an organization charge with this 
responsibility would be better than multiple systemic 
regulators which would likely have difficulty because of 
jurisdictional conflicts, unintended regulatory gaps, 
inefficient and costly redundancies. So to the extent a 
regulatory shop can be constructed, it should be a single 
entity to have that responsibility.
    We do support confidential reporting to that systemic 
regulatory structure by entities the regulator deems to be of 
systemic relevance any information the regulator deems 
necessary or advisable for it to assess systemic risk 
potential. It is important for this authority to allow the 
regulator to be forward-looking and adaptable to ever-changing 
market conditions. It is critical that reported information be 
granted full protection from public disclosure, which we 
believe can be done without inhibiting the ability of the 
regulator to protect the overall system.
    In our view, the mandate of this entity should be 
protection of the financial system and not include investor 
protection or market integrity, a role that already exists in 
the hands of multiple existing regulatory bodies.
    With respect to that mandate, because systemically relevant 
firms likely would not pose the same risk in all circumstances, 
we also believe the regulators should not focus on preventing 
the failure of a particular firm but, rather, only in the event 
that firm's failure would be likely to bring about adverse 
financial system consequences.
    We strongly believe the systemic risk regulator should 
implement its authority in a way that avoids competitive 
concerns and moral hazards that could result from a firm having 
an ongoing established Government guarantee against its 
failure. Therefore, we believe a systemic risk regulator would 
need authority to seek to prevent systemic risk in a forward-
looking manner, address systemic concerns once they have arisen 
in the manner it deems appropriate, the ability to ensure that 
a failing firm does not threaten the financial system, and we 
know that policymakers are also contemplating concurrently a 
notion of a prudential regulatory framework, including 
mandatory registration.
    We believe that well-advised regulation should be based on 
the following principles: regulation that is tailored to meet 
identified needs, not nebulous in construct; second, ongoing 
public-private exchange with notice, comment, and 
implementation so that appropriate comment may be made on 
proposed regulatory interventions; reporting of appropriate 
information, which could be left to the regulator, with 
confidentiality of sensitive and proprietary always being 
protected. Regulatory distinctions to be recognized between the 
various nature of the differing market participants, and 
encouragement of strong industry practices and robust investor 
diligence.
    I would like to mention just briefly one other area I know 
of concern. Short selling facilitates price discovery, 
mitigates asset bubbles, and increases market liquidity. It is 
a critical risk management tool for investors which allows them 
to take long positions in the market. There are absolute 
solutions to address the stated concerns about short-selling 
that would enable us to continue in our current market 
practices without jeopardizing the important market benefits.
    We look forward to a continued discussion and answering any 
questions you may choose to pose. Thank you, Mr. Chairman.
    Senator Reed [presiding]. Thank you, Congressman Baker.
    Mr. Chanos.

   STATEMENT OF JAMES CHANOS, CHAIRMAN, COALITION OF PRIVATE 
                      INVESTMENT COMPANIES

    Mr. Chanos. Thank you. Good afternoon, Mr. Chairman, 
Senator Shelby, and Members of the Committee. My name is Jim 
Chanos. I am here today testifying as Chairman of the Coalition 
of Private Investment Companies. I thank you for the 
opportunity to testify on this important subject today.
    The damage done by the collapse of global equity credit and 
asset-backed markets has been staggering in scope. The plain 
truth is that there is not a single market participant, from 
banker to dealer to end user and investor, that does not have 
to absorb some degree of responsibility for the difficulties we 
are confronting today. And while there is plenty of blame to 
spread around, there is little doubt that the root cause of the 
financial collapse lay at the large global diversified 
investment and commercial banks, insurance companies, and 
government-sponsored enterprises under direct regulatory 
scrutiny.
    Notably, hedge funds and investors have generally absorbed 
the painful losses of the past year without any government 
cushion or taxpayer assistance. While hedge funds and other 
types of private investment companies were not the primary 
catalyst for our current situation, it is also true that these 
private pools of capital should not be exempt from the 
regulatory modernization and improvement that will be developed 
based on lessons learned from the financial calamities of the 
past 20 months.
    CPIC believes that there are a few key principles that 
should be followed in establishing a regulatory regime for 
monitoring systemic risk. First, regulatory authority should be 
based upon activities and not actors. The same activities 
should be treated similarly, regardless of where it takes 
place. Proprietary trading at a major bank should not receive 
less scrutiny than the trading activity of a hedge fund.
    Second, the system should be geared to size, meaning 
overall size or relative importance in a given market and 
complexity.
    Third, all companies performing systemically important 
functions, such as credit rating agencies and others, should be 
included in this regime.
    Fourth, accuracy of required disclosures to shareholders 
and counterparties should be considered systemically 
significant.
    Fifth, the regulatory regime should be able to follow 
activities at systemically important entities regardless of the 
affiliated business unit in which the entity conducts these 
activities.
    Sixth and finally, the regulatory regime itself should be 
clear and unambiguous about the criteria that brings an entity 
under the new oversight regime.
    Increasing the financial regulation of hedge funds and 
other private investment companies carries both risks and 
benefits. I would like to chat about that for a few seconds. 
Relying on the fact of direct regulation in lieu of one's own 
due diligence will undermine those parts of the private sector 
that continue to work well and thus hamper the goal of 
restoring market strength and confidence.
    While it is clear that a regulator should have the ability 
to examine the activities of significant pools of capital to 
help mitigate against activities that would disrupt the 
markets, simply trying to wedge hedge funds and other private 
investment funds into the Investment Company Act or Investment 
Advisers Act is not likely to achieve that goal. If direct 
regulation is deemed necessary, Congress should consider a 
stand-alone statutory authority for the SEC or other regulator 
that permits the Commission to focus on market-wide issues that 
are relevant to managers of institutional funds while not 
undermining essential investor due diligence.
    Perhaps the most important role that hedge funds play is as 
investors in our financial system. To that end, CPIC believes 
that maximum attention should be paid to maintaining and 
increasing the transparency and accuracy of financial reporting 
to shareholders, counterparties, and the market as a whole. 
Undermining accounting standards may provide an illusion of 
temporary relief, but will ultimately result in less market 
transparency and a much longer recovery.
    Private investment companies play important roles in the 
market sufficiency and liquidity. They help provide price 
discovery, but they also play the role of financial detectives. 
Government actions that discourage investors from being 
skeptical, from being able to hear from differing opinions, or 
to review negative research ultimately harms the market. 
Indeed, some say that if Madoff Securities had been a public 
entity, short sellers would have blown a market whistle long 
ago.
    Honesty and fair dealing are at the foundation of investor 
confidence our markets have enjoyed for so many years. A 
sustainable economic recovery will not occur until investors 
can again feel certain that their interests come first and 
foremost with the companies, asset managers, and others with 
whom they invest their money and until they believe that 
regulators are effectively safeguarding them against fraud. 
CPIC is committed to working diligently with this Committee and 
other policymakers to achieve that difficult but necessary 
goal.
    Thank you very much.
    Senator Reed. Thank you very much.
    Ms. Roper.

 STATEMENT OF BARBARA ROPER, DIRECTOR OF INVESTOR PROTECTION, 
                 CONSUMER FEDERATION OF AMERICA

    Ms. Roper. Thank you for the opportunity to testify here 
today regarding the steps that the Consumer Federation of 
America believes are necessary to enhance investor protection 
and improve regulation of the securities market.
    My written testimony describes a dozen different policies 
in a dozen different areas. Out of respect for the length of 
today's hearing, I will confine my oral comments to just two of 
those, bringing the shadow banking system within the regulatory 
structure and reforming credit rating agencies.
    Before I get into the specifics of those issues, however, I 
would like to spend a brief moment discussing the environment 
in which this policy review is taking place. For nearly three 
decades, regulatory policy in this country has been based on a 
fundamental belief that market discipline and industry self-
interest could be relied on to rein in Wall Street excesses. 
That was the philosophy that made the Fed deaf to warnings 
about unsustainable subprime mortgage lending. It was the 
philosophy that convinced an earlier Congress and 
administration to override efforts to regulate over-the-counter 
derivatives markets. And it is the philosophy that convinced 
financial regulators that financial institutions could be 
relied on to adopt appropriate risk management practices. In 
short, it was this misguided regulatory philosophy that brought 
about the current crisis and it is this philosophy that must 
change if we are to take the steps needed to prevent a 
recurrence.
    In talking about regulatory reform, many people have 
focused on creation of a Systemic Risk Regulator, and that is 
something CFA supports, although, as others have noted, the 
devil is in the details. We believe it is at least as 
important, however, to directly address the risks that got us 
into the current crisis in the first place, and that includes 
bringing the shadow banking system within the regulatory 
structure.
    Overwhelming evidence suggests that a primary use of the 
shadow banking system, and indeed a major reason for its 
existence, is to allow financial institutions to do indirectly 
what they would not be permitted to do directly in the 
regulated market. There are numerous examples of this in the 
recent crisis, including, for example, banks holding toxic 
assets through special purpose entities for which they would 
have had to set aside additional capital had they been held on 
balance sheets, or AIG offering insurance in the form of credit 
default swaps without any of the protections designed to ensure 
their ability to pay claims.
    The main justification for allowing these two systems to 
operate side by side, one regulated and one unregulated, is 
that sophisticated investors are capable of protecting their 
own interests. If that was true in the past, it is certainly 
not true today, and the rest of us are paying a heavy price for 
their failure to protect their interests.
    To be credible, therefore, any regulatory reform proposal 
must confront the shadow banking system issue head on. This 
does not mean that all financial activities must be subject to 
identical regulations, but it does mean that all aspects of the 
financial system must be subject to regulatory scrutiny.
    One focus of that regulation should be on protecting 
against risk that could spill over into the broader economy, 
but regulation should also apply basic principles of 
transparency, fair dealing, and accountability to these 
activities in recognition of two basic lessons of the current 
crisis: One, protecting investors and consumers contributes to 
the safety and stability of the financial markets; and two, the 
sheer complexity of modern financial products has made former 
measures of investor sophistication obsolete.
    Complex derivatives and mortgage-backed securities were the 
poison that contaminated the financial system, but it was their 
ability to attract high credit ratings that allowed them to 
penetrate every corner of the market. Given the repeated 
failure of the credit rating agencies in recent years to 
provide timely warnings of risk, it is tempting to conclude, as 
many have done, that the answer to this problem is simply to 
remove all references to credit ratings from our financial 
regulations. We are not yet prepared to recommend that step.
    Instead, we believe a better approach is found in 
simultaneously reducing, but not eliminating, our reliance on 
ratings; increasing the accountability of ratings agencies, by 
removing First Amendment protections that are inconsistent with 
their legally sanctioned status; and improving regulatory 
oversight.
    While we appreciate the steps Congress and this Committee 
in particular took in 2006 to enhance SEC oversight of ratings 
agencies, we believe the current crisis demands a more 
comprehensive response.
    As I said earlier, these are just two of the issues CFA 
believes deserve Congressional attention as part of a 
comprehensive reform plan. Nonetheless, we believe these two 
steps would go a long way toward reducing systemic risk, 
particularly combined with additional steps to improve 
regulatory oversight of systemic risks going forward.
    Bold plans are needed to match the scope of the crisis we 
face. CFA looks forward to working with this Commission to 
craft a reform plan that meets this test and restores 
investors' faith both in the integrity of our markets and in 
the effectiveness of our government in protecting their 
interests.
    Senator Reed. Thank you very much.
    Mr. Tittsworth.

   STATEMENT OF DAVID G. TITTSWORTH, EXECUTIVE DIRECTOR AND 
    EXECUTIVE VICE PRESIDENT, INVESTMENT ADVISER ASSOCIATION

    Mr. Tittsworth. Thank you, Senator Reed. We really 
appreciate the opportunity to testify today.
    The Investment Adviser Association represents the interests 
of SEC-registered investment advisers. The advisory profession 
serves a wide range of clients, including individuals, trusts, 
families, as well as institutions such as endowments, 
foundations, charities, State and local governments, pension 
funds, mutual funds, and hedge funds. There are about 11,000 
SEC-registered advisers. Most of these are small businesses. 
About 7,500 employ ten or fewer employees, and 90 percent 
employ fewer than 50.
    Our statement outlines our views on broad regulatory reform 
topics, but I am just going to emphasize one point, the need to 
address true regulatory gaps in two situations.
    First, we continue to support the registration, regulation 
of hedge fund managers by the SEC. We believe that investors 
and the markets will benefit from the disclosure, compliance 
protocols, recordkeeping, examinations, and other requirements 
that accompany SEC registration. We also support regulation of 
credit default swaps and other derivatives. Action must be 
taken to ensure that they can no longer exist outside of the 
regulatory system.
    Our testimony also addresses two issues that directly 
relate to the Investment Advisers Act. The first is the so-
called harmonization of broker and adviser regulation. This 
idea seems to be predicated on the notion that brokers and 
advisers do exactly the same thing and that one set of laws and 
regulations should apply to both. We respectfully disagree.
    There are differences between most broker-dealer and most 
investment advisers. Brokers, or the sell side, typically 
execute securities transactions and sell financial products. 
Investment advisers, the buy side, provide advisory services, 
including managing client portfolios. Brokers often are 
compensated by commissions from selling products or executing 
trades and any related financial advice is nondiscretionary, 
that is, requires customer consent to buy or sell. In contrast, 
advisers generally are compensated by fees and provide ongoing 
discretionary management of client assets. Finally, brokers 
generally have custody of customer assets, whereas most 
investment advisers use the services of independent third-party 
custodians.
    Because of these and other differences, it doesn't make 
sense to impose rules on investment advisers that are tailored 
to produce sales.
    In recent years, brokers have migrated toward the 
investment advisory business, blurring some of the traditional 
lines and creating investor confusion. Accordingly, we believe 
that fiduciary standards should apply to anyone who offers 
investment advice. This week, we joined with the State 
securities organization, NASAA, and the Consumer Federation of 
America in a joint letter to the Committee to underscore this 
very important point.
    The second issue addressed in our testimony is the proposed 
creation of a self-regulatory organization, or SRO, for 
investment advisers, which we oppose. Our statement outlines 
drawbacks to an SRO, including inherent conflicts of interest, 
questions about transparency, accountability, and oversight, 
and added costs and bureaucracy. We particularly oppose the 
idea of FINRA as the SRO for investment advisers, given its 
governance structure, costs, track record, and its bias 
favoring the broker-dealer regulatory model.
    In closing, we believe the SEC has the expertise and 
experience to best regulate our profession and it should have 
appropriate resources to do its job. Instead of creating an SRO 
for investment advisers, the following alternatives should be 
pursued.
    First, the SEC should be fully funded and Congress should 
examine alternatives to allow it to achieve long-term and more 
stable funding, including self-funding mechanisms.
    Second, as NASAA testified, the SEC should increase the $25 
million threshold that separates SEC and State-registered 
advisers.
    Third, the SEC should improve its inspection program to 
better leverage and focus its resources.
    We would be pleased to work with the Committee and the SEC 
to explore additional ways to ensure the appropriate and 
effective regulation and oversight of investment advisers and I 
would be happy to respond to any questions. Thank you.
    Senator Reed. Thank you very much.
    Ms. Bolger.

    STATEMENT OF RITA M. BOLGER, SENIOR VICE PRESIDENT AND 
ASSOCIATE GENERAL COUNSEL, GLOBAL REGULATORY AFFAIRS, STANDARD 
                            & POOR'S

    Ms. Bolger. Thank you, and good afternoon----
    Senator Reed. Could you make sure that is on and bring it 
closer to you?
    Ms. Bolger. Is that better?
    Senator Reed. I think so, yes. I am kind of deaf.
    Ms. Bolger. I would like to state at the outset that we at 
S&P appreciate the seriousness of the current dislocation in 
the capital markets and the challenges it poses for the 
American and global economies. Restoring confidence is 
critical, and workable solutions will involve both governmental 
action and private initiative.
    S&P has a long tradition of and a strong cultural 
commitment to integrity and professionalism. We recognize, 
however, that a number of our recent ratings in the structured 
finance area have not performed in line with our historical 
standards. We have reflected on these events and we have made a 
number of changes to enhance our processes.
    Recent calls for increased regulation of credit rating 
agencies have arisen in large part out of the poor performance 
of structured finance securities issued between the middle of 
2005 and the middle of 2007, the years in which subprime 
lending was at its peak. From a regulatory perspective, it is 
important to point out that the world in which virtually all of 
these structured finance ratings were issued is not the world 
that we live and find ourselves in today.
    NRSROs, such as S&P, are now subject to a robust regulatory 
regime. That regime starts with the Credit Rating Agency Reform 
Act, which went into effect in June 2007, and the rules 
promulgated by the SEC under it. Those rules deal with 
important topics such as resources, potential conflicts of 
interest, misuse of nonpublic information, and potentially 
abusive and unfair practices.
    The SEC also has broad enforcement powers over NRSROs. Not 
only does the SEC have extensive examination and inspection 
authority, but it can take disciplinary action against NRSROs. 
Those include censure, fines, or even revocation of 
registration if it deems such action to be in the interest of 
investors.
    From my perspective as a participant in the process, the 
SEC has been an extremely active regulator in exercising its 
oversight authority. Last year, the SEC conducted an extensive 
examination of S&P focused on our structured finance ratings. 
The exam, which lasted several months, involved dozens of 
meetings and interviews, production of a significant volume of 
documents, and resulted in a number of recommendations that we 
are implementing.
    While the current regime has accomplished much in the short 
time it has been in place, we do believe additional measures 
could play a meaningful role in restoring investor confidence. 
Appropriate regulation can provide a level of comfort to 
investors that policies are being enforced and that there is 
consistency and integrity in the rating process.
    I also do want to note that we are pleased to be 
participating in the SEC's April 15 roundtable on rating 
agencies, which Chairman Schapiro referenced this morning.
    We also believe in an end-to-end approach for legislation 
and regulation. That is, it should be designed to cover all 
aspects of the capital markets that when taken together 
contribute in a systemic way to their functioning, with 
particular regard to ratings. Such an approach would include 
not just oversight of rating agencies, but also appropriate 
measures for those involved in generating the information that 
is used in the analysis, the sale and the marketing of the 
rated securities, and the use of ratings.
    For example, an important factor in ratings quality is the 
quality of information available to be analyzed. That 
information is not generated by rating agencies but by others, 
such as in the RMBS area, mortgage originators, and lenders. In 
our view, oversight of these entities and the roles they 
perform should be part of any regulatory approach.
    As detailed in my written statement, earlier this month, 
S&P published an article reflecting our thoughts on what a 
regulatory framework for rating agencies might look like. I 
have included a copy of that for the record. I would like to 
highlight here just two particular features.
    The first is analytical independence. For the markets to 
have confidence in ratings, they must be made independently. 
That means, of course, that the judgments must be free of 
conflicts of interest and undue commercial considerations. We 
are fully committed to that principle. It also means that the 
judgments must truly reflect the substantive views of the 
analysts making them and not directives by a regulator or other 
external authority.
    The second point is the need for international regulatory 
consistency. Ratings are issued and used globally. A rating 
produced under one set of regulations may not mean the same 
thing or address the same risks as one produced under another 
if those regulations are not compatible. Inconsistent ratings 
regulation could actually promote uncertainty in the markets at 
a time when it can be least afforded.
    In short, the focus should be on promoting consistency and 
integrity in the ratings process. Many of the steps we have 
outlined and the measures we have taken are aimed at precisely 
that goal.
    Thank you for the opportunity to participate in the 
hearing. Let me also assure you again of our commitment to 
analytical excellence and our desire to continue to work with 
Congress and all governments worldwide. I would be happy to 
answer any questions.
    Senator Reed. Thank you.
    Before I introduce Mr. Curry, I must excuse myself and 
Senator Akaka will take the gavel and kind of conclude the 
hearing. Thank you, Senator Akaka. Thank you, ladies and 
gentlemen.
    Mr. Curry.

        STATEMENT OF DANIEL CURRY, PRESIDENT, DBRS, INC.

    Mr. Curry. Thank you, Senator Reed. Thank you, Senator 
Akaka. Good afternoon. My name is Dan Curry and I am the 
President of DBRS, Inc. I am pleased to have the opportunity to 
present DBRS's views on the regulation of credit rating 
agencies and investor protection, but first, I would like to 
give you some background on our firm.
    DBRS is a Toronto-based credit rating agency established in 
1976 and still owned by its founders. With a U.S. affiliate 
located in New York and Chicago, DBRS is a full-service rating 
agency that maintains ratings on more than 43,000 securities in 
35 countries.
    DBRS is committed to ensuring the objectivity and integrity 
of its ratings and the transparency of its operations. DBRS was 
designated as an NRSRO in 2003, the first non-U.S.-based rating 
agency to attain that designation. DBRS is now registered under 
the Credit Rating Agency Reform Act, which Congress passed in 
2006.
    Now I would like to turn my attention to the important 
issue of competition. It is no secret that the credit rating 
industry in the United States is dominated by three large 
agencies. The market you see today was fostered by a regulatory 
system that gave special treatment to NRSRO credit ratings, yet 
made the process of attaining that designation opaque and hard 
to navigate. Although the Credit Rating Agency Act has made 
more competition possible, the actual competitive landscape has 
been slow to change. We believe that the continued dominance of 
the three largest rating agencies contributed to the recent 
turmoil in the structured finance market when changes in the 
assumptions underlying their rating models led to rapid and 
dramatic rating downgrades.
    As the markets struggle to regain their footing, more needs 
to be done to open this industry to competition. Although the 
government can be a catalyst for change, the opposite seems to 
be occurring.
    Recognizing that the securitization markets have ceased to 
function, the Federal Reserve has created the Term Asset-Backed 
Securities Loan Facility, or TALF. In order to be eligible for 
this program, the security must receive a AAA rating from 
Standard and Poor's, Moody's, or Fitch, which the Fed calls 
``major'' NRSROs. The result of this approach is that DBRS, 
with over 30 years of experience as a rating agency and more 
than six as an NRSRO, is unable to rate TALF-eligible 
securities, even though several issuers have asked it to do so.
    For the foreseeable future, the TALF is likely to be the 
entire securitization market in the United States. Therefore, 
by excluding all but the three largest rating agencies from 
this program, the government may be further entrenching the 
historic oligopoly for years to come.
    The long-term efficiency of the capital markets requires 
that rating agencies be allowed to compete on the quality of 
their work, not their size or their legacy. DBRS urges Congress 
to take whatever steps are necessary to make the Rating Agency 
Act's promise of competition a reality.
    The next issue I would like to address is that of uniform 
regulation. Ensuring that NRSRO regulation treats all business 
models equally is critical to investor protection. This is 
especially true in the area of ratings transparency. There has 
been much debate about the relative accuracy of ratings 
determined under the issuer-pay model and subscriber-pay model. 
This debate cannot be resolved so long as investors and other 
market participants are unable to verify the accuracy claims 
made by subscriber-based ratings providers. Anecdotal 
discussions by these firms of where they got it right are no 
substitute for an objective, independent analysis of the 
universe of their ratings. DBRS urges policymakers and 
regulators to recognize the importance of transparency for all 
rating agencies.
    Finally, I would like to address the need for stable 
regulation. DBRS sees no need to abandon the regulatory regime 
established under the Rating Agency Act because this regime is 
barely 18 months old and no superior alternative has been 
identified. Moreover, DBRS sees no benefit in transferring 
jurisdiction over rating agencies from the SEC, which has 
overseen this area for 34 years, to a regulator that has no 
experience. Interposing a self-regulatory body between rating 
agencies and the SEC would be the worst idea of all, since this 
would lead to a duplicative regulation by a costly private 
bureaucracy that may or may not know anything about the 
industry. A better approach would be to ensure that the SEC has 
the necessary resources to effectively examine NRSROs and to 
enforce the existing laws and rules.
    My written statement addresses some additional issues. I 
would be happy to answer any questions you may have. Thank you.
    Senator Akaka [presiding]. Thank you very much, Mr. Curry.
    I want to thank all of you for your patience and also to 
tell you that your full statements will be placed in the 
record.
    I would like to ask my first question to one who has been 
an advocate, one that I have been with before, and I want to 
ask Ms. Roper as an advocate, as an independent entity within 
the Internal Revenue Service, the National Taxpayer Advocate 
has evolved into an essential organization that has protected 
and assisted taxpayers. I have highly valued the dedicated 
efforts of the National Taxpayer Advocate and Ms. Nina Olson 
and her staff.
    Using the Taxpayer Advocate organization as a model and 
creating an Investor Advocate at the Securities and Exchange 
Commission has the potential to be an extremely valuable 
addition to assist and protect taxpayers. So my question to you 
is, what is your evaluation of creating an Investor Advocate at 
the SEC?
    Ms. Roper. Thank you, Senator. Ideally, it would be 
superfluous to have an Investor Advocate at the SEC. The SEC 
portrays itself as the investor advocate. My experience working 
on these issues as an external investor advocate for over 20 
years now is that there are many times when we would have 
benefited from having an advocate on the inside to carry 
investors' case. I can see several different areas where I 
think this would be particularly useful.
    As investor advocates, we have often been frustrated that 
our view is not addressed in the agency policymaking from the 
outset, that it is something that ends up being incorporated, 
at best, later during the comment period, often with very 
little effect. Having an internal advocate who could ensure 
that investors' views are integrated into the rulemaking 
process, conduct research outreach, I think would be 
extraordinarily useful.
    Senator Akaka. Also, Ms. Roper, we share an interest in 
protecting mutual fund investors. Mutual funds are what average 
investors rely on in their retirement, savings for their 
children's college education, as well, and other financial 
goals and their dreams. I have advocated for strengthening the 
independence of mutual fund boards and improving relevant and 
meaningful disclosures for investors' transparency. My question 
to you is, what must be done to better protect and inform 
mutual fund investors?
    Ms. Roper. Thank you again, Senator. As you know, we have 
endorsed your legislation on mutual fund and share those goals. 
And I very much look forward to a time when our primary 
priorities are helping average retail investors make better 
informed decisions and have better protection in the 
marketplace. That hasn't been at the top of our agenda with the 
global economy in crisis. But I think--and because the damage 
that has been done to investors has been sort of done 
indirectly through the failure of a system as a whole.
    There was a robust mutual fund reform agenda that was put 
on the table at the SEC in the wake of the mutual fund trading 
scandals and then was allowed to sort of fall by the wayside. I 
think it would be extraordinarily useful to bring back some of 
the ideas that were under discussion at that time, including 
better point of recommendation disclosures, independence 
governance, as you have suggested, and not just limited to 
mutual funds, but the entire issue of broker-dealer 
compensation and how that creates a set of incentives that 
operate against investor interest, I think, are extraordinarily 
important issues that it would be nice to be able to get back 
to at some point in the near future.
    Senator Akaka. Thank you for your responses.
    I would like to ask the next question to Mr. Richard 
Ketchum. Our modern complex economy depends on the ability of 
the consumers to make informed financial decisions, and as you 
know, we have been supporting trying to move financial literacy 
in our country. Without sufficient understanding of economics 
and personal finance, individuals will not be able to 
appropriately evaluate credit opportunities, successfully 
invest for long-term financial goals, or be able to manage 
difficult financial situations. My question to you is, what 
must be done to ensure that investors have the knowledge and 
skills necessary to make informed investment decisions?
    Mr. Ketchum. Well, thank you, Senator. It is a great 
question.
    Senator Akaka. Before you do that, let me say that FINRA 
has been doing a good job already, and I know that. Thank you.
    Mr. Ketchum. Well, I appreciate that. As you know, the 
FINRA Investor Education Foundation is the largest foundation 
solely focused on investor education, and given that we both 
feel good about the progress we have made and recognize the 
enormity of the task, we have tried to, as best we can, both 
through placing a rich series of informative efforts on our Web 
site at finra.org and efforts to try to attract investors to 
look at those various different pieces of information, efforts 
to identify everything from questions to ask with respect to 
complex products to things to be concerned about with respect 
to potential scams, as well working very closely with some of 
the most vulnerable constituencies, particularly from the 
standpoint of our seniors, our military, et cetera.
    I think the only answer with respect to investor education 
is to keep on going on with more and more resources and more 
and more cooperation between enterprises that have 
constituencies and concern with respect to this area. And you 
are right. It can't just be with respect to investors that 
exist today. It has to be a strong effort from the standpoint 
of our schools, as well.
    But we are very much committed to be part of that process. 
It is something that deserves more attention from a 
governmental standpoint and more attention across any of us 
that cares deeply about the quality of our securities markets.
    Senator Akaka. Thank you very much for that.
    I want to pose this next question to a person that I knew 
in the House, Representative Baker. I think you left there, or 
you were there when I left there, in the House and moved to the 
Senate. But it is good to see you again.
    Mr. Baker. Thank you, Senator.
    Senator Akaka. Chairman Breeden said, and I am quoting, 
``The disasters we have seen did not arise due to lack of 
resources for the Federal Reserve, the SEC, or any other 
agencies that did not perform as well as needed to do, or 
because of outdated laws from the 1930s.''
    The banking and securities regulators generally had tools 
to address the abuse of practices but did not use their powers 
forcefully enough or ask for new authority promptly when they 
needed it.
    My question to you, how would you recommend addressing this 
problem so that the regulators will be more effective in the 
future?
    Mr. Baker. Thank you, Senator. It is a tremendously 
difficult question in that if you would go back in time, 
perhaps 24 months, and look at market conditions and the 
tremendous profitability that had existed for some number of 
years, and the expectation by many that it would continue into 
the foreseeable future, there was at the same time columns of 
regulatory authority that were constructed.
    Within each column, there may have been particular skill 
sets which could have been deployed, but because of the lack of 
information flows between those columns, complex instruments 
were created that did not fit neatly within a column and 
remained outside the transparency required for someone to make 
an informed decision.
    I would say that there were people in the market who 
exercised analytical skills and who did, in fact, predict that 
some of these very unfortunate circumstances possibly would 
occur. They, for the most part, were in the private sector, who 
were skilled analysts looking at the financial bubble that was 
growing in significant size.
    How we could construct a new systemic regulatory structure 
and enable a single person to be able to see the entire view of 
the market and come to an appropriate and timely decision would 
probably be almost impossible. Having an organization of some 
sort--there has been discussion this morning as to concerns 
about the SEC, the Federal Reserve, the existing entities. But 
I think we should be cognizant of the fact that none of those 
entities had access to the level of transparency that would 
have enabled them to make that collective, almost omniscient, 
insight into the coming storm.
    So I believe that, as we suggested in our testimony, the 
construction of a regulatory entity--I have been very careful 
not to say a particular agency--that has access to market 
information in a timely manner, while at the same time 
protecting the privacy of that disclosure by the registered 
entity, would perhaps--I am not sure it would guarantee--enable 
that entity to be able to take steps early on and perhaps limit 
the scale and scope of damage.
    Certainly, we would like to be a participant in that 
discussion going forward. We have specific ideas at the 
appropriate time that may be appropriate to consider. But we 
recognize that it is a very difficult problem. I am glad you 
are where you are, Senator, and I am glad I do not have that 
decision any longer.
    Senator Akaka. Thank you very much, Representative Baker.
    I want to direct my next question to Mr. Stack.
    In our last hearing on securities regulation, Thomas Doe, a 
former member of your board, stated, and I am quoting, that 
``the 34-year era of the municipal industry self-regulation 
must come to an end.''
    In advocating this position, Mr. Doe emphasized that MSRB 
structure, two-thirds of which is comprised of either bank 
dealers or securities dealers, has led to a situation of 
industry capture, where the issuers and other writers are then 
responsible for regulating their own conduct.
    What is your evaluation of these comments?
    Mr. Stack. Senator, I take extreme exception to Thomas 
Doe's comments. I believe that the MSRB, which was the first 
SRO upgrade in 1975, has worked extraordinarily well.
    The measure of an SRO, such as the MSRB, is, first, do we 
protect investors? How we do that is through our ability to 
ensure immediate and clear disclosure to both retail, 
institutional, small and large investors. We have established a 
new electronic system on the Web to ensure up-to-date investor 
information.
    We also regulate, up to the extent that the statute allows, 
very clearly all of the municipal dealers and brokers in very 
strong terms. For example, we are the only group that prohibits 
a pay to play; that is, that you cannot do municipal securities 
financings with an issuer if you contribute to somebody running 
for office who is an official of that issuer. No one else has 
done that. Interestingly enough, because we are an SRO, we can 
do something even tougher than what we call our parent body, 
the SEC, because we have the ability to set very, very strong 
rules.
    Another thing I would like to say is that all of our rules 
governing our brokers and their dealers are sent out for 
comment to the public, to investors, to everybody around, and 
then we present our proposed rules to the SEC. So it is not 
that we are off in the ether land, just kind of somewhere out 
there making our own rules for brokers. All of our rules go to 
the SEC for review, and the SEC decides whether or not to 
approve them.
    Finally, some of the problems I mentioned in my testimony 
that we have encountered are that there are many participants 
in our market who right now are unregulated: financial 
advisors, swap advisors, investment advisors. They are not 
registered with the SEC, and we have no power to regulate them.
    We have written the House Committee and have written your 
Committee and asked for the ability--asked for Federal 
regulation of these groups in order that they can have 
professional standards, in order that they can meet the kind of 
stringent requirements that we have for brokers and dealers, 
including and specifically pay to play. We think if we can 
regulate those participants, that the market will operate well.
    In conclusion, we believe the SRO system does work well and 
it is a way of using the expertise of the market participants 
to come up with rules to govern it. I have read the Senate 
Committee report when the MSRB was set up in 1975, and that was 
the Committee's intent. These rules, as I say, can be tougher, 
and then those rules are submitted to the SEC. And the SEC then 
approves whether or not those rules go into effect.
    So we think that the SRO is actually a very tough way to 
organize and to supervise dealers. The SEC is not limited, but 
it sticks pretty much to antifraud issues. We can go much 
further and pay to play is a perfect example of where we have.
    Senator Akaka. Well, I thank you so much for that. You know 
of it personally. I would rather that we not craft laws just to 
try to deal with these. In this particular case, the MSRB 
should just move--as you said, what you mentioned, I wish we 
could do at this time. But thank you so much for your comments 
on that.
    Mr. Stack. Thank you, Senator.
    Senator Akaka. Let me direct the next question to Mr. 
Tittsworth, and is Chanos or Chanos?
    Mr. Chanos. Chanos, Senator.
    Senator Akaka. Chanos. Thank you.
    And I am looking for an important recommendation, so I 
would like to hear from both of you.
    Which is one recommendation that you feel is the most 
important legislative or regulatory initiative that this 
Committee must undertake in the modernization of financial 
market regulation?
    Mr. Tittsworth. I will take it very quickly, Senator.
    As I said at the top of our testimony, it is closing what I 
would call true regulatory gaps, not the perceived regulatory 
gap that some have talked about between investment advisers and 
broker-dealers, which is totally nonexistent. True regulatory 
gaps. And by that, I mean products or services that are 
unregulated and are outside the regulatory system. And the two 
I mentioned are hedge fund managers and credit default swaps 
and derivatives.
    Senator Akaka. Thank you very much.
    Any other comment?
    Mr. Chanos. Senator, I would use my answer to just point 
out our overriding viewpoint on regulation, current and future. 
And that is that the current and expected regulatory framework 
regulates and examines the activities, not the actors. That is, 
they focus on that which is going on in the marketplace across 
different corporate and private and public investment lines, 
and not just be hamstrung, for example, for the Fed to look at 
bank holding companies; the SEC to look at securities firms.
    We need to really focus on how our markets have changed 
down through the years and have morphed beyond the view of the 
33 and 34 and 40 acts, and come up with smart regulation as 
someone said earlier, not necessarily more regulation.
    Senator Akaka. Thank you very much.
    I wanted to be certain that we would offer every one of you 
a chance to make comments, so let me direct this question to 
Ms. Bolger and Mr. Curry.
    The Wall Street Journal reported that despite the failure 
of ratings agencies' models during this financial crisis, 
Moody's, S&P and Fitch have ``made few fundamental changes to 
the way they assess debt.''
    Please tell us what you think went wrong in your original 
assessment of these assets and why we should trust your 
agencies to rate these same assets again, now that taxpayer 
money is at risk.
    Ms. Bolger. Thank you, Senator. And, actually, before 
answering, I would respectfully request that the white paper on 
regulation, I mentioned it in my remarks, that that be placed 
in the record. Thank you.
    Ms. Bolger. I think certainly in terms of some of the 
ratings and structured finance, just stepping back, we have 
almost a hundred year history of rating a tremendous amount of 
securities and a very good track record. But in connection with 
some of those securities, I think the performance that we have 
seen, that the market has seen, has not been consistent with 
that historical track record. Some of the assumptions that we 
use simply were not borne out.
    However, we have stepped back. We have taken a very serious 
look at our processes and we have made a number of changes, 
changes both that have been required in connection with two, 
now two--and, actually, today is the conclusion of a final 
draft period for SEC rulemaking, so we have made changes in 
connection with their requirements.
    We have also made some changes on our own initiative. And 
we think moving forward, it is important, again, picking up on 
the theme of smart regulation, that we focus on regulation that 
preserves our analytical independence and also that is globally 
consistent in connection with some of these actions we have 
taken.
    Senator Akaka. Thank you.
    Mr. Curry.
    Mr. Curry. Thank you, Senator.
    I think that the root of the problem in the structured 
securities was the reliance on the decisions of just a few 
people using models to determine these ratings. At the same 
time, the securities became so complex that investors were 
really unable to exercise enough judgment around the risks that 
they were taking. And we are going through the flip side of 
that process, I think, right now, where there are some very 
substantial changes to assumptions, again, in these models made 
by a few people, that lead to massive rating downgrades, but 
still a lack of understanding of fundamentally what is behind 
this analysis.
    Given that the current Rating Agency Reform Act does not 
extend to the substance of ratings, I think that transparency 
becomes very critical, and that is going to be a big challenge 
in how that is managed. I still do not think that the 
transparency is adequate and I worry that a lot of the changes 
that have taken place are more administrative and do not really 
prevent us from ending up in this same situation again seven or 
8 years down the road.
    Senator Akaka. Thank you very much, Mr. Curry.
    Without question, all of you have been very helpful to the 
Committee. We are looking forward to improve whatever needs 
that in our Nation. I want to thank all the witnesses for being 
here. And I want you to know that we appreciate the significant 
time that you witnesses have spent with us today.
    This hearing record compiled today will, without question, 
help us develop policies to better protect investors and 
improve the regulation of the securities market. We look 
forward to continuing to hear from you, and with much hope, we 
are looking at an improvement in our Nation's crisis that we 
are in at this time.
    This hearing record will remain open for a week for Members 
to submit any additional statements or questions that they may 
have. Again, thank you very much, and this hearing is 
adjourned.
    [Whereupon, at 1:35 p.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follow:]

                 PREPARED STATEMENT OF MARY L. SCHAPIRO
                               Chairman,
                   Securities and Exchange Commission
                             March 26, 2009
I. Introduction
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee: 
Thank you very much for inviting me to testify as we face a critical 
juncture in the history of our Nation's financial markets. I am here 
today testifying on behalf of the Commission as a whole. The Commission 
agrees that our goal is to improve the financial regulatory system, 
that we will work constructively to that end, and that we all are 
strongly dedicated to the mission of the SEC. In light of the economic 
events of the past year and their impact on the American people, I 
believe this Committee's focus on investor protection and securities 
regulation as part of a reconsideration of the financial regulatory 
regime is timely and critically important.
    Thank you also for giving me an opportunity to talk about the 
historic mission of the Securities and Exchange Commission, what we do 
for the Nation's investors and capital markets, and how our critical 
mission is a necessary foundation for a modernized financial regulatory 
structure. These are matters that have been the central focus of my 
entire professional career.
    I strongly support the view that there is a need for system-wide 
consideration of risks to the financial system and for the creation of 
mechanisms to reduce and avert systemic risks. I am convinced that 
regulatory reform must be accomplished without compromising the quality 
of our capital markets or the protection of investors. I am also 
convinced that getting it right will require hard work, attention to 
detail, and an over-riding commitment--not to engage in bureaucratic 
turf wars--but to further the public interest. All of that is well 
within our grasp.
    In my testimony this morning, I will explain some general 
principles that I believe should guide this effort. These principles 
are: first, an integrated capital markets regulator that focuses on 
investor protection is indispensable; second, that regulator must be 
independent; and third, a strong and investor-focused capital markets 
regulator complements the role of a systemic risk regulator, resulting 
in a more effective financial oversight regime. Included as an Appendix 
to my testimony is an overview of the major functions of the SEC, a 
summary of recent activity, and the resources allocated to each 
function.

II. A Capital Markets Regulator Devoted to Investor Protection Is 
        Indispensable
    All economic activity starts with capital. Small businesses need 
money to start up, and all companies need capital to innovate, compete, 
create jobs, and thrive. This capital comes from a variety of sources. 
Ultimately, capital comes from investors--people who invest directly in 
companies; people who invest in financial institutions that lend 
capital; people who invest in mutual funds and other pooled vehicles 
that in turn invest in America's businesses; people who buy municipal 
securities to help fund the operations of state and local governments; 
and people who look to the capital markets to save, put away money for 
their kids' education, and prepare for retirement. Markets that attract 
this capital are critical to America's economic future. And a strong, 
focused, vibrant, and nimble market regulator is critical to getting 
investors back into the market and to maintaining their trust and 
confidence in the future. Such a regulator is fundamental to the future 
growth of our economy.
    That's where the SEC comes in. Let me review some of the core 
functions of the SEC. These functions are interdependent: remove one 
function and the agency's capacity to do the others is diminished.

A. Regulation of the Integrity of Markets
    Investor protection starts with fair and efficient capital markets. 
In these tumultuous economic times, despite record volumes and enormous 
volatility, the markets that the SEC oversees have priced, processed, 
and cleared trillions of dollars in customer orders in an orderly and 
fair way. The dollar value of average daily trading volume was 
approximately $251 billion a day in February 2009 in stocks, exchange-
traded options and security futures. By comparison, the average daily 
trading volume for such securities was approximately $87 billion a day 
in February 1999, and $10 billion a day in February 1989.
    The securities laws and our rules, and the rules of the exchanges 
and the national securities association we supervise, prohibit 
fraudulent trading practices, manipulation of securities prices, 
insider trading and other abuses. These laws and rules require trades 
to be executed at fair prices, require market participants to keep 
records of their activities, and require prompt dissemination of 
pricing information. We regulate transfer agents and clearing agencies, 
so that transactions are effected seamlessly and without interruption. 
In overseeing the markets, the Commission is guided by its professional 
staff, which has extensive knowledge and expertise developed over 
decades of overseeing our Nation's dynamic capital markets.
    Innovation has completely transformed our securities markets over 
the last decade. The shouts on the trading floors of the Nation's 
securities exchanges have largely given way to the whir of computers. 
Transactions that took minutes to execute now take well under a second. 
In an instant, traders can search within markets and across markets to 
locate counterparties willing to pay the very best price. Spreads--that 
is the price differences in transactions captured by intermediaries 
rather than investors--have narrowed dramatically over the past decade. 
This has been due in part to the SEC's rules requiring intermediaries 
acting for customers to trade at the very best prices as well as rules 
permitting securities prices to be quoted in pennies. In many 
instances, spreads in stocks have shrunk from 12 cents to less than a 
penny. According to a 2005 GAO study, decimalization of stock quotes 
alone cut trading costs by 30-50 percent. We've achieved similar 
results in the options markets.
    These pro-investor changes have been possible because of a 
regulatory regime that focuses on competition--one that does not pick 
winners and losers but instead, one that removes barriers to new 
entrants. It is a regime that requires a focus on the needs of 
investors and their welfare, allowing market participants to innovate 
and compete for their customers' business. While it is a regime that 
works well, it is one that requires a regulator to keep up with the 
breakneck pace of change in our ever-evolving markets.
    This is not to say that our markets always function perfectly. 
There are practices that are contrary to fair and orderly markets; 
abusive short selling, for example, would fall into that category. To 
target potentially abusive ``naked'' short selling in certain equity 
securities, the Commission has tightened up the close-out requirements 
and adopted a new antifraud rule specifically aimed at abusive short 
selling when it is part of a scheme to manipulate the price of a stock. 
And, early next month, the Commission will consider proposals to re-
institute the uptick rule, or something much like it.

B. Regulation of the Integrity of Market Information
    However well structured, markets fail without timely and reliable 
information. Accurate information is the lifeblood of the securities 
market. A big part of the SEC's mission is to safeguard the markets' 
blood supply. We operate from the premise that our markets work best 
when investors are fully informed. Our job is to make sure investors 
get full and complete information. It involves setting meaningful 
disclosure standards, monitoring compliance with them, and, when 
appropriate, enforcing the law against those who fail to comply. It 
also involves programs to equip investors with tools to understand and 
analyze the market information they receive.
    SEC rules require complete and accurate disclosure of information 
that investors need to make informed investment and voting decisions. 
Companies cannot raise capital from the public without first filing 
with us comprehensive disclosures about their business, their 
performance, and their prospects. One of our major accomplishments over 
the last few years has been to streamline this process so that 
potential issuers of securities can raise money more quickly, while 
providing investors with more, and more current, information.
    Registrants file extensive disclosures about their business 
performance annually and update them quarterly, and--because today's 
markets demand immediate information--whenever certain specified events 
occur. We review these filings on a selective basis, and work closely 
with reviewed companies to improve the quality of their disclosure. In 
fiscal year 2008, our staff reviewed the filings of nearly 5,000 
reporting companies in addition to more than 600 new issuers.
    Accurate information, of course, encompasses both words and 
numbers, and we work to protect the integrity of both. We play a 
special role in the formation of accounting standards for public 
companies and other entities that file financial statements with the 
Commission. We oversee the process by which they are set to ensure that 
professional, independent standard-setters include those whose primary 
concern is the welfare of investors, that the deck is not stacked 
against investors, and that the outputs of the process are fair and 
appropriate.
    There is a delicate balance here. We have authority to set 
standards, and we use this authority prudently. Sometimes we prod the 
standard-setters to act more quickly, and we often give them the 
benefit of our views. But we are convinced that accounting standard-
setting should be the product of an independent, expert body that is 
organized to act in the public interest and with appropriate due 
process.
    While the Commission rarely sets accounting standards, we deal with 
accounting matters every day. We and our staff provide guidance about 
how accounting standards should be applied in particular situations; 
our staff reviews corporate filings to determine whether companies are 
applying standards properly; and where the accounting is wrong, we ask 
companies to fix it. Our rules, given new vigor by the landmark 
Sarbanes-Oxley Act that emerged from this Committee in 2002, promote 
the independence of those who audit the financial statements of public 
companies.
    Investors need accurate and comprehensive information not only when 
they trade but also when they vote, whether it is to elect directors, 
adopt compensation plans, approve transactions, or consider shareholder 
proposals. And so we have a variety of means to promote fair corporate 
voting.
    Speaking for myself, I believe the SEC has not gone far enough in 
this latter area. And so I intend to make proxy access--meaningful 
opportunities for a company's owners to nominate its directors--a 
critical part of the Commission's agenda in the coming months.

C. Regulation and Oversight of Financial Intermediaries and Market 
        Professionals
    For our markets to be fair and efficient and to operate in the best 
interests of investors, those who control access to our capital markets 
must be competent, financially capable, and honest. That brings me to a 
third core function of the SEC: regulation and oversight of financial 
intermediaries and other market professionals, including approximately 
5,500 broker-dealers, over 11,000 investment advisers, stock and option 
exchanges, clearing agencies, credit rating agencies and others. 
Exchanges and clearing agencies are an essential part of the plumbing 
of our financial system. Their smooth operation is something that many 
Americans take for granted, but that the Commission takes very 
seriously and works to ensure. Brokers, advisers and credit rating 
agencies are the entities that Americans turn to for guidance and 
technical assistance when accessing our Nation's financial markets. It 
is essential that these firms--and the people who work in them--be held 
to the high standards expected of professionals.
    The SEC's regulatory role, along with its oversight of the various 
self-regulatory organizations with respect to financial intermediaries 
and market professionals, focuses on helping to ensure that investors 
are treated fairly and that the institutions managing and processing 
their investments are subject to meaningful controls to protect 
investor assets. Our statutes and rules require that brokers and 
advisers tell investors the truth, that brokers recommend to their 
customers only those products that are suitable for them to buy, and 
that advisers act in accordance with their fiduciary duties. In the 
same way, we require that investment advisers manage any potential 
conflicts of interests and fully disclose them to investors.
    Our capital requirements go a long way to ensuring that customer 
funds entrusted with a broker-dealer are safe in the event the broker-
dealer gets in financial trouble. Again, our focus is not to insulate 
broker-dealers from competition and the risks of failure, but to 
protect investors in the event that failures do occur. We conduct 
examinations of these firms to assess their compliance with laws and 
regulations. And when we find violations or deficiencies, we direct 
that corrective action be taken.
    Since 2006, with the authority provided by the Congress, we have 
adopted significant reforms related to credit rating agencies. Given 
the critical role of ratings in our capital markets, it is essential 
that we stay active in this area. We have rule proposals outstanding 
and are convening a public roundtable on possible further reforms to be 
held next month.
    Some of our rules regulating financial intermediaries need to be 
modernized, and the Commission is considering what, if any, legislation 
to ask for from the Committee. Among other things, we are considering 
asking for legislation that would require registration of investment 
advisers who advise hedge funds, and possibly the hedge funds 
themselves. We are studying whether to recommend legislation to break 
down the statutory barriers that require a different regulatory regime 
for investment advisers and broker-dealers, even though the services 
they provide often are virtually identical from the investor's 
perspective. We also are carefully considering whether legislation is 
needed to fill other gaps in regulatory oversight, including those 
related to credit default swaps and municipal securities. It is time 
for those who buy the municipal securities that are critical to state 
and local funding initiatives to have access to the same quality and 
quantity of information as those who buy corporate securities. I will 
lead the Commission to continue to focus efforts in this area in 2009.
    In addition, I have asked the staff to develop a series of reforms 
designed to better protect investors when they place their money with a 
broker-dealer or an investment adviser. I have asked the staff to 
prepare a proposal for Commission consideration that would require 
investment advisers with custody of client assets to undergo an annual 
third-party audit, on an unannounced basis, to confirm the safekeeping 
of those assets. I also expect the staff to recommend proposing a rule 
that would require certain advisers to have third-party compliance 
audits to review their compliance with the law. And to ensure that all 
broker-dealers and investment advisers with custody of investor funds 
carefully review controls for the safekeeping of those assets, I expect 
the staff to recommend that the Commission consider requiring a senior 
officer from each firm to attest to the sufficiency of the controls 
they have in place to protect client assets. The list of certifying 
firms would be publicly available on the SEC's Web site so that 
investors can check on their own financial intermediary. In addition, 
the name of any auditor of the firm would be listed, which would 
provide both investors and regulators with information to then evaluate 
the auditors.

D. Regulation of Mutual Funds and Other Pools of Investor Money
    Most retail investors participate in the capital markets through 
pooled investment vehicles, the most common of which are mutual funds. 
The size of these investments is astonishing: mutual funds hold over $9 
trillion in assets--representing the investments of approximately 92 
million Americans. As part of its oversight functions, the SEC focuses 
on ensuring that funds are run to benefit investors and not insiders. 
SEC rules also seek to ensure that fund investors are provided 
accurate, timely and complete information about their funds in a form 
that is investor-friendly. The SEC requires that funds comply with 
investor-oriented prohibitions against complex capital structures, 
excessive leverage and preferential treatment for certain shareholders. 
In addition, the SEC examines the actions of independent fund directors 
and chief compliance officers to evaluate whether they are fulfilling 
their critical responsibilities on behalf of fund investors.
    A particular focus of the Commission in coming weeks will be 
proposals to enhance the standards applicable to money market mutual 
funds, which are widely used by both retail and institutional investors 
as a cash management vehicle. The SEC has been closely monitoring money 
market funds and their investments, since we permitted the first money 
market fund in the early 1970s. Over that time, we have built up 
significant money market fund expertise. We will bring that expertise 
to bear as we act quickly this spring to strengthen the regulation of 
money market funds by considering ways to improve the credit quality, 
maturity, and liquidity standards applicable to these funds. These 
efforts will be aimed at shoring up money market fund investments and 
mitigating the risk of a fund experiencing a decline in its normally 
constant $1.00 net asset value, a situation known colloquially as 
``breaking the buck.''

E. Enforcement of the Securities Laws
    Finally, there's enforcement. We are an integrated regulator of the 
country's capital markets with an important focus on law enforcement. 
We enforce the securities laws aggressively and intelligently, without 
fear or favor. Enforcement is one of our core competencies and a 
central part of our heritage as an agency.
    In the past year alone, the SEC has brought enforcement actions 
related to sub-prime abuses, market manipulation through the 
circulation of false rumors, insider trading by hedge funds and other 
institutional investors, Ponzi schemes, false corporate disclosures, 
and penny stock frauds. This past year we brought the biggest foreign 
bribery case ever. We also required securities violators to disgorge 
illegal profits of approximately $774 million and to pay penalties of 
approximately $256 million, and we distributed over $1 billion to 
injured investors.
    Enforcement is integrated with our regulation of the capital 
markets for the benefit of investors. We enforce the securities laws 
and the rules we promulgate. We understand markets because we regulate 
them. We understand disclosure because we regulate it. Our regulatory 
functions add nuance and sophistication to our enforcement efforts, and 
enforcement adds backbone to our rules. It is all one piece.
    We have work to do to stay one step ahead of the predators and 
sharp practices that prey on investors. It is a never-ending struggle, 
and it requires never-ending energy and ingenuity. As part of this 
effort, I expect to come to you in the near term with a request for 
authority to compensate whistleblowers who bring us well-documented 
evidence of fraudulent activity. Currently, we have the authority to 
compensate sources in insider trading cases. I would like to see this 
authority extended so that the SEC can further encourage individuals to 
come forward with helpful information.

III. A Capital Markets Regulator Devoted to Investor Protection Should 
        Be Independent
    As we look to the future of securities regulation, we believe that 
independence is an essential attribute of a capital markets regulator 
that protects investors. There are other agencies of government that 
touch on what we do, just as what we do touches on other agencies of 
government. But Congress created only one agency with the mandate to be 
the investors' advocate. Other agencies have had, as part of their 
responsibilities, the protection of important financial institutions 
and, as part of those responsibilities, customer protection. But, as 
Justice Douglas pointed out long ago, only the SEC has the mission, and 
the privilege, of serving as ``the investors' advocate.''
    We are a creature of the Congress. The vision of the Congress when 
it created an independent SEC was to make sure that there was one 
agency of government focused single-mindedly and without dilution on 
the well-being of America's investors. That independence has allowed us 
to build expertise and a culture of investor protection, which benefits 
the public and the economy. And it has been a tremendous success as 
U.S. capital markets lead the world.
    If there were ever a time when investors need and deserve a strong 
voice and a forceful advocate in the federal government, that time is 
now. Individual investors may not be the strongest political force; 
they are disparate in their backgrounds and not always well-organized 
or funded. They are typical Americans--our families, friends, and 
fellow citizens. These investors expect and deserve a strong and 
independent regulator dedicated to providing for fair financial 
dealings, timely and meaningful disclosure of information, and 
protection from unscrupulous actors.
    Congress made us independent precisely so we can champion those who 
otherwise would not have a champion, and when necessary take on the 
most powerful interests in the land. Regulatory reform must guarantee 
that independence in the future.

IV. A Strong and Independent Capital Markets Regulator Is Important to 
        Systemic Risk Oversight
    An independent, investor-first capital markets regulator is vital 
to a revamped regulatory structure that pays due attention to 
overarching systemic risk. Investor protection enhances the mission of 
controlling systemic risk. More than that, financial services exist to 
serve investors and our markets, and a focus on investors is absolutely 
essential to any credible regulatory restructuring. The SEC, as the 
independent capital markets regulator with unique experience and 
competencies, must continue to be the primary regulator of important 
market functions, and would be a critical party in contributing to any 
systemic risk regulator's evaluation of risks. Appropriate regulation 
must safeguard both investor protections and important market 
functions.
    The SEC, as a strong independent regulator with market expertise, 
can perform its critical capital markets and investor protection 
functions without compromising the oversight of systemic risk. Even as 
attention focuses on reconsidering the management of systemic risk, 
investor protection and capital formation--both of which are 
fundamental to economic growth--cannot be compromised as a product of 
any reform effort. The SEC stands alone as the government agency 
responsible for both protecting investors and promoting capital 
formation for the past 75 years.
    To the extent the activities of the SEC touch systemically 
significant institutions, there is rarely a risk of inconsistency 
between the SEC and other regulators focused on systemic risk. No one, 
for example, argues that major financial institutions should be 
permitted to lie, cheat, or steal as a means of avoiding systemic risk. 
To the extent those issues do arise, and have arisen in the past, any 
tensions have been creative, and well-meaning regulators can and have 
been able to resolve them.
    There are questions that need to be answered in the months ahead. 
Among others, there is a need to identify or create the appropriate 
systemic regulatory regime; determine how such a regime can identify 
systemic risks without creating additional ones; and determine how much 
and how heavily any systemic risk regulator should touch the other 
participants in the system of financial regulation. We will need to 
figure out what should be consolidated, what should be split off, what 
should be added, and what should be subtracted. As it has since it was 
formed, the Commission stands ready to assist.
    We view regulatory reform as vital. We will give Congress, our 
fellow regulators, and other parts of the government the benefit of our 
insights. It is critical that the reform is done right, and the 
Commission will actively engage with all stakeholders throughout the 
process.

V. Conclusion
    When I returned to the SEC as Chairman in January, I appreciated 
the need to act swiftly to help restore investor confidence in our 
capital markets. In less than 2 months, we have instituted important 
reforms to reinvigorate our enforcement program, better train our 
examination staff and improve our handling of tips and complaints. In 
the near term, I will ask the Commission to consider taking action 
related to short selling, money market fund standards, investor access 
to public company proxies, credit rating agencies, and controls over 
the safekeeping of investor assets. But, speaking personally, much more 
needs to be done. Everyday when I go to work, I am committed to putting 
the SEC on track to serve as a forceful capital markets regulator for 
the benefit of America's investors. Today, more than ever, the SEC's 
core mission of capital markets oversight and investor protection is as 
sound and fundamentally important as it ever was, and I am fully 
committed to ensuring that the SEC carries out that job in the most 
effective way it can.
    Thank you again for the opportunity to share the SEC's views. We 
look forward to working with the Committee on any financial reform 
efforts in the months ahead, and I would be pleased to answer any 
questions.









                                 ______
                                 

                  PREPARED STATEMENT OF FRED J. JOSEPH
                               President,
          North American Securities Administrators Association
                             March 26, 2009

    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
I am Fred Joseph, Colorado Securities Commissioner and President of the 
North American Securities Administrators Association, Inc. (NASAA). \1\ 
I am honored to be here today to discuss legislative and regulatory 
changes that are most relevant to the millions of Main Street Americans 
who are looking to regulators and lawmakers to help them rebuild and 
safeguard their financial security. At this critical time in the 
Nation's history, it's imperative that our system of financial services 
regulation be improved to better protect investors, markets, and the 
economy as a whole. I commend the Banking Committee for its 
deliberative approach of holding comprehensive hearings, briefings and 
meetings to determine how best to modernize our financial regulatory 
system.
---------------------------------------------------------------------------
     \1\ The oldest international organization devoted to investor 
protection, the North American Securities Administrators Association, 
Inc., was organized in 1919. Its membership consists of the securities 
administrators in the 50 States, the District of Columbia, the U.S. 
Virgin Islands, Canada, Mexico, and Puerto Rico. NASAA is the voice of 
securities agencies responsible for grass-roots investor protection and 
efficient capital formation.
---------------------------------------------------------------------------
    In November 2008, NASAA released its Core Principles for Regulatory 
Reform in Financial Services and subsequently issued a pro-investor 
legislative agenda for the 111th Congress that responds to universal 
calls for increased responsibility, accountability, and transparency, 
and offers a series of positive and proactive policy recommendations to 
better protect investors and restore confidence in our financial 
markets. Today, I would like to highlight the recommendations that we 
feel are most vital to sound regulatory reform and strong investor 
protection.

State Securities Regulatory Overview
    The securities administrators in your states are responsible for 
enforcing state securities laws, the licensing of firms and investment 
professionals, registering certain securities offerings, examining 
broker-dealers and investment advisers, pursuing cases of suspected 
investment fraud, and providing investor education programs and 
materials to your constituents. Ten of my colleagues are appointed by 
state Secretaries of State, five fall under the jurisdiction of their 
states' Attorneys General, some are independent commissions and others, 
like me are appointed by their Governors and Cabinet officials. We are 
often called the ``local cops on the securities beat,'' and I believe 
that is an accurate characterization.

NASAA's Core Principles for Regulatory Reform in Financial Services
    The unique experiences of state securities regulators on the front 
lines of investor protection provide the framework for NASAA's Core 
Principles for Regulatory Reform, which I want to discuss today. We 
believe Main Street investors deserve a regulatory structure that is 
collaborative, efficient, comprehensive, and strong and we have 
developed specific recommendations to help achieve those objectives.
    We urge you to consider and implement the following five guiding 
principles, which we believe will create a strong and practical 
foundation for an enhanced regulatory framework that better serves 
investors and our markets as a whole.

    Preserve the system of state/federal collaboration while 
        streamlining where possible.

    Close regulatory gaps by subjecting all financial products 
        and markets to regulation.

    Strengthen standards of conduct, and use ``principles'' to 
        complement rules, not replace them.

    Improve oversight through better risk assessment and 
        interagency communication.

    Toughen enforcement and shore up private remedies.

Congressional Action That Will Advance the Core Principles
    Implementing NASAA's Core Principles will require a broad range of 
actions, both legislative and regulatory, but at the heart is a call 
for decisive Congressional leadership. Here are our specific 
legislative recommendations, set forth in the context of our core 
principles.

Core Principle One: Preserve State/Federal Collaboration While 
        Continuing To Streamline the Regulatory System Where 
        Appropriate
    With so much at stake for investors and the United States' economy, 
NASAA's top legislative priority is to protect investors by preserving 
state securities regulatory and enforcement authority over those who 
offer investment advice and sell securities to their residents. In some 
areas, the states' authority should be increased.
Support a Strong State Regulatory Structure for Capital Markets
    State regulation is an essential component of our current 
regulatory structure and it must be preserved. In the area of 
securities regulation, the states bring experience, resources, and 
passion to the job of licensing professionals, conducting examinations, 
and bringing enforcement actions--both civil and criminal--against 
those who prey on our Nation's citizens. The states also serve as a 
local resource that investors can turn to for help when they have been 
exploited.
    Our proximity to individual investors puts us in the best position, 
among all law enforcement officials, to deal aggressively with 
securities law violations. State securities regulators respond to 
investors who typically call them first with complaints, or request 
information about securities firms or financial professionals. They 
work on the front lines, investigating potentially fraudulent activity 
and alerting the public to problems. Because they are closest to the 
investing public, state securities regulators are often first to 
identify new investment scams and to bring enforcement actions to halt 
and remedy a wide variety of investment related violations. The $60 
billion returned to investors to help resolve the demise of the Auction 
Rate Securities (ARS) market is the most recent example of the states 
initiating a collaborative approach to a national problem.
    Attached to my testimony is a chart, ``States: On the Frontlines of 
Investor Protection,'' which illustrates many examples where the states 
initiated investigations, uncovered illegal securities activity, then 
worked with federal regulators or with Congress to achieve a national 
solution.
    These high profile national cases receive greater public attention, 
but they should not obscure the more routine and numerically much 
larger caseload representing the bulk of the states' enforcement work, 
which affects everyday citizens in local communities across the 
country. In the past three months alone, the Washington State Division 
of Securities, working with the Federal Bureau of Investigation and the 
IRS Criminal Investigation Division, broke up a $65 million oil and gas 
investment Ponzi scheme; Hawaii's securities commissioner, with the 
assistance of the SEC and CFTC, shuttered a suspected Ponzi scheme 
targeting the deaf community in Hawaii, parts of the mainland and 
Japan; an investigation by the Texas State Securities Board resulted in 
a 60-year prison sentence for a Ponzi scheme operator who stole at 
least $2.6 million from investors; and the Arizona Corporation 
Commission stopped a religious affinity fraud ring and ordered more 
then $11 million returned to investors. Since January 1, 2009, the 
Alabama Securities Commission has announced the conviction of nine 
different individuals convicted of securities fraud.
    Just one look at our enforcement statistics shows the effectiveness 
of state securities regulation. During our three most recent reporting 
periods, ranging from 2004 through 2007, state securities regulators 
have conducted investigations that led to more than 8,300 enforcement 
actions, which led to $178 million in monetary fines and penalties, 
more than $1.8 billion ordered returned to investors, and jail 
sentences totaling more than 2,700 years.
    Last year, in my own State of Colorado, my office conducted 
investigations that led to 246 administrative, civil and criminal 
actions, resulting in $3 million ordered to be returned to investors 
and 434 years of prison time for fraudsters. And just last month, a 
Ponzi scheme investigation launched by my office resulted in a prison 
sentence of 132 years for the main perpetrator and a court order to 
repay investors $3.4 million.
    In light of the demonstrable value of state securities regulation, 
we urge Congress to reject any attempts to preempt or otherwise 
restrict the role of state securities regulators.

Restore the Authority of State Securities Regulators Over Offerings 
        under Rule 506 of Regulation D
    In thinking about the role of state and federal enforcement 
authorities, it is instructive to look back at the regulatory responses 
to the major financial scandals over the past decade. From the 
investigation into the role of investment banks in the Enron fraud, to 
exposing securities analyst conflicts of interest, ``market timing'' in 
mutual funds, and the recent auction rate securities cases, state 
securities regulators have consistently been in the lead.
    Because we are the local cop on the beat, state securities 
regulators are often first to discover and investigate our Nation's 
largest frauds. Also, it has been shown that in cases where state and 
federal regulators work cooperatively, the actions of state securities 
regulators cause a significant increase in the penalty and restitution 
components of the federal regulator's enforcement efforts. \2\
---------------------------------------------------------------------------
     \2\ Eric Zitzewitz, An Eliot Effect? Prosecutorial Discretion in 
Mutual Fund Settlement Negotiations, 2003-7, http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=1091035.
---------------------------------------------------------------------------
    And yet, over a number of years there has been a concerted assault 
on state securities regulation, targeting both regulatory and 
enforcement activities. For example, in 1996, the National Securities 
Markets Improvement Act (NSMIA) preempted much of the states' 
regulatory apparatus for securities traded in national markets, and 
although it left state antifraud enforcement largely intact, it limited 
the states' ability to address fraud in its earliest stages before 
massive losses have been inflicted on investors.
    A prime example is in the area of private offerings under Rule 506 
of Regulation D. Even though these securities do not share the 
essential characteristics of the other national securities offerings 
addressed in NSMIA, Congress nevertheless precluded the states from 
subjecting them to regulatory review. These offerings also enjoy an 
exemption from registration under federal securities law, so they 
receive virtually no regulatory scrutiny. Thus, for example, NSMIA has 
preempted the states from prohibiting Regulation D offerings even where 
the promoters or broker-dealers have a criminal or disciplinary 
history. Some courts have even held that offerings made under the guise 
of Rule 506 are immune from scrutiny under state law, regardless of 
whether they actually comply with the requirements of the rule. \3\
---------------------------------------------------------------------------
     \3\ See, e.g., Temple v. Gorman, 201 F. Supp. 2d 1238 (S.D. FL. 
2002).
---------------------------------------------------------------------------
    As a result, since the passage of NSMIA, we have observed a steady 
and significant rise in the number of offerings made pursuant to Rule 
506 that are later discovered to be fraudulent. Further, most hedge 
funds are offered pursuant to Rule 506, so state securities regulators 
are prevented from examining the offering documents of these 
investments, which represent a huge dollar volume. Although Congress 
preserved the states' authority to take enforcement actions for fraud 
in the offer and sale of all ``covered'' securities, including Rule 506 
offerings, this power is no substitute for a state's ability to 
scrutinize offerings for signs of potential abuse and to ensure that 
disclosure is adequate before harm is done to investors. In light of 
the growing popularity of Rule 506 offerings and the expansive reading 
of the exemption given by certain courts, NASAA believes the time has 
come for Congress to reinstate state regulatory oversight of all Rule 
506 offerings by repealing Subsection 18(b)4(D) of the Securities Act 
of 1933.

Broaden the States' Regulatory and Enforcement Authority Over 
        Investment Advisers
    Recent scandals have highlighted the need for more examination and 
enforcement in the area of investment adviser regulation. The Madoff 
case illustrates the horrific consequences we face when an investment 
adviser's illegal activity goes undetected and unchecked for an 
extended period. NASAA recommends two changes to enhance the states' 
role in policing investment advisers. First, the Securities Exchange 
Commission (SEC) should expand the class of investment advisers that 
are subject to state registration and oversight. In NSMIA, adopted in 
1996, Congress provided that the states would regulate investment 
advisers with up to $25 million in assets under management, while the 
SEC would regulate the larger investment advisers. Congress further 
intended that the SEC would periodically review this allocation of 
authority and adjust it appropriately. The $25 million ``assets under 
management'' test should now be increased to $100 million. This 
adjustment is appropriate in light of changes in the economic context. 
Today, even small investment advisers typically have more that $25 
million under management. In addition, this increase will reduce the 
number of federally registered investment advisers, thereby permitting 
the SEC to better focus its examination and enforcement resources on 
the largest advisers.
    Congress should also increase the states' enforcement authority 
over large investment advisers. Currently, a state can only take 
enforcement action against a federally registered investment adviser if 
it finds evidence of fraud. This authority should be broadened to 
encompass any violations under state law, including, dishonest and 
unethical practices. This enhancement will deter all forms of abuse by 
the large investment advisers, without interfering with the SEC's 
exclusive authority to register and oversee the activities of the large 
investment advisers.

Core Principle Two: Close Regulatory Gaps by Subjecting All Financial 
        Products and Markets to Regulation
    An enormous amount of capital is traded through esoteric investment 
instruments on opaque financial markets that are essentially 
unregulated. Our system must be more comprehensive and transparent, so 
that all financial markets, instruments, and participants--from 
derivatives to hedge funds--are subject to effective regulation through 
licensing, oversight, and enforcement.

Increase Transparency of Derivative Instruments
    The lack of regulation governing the over-the-counter derivatives 
market is a regulatory gap that Congress must close. The hands-off 
approach to these financial instruments can be traced largely to the 
Commodity Futures Modernization Act, passed by Congress in 2000, which 
specifically exempted swaps from regulatory oversight. This lack of 
oversight was a contributing cause of the financial crisis and must be 
addressed.
    NASAA believes that Congress, at a minimum, should pass legislation 
to subject derivatives to much more comprehensive regulation. NASAA 
supports recent efforts to provide clearing services for certain credit 
default swap contracts, but suggests that Congress explore the 
necessity of imposing a much broader range of regulatory safeguards 
over the derivative markets. Regulatory requirements that deserve 
careful consideration include mandatory exchange trading, licensing of 
market participants, capital requirements, recordkeeping obligations, 
conduct standards, enforcement remedies, and even prohibition, where 
appropriate.

Authorize Regulation of Hedge Funds
    NASAA has long supported regulation of hedge fund advisers in a 
manner that will provide greater transparency to the marketplace while 
not overburdening the hedge fund industry. Advisers to hedge funds 
should be subject to the same standards of examination as other 
investment advisers.
    Because they qualify for a number of exemptions to federal and 
state registration and disclosure laws, hedge funds remain largely 
unregulated today. The SEC has attempted to require hedge fund managers 
to register as investment advisers, but that attempt has been rejected. 
\4\ Therefore, Congress should give the SEC explicit statutory 
authority to regulate hedge fund advisers as investment advisers. In 
addition, Congress should grant the SEC authority to require hedge 
funds to disclose their portfolios, including positions, leverage 
amounts, and identities of counterparties to the appropriate 
regulators.
---------------------------------------------------------------------------
     \4\ See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
---------------------------------------------------------------------------
Core Principle Three: Strengthen Standards of Conduct, and Use 
        ``Principles'' To Complement Rules, Not Replace Them
    At the heart of any regulatory system are strong and clear 
standards of conduct. In the area of securities regulation, we should 
impose the fiduciary duty--in addition to existing standards--on all 
securities professionals who dispense investment advice, including 
broker-dealers. We must also recognize that a ``principles-based'' 
approach to regulation is no substitute for a clear and strong system 
of prescriptive rules. Broadly framed standards of conduct can serve as 
helpful guides for industry as well as useful enforcement tools for 
regulators, but standing alone, they leave too much room for abuse.

Impose the Fiduciary Duty on Broker-Dealers as Well as Investment 
        Advisers
    Over the last two decades, broker-dealers have increasingly engaged 
in services traditionally rendered by investment advisers. The conduct 
of investment advisers, broker-dealer agents and financial planners has 
become increasingly blurred in recent years, and most investors do not 
understand the legal obligations that each have to their clients. The 
financial services industry today continues to expose investors to vast 
differences in competency exam requirements, education requirements, 
product knowledge, regulatory structures, and investor protections--
including vast differences in the standard of care owed to the client.
    The primary purpose of the Investment Advisers Act of 1940 was to 
protect the public and investors from unscrupulous practices by those 
who dispense investment advice about securities for compensation. 
Congress set out to accomplish this goal in large part by establishing 
a federal fiduciary standard to govern the conduct of investment 
advisers. The fiduciary duty is the obligation to place the client's 
interests first, to eliminate any conflicts of interest and to make 
full and fair disclosure to clients. NASAA urges Congress to apply the 
fiduciary duty standard of care to all financial professionals who give 
investment advice regarding securities--broker-dealers and investment 
advisers alike. This step will enhance investor protection, eliminate 
confusion, and even promote regulatory fairness by establishing conduct 
standards according to the nature of the services provided, not the 
licensing status of the provider. We urge Congress to ratify the 
highest standard of care. For all financial professionals, the 
interests of the client must come first at all times. Investors deserve 
no less.

Core Principle Four: Improve Oversight Through Better Risk Assessment 
        and Interagency Communication.
    Enhancing our ability to detect and manage risk in all financial 
markets is one of our most important--and difficult--challenges. The 
single most effective remedy for excessive risk accumulation is closing 
regulatory gaps, as set forth in Core Principle Two. If we ensure that 
every financial product is subjected to strong oversight by competent 
regulators, we will have taken a major step toward better risk 
assessment and control. Some additional steps are necessary, however. 
Congress should establish an independent risk assessment body, and it 
should eliminate fundamental conflicts of interest that have undermined 
the objectivity and reliability of our credit rating agencies.

Establish an Independent Body To Monitor the Accumulation of Risk and 
        Recommend Corrective Measures
    NASAA believes that Congress should establish an independent risk 
assessment body comprised of representatives from the state and federal 
agencies that regulate securities, banking, and insurance. Their task 
would be to monitor the accumulation of risk in all financial markets, 
to advise the regulators who have primary jurisdiction over those 
markets, and to recommend decisive corrective measures when necessary. 
They would also be charged with identifying the emergence of new 
financial products that require regulation. This approach is preferable 
to vesting broad risk assessment authority in an existing federal 
agency. A new body with diverse and balanced representation offers more 
expertise, more objectivity, and greater resistance against industry 
influence or ``regulatory capture.''
    On a more informal level, to facilitate communication and 
coordination on all financial services issues, NASAA believes the 
President's Working Group on Financial Markets should be expanded to 
include representatives from the state agencies that regulate banking, 
insurance, and securities.

Eliminate Conflicts Within Nationally Recognized Statistical Rating 
        Organizations (``NRSROs'')
    Nationally Recognized Statistical Rating Organizations 
(``NRSROs''), or credit rating agencies, play a vital role in our 
capital market. Their evaluations of the creditworthiness of companies 
and securities help hedge funds, mutual funds, pension funds, and 
individual investors make their investment decisions, and their ratings 
are used for a variety of regulatory purposes as well. As our financial 
markets have become more complex, the role of NRSROs has grown in 
significance. However, it is now clear that NRSROs contributed to the 
turmoil in our credit markets with inaccurate ratings due in large part 
to a faulty business model. NASAA regards the SEC's recently finalized 
rules, which were intended to curb conflicts of interest and increase 
transparency and accountability, as a constructive first step, but they 
may not go far enough. Also, the SEC's upcoming roundtable should yield 
additional proposals to enhance oversight of the ratings industry. 
Still, Congress must examine the models that rating agencies use and 
the assumptions they rely upon in determining ratings to ensure that 
they accurately reflect risks. Congress should also examine the issuer-
pay business model that contains inherent conflicts of interest and 
that lends itself to ``ratings shopping,'' and should consider 
legislative solutions that are beyond the reach of the SEC's regulatory 
authority.

Core Principle Five: Toughen Enforcement and Shore Up Private Remedies
    Enforcement is one of the most effective tools for deterring 
lawless behavior in our markets, but for years, it has received far 
less support than it deserves. We should toughen punishments for those 
who violate the law and increase enforcement budgets for state and 
federal regulators, including the SEC. We must remember that the 
private rights and remedies of injured consumers are an essential 
complement to government enforcement efforts aimed at deterring fraud. 
The pendulum has swung too far in the direction of limiting private 
rights of action, and now Congress should legislatively reverse some of 
the Supreme Court's most ill-conceived and anticonsumer decisions.

Reexamine and Remove Some of the Hurdles Facing Private Plaintiffs Who 
        Seek Damages for Securities Fraud
    Private actions are the principal means of redress for victims of 
securities fraud, but they also play an indispensable role in deterring 
fraud and complementing the enforcement efforts of government 
regulators and prosecutors. Congress and the courts alike have 
recognized this fact. The Senate Report accompanying the Private 
Securities Litigation Reform Act of 1995 (PSLRA) described the 
importance of private rights of action as follows:

        The SEC enforcement program and the availability of private 
        rights of action together provide a means for defrauded 
        investors to recover damages and a powerful deterrent against 
        violations of the securities laws. As noted by SEC Chairman 
        Levitt, ``private rights of action are not only fundamental to 
        the success of our securities markets, they are an essential 
        complement to the SEC's own enforcement program.'' [citation 
        omitted] \5\
---------------------------------------------------------------------------
     \5\ See S. Rep. No. 104-98, at 8 (1995), reprinted in 1995 
U.S.C.C.A.N. 679, 687; see also Basic Inc. v. Levinson, 485 U.S. at 
230-31 (observing that the private cause of action for violations of 
Section 10(b) and Rule 10b-5 constitutes an ``essential tool for 
enforcement of the 1934 Act's requirements'').

    The problem, of course, is that over the last 15 years, Congress 
and the U.S. Supreme Court have restricted the ability of private 
plaintiffs to seek redress in court for securities fraud. These 
restrictions have not only reduced the compensation available to those 
who have been the victims of securities fraud, they have also weakened 
a powerful deterrent against misconduct in our financial markets.
    For example, in the PSLRA, Congress imposed stringent pleading 
requirements and other limitations on plaintiffs seeking damages for 
fraud under the securities acts. The intent of the Act was to protect 
companies from frivolous lawsuits and costly settlements. Many 
observers, however, believe that PSLRA has placed unrealistic burdens 
on plaintiffs with meritorious claims for damages.
    The Supreme Court has compounded the problem by issuing decisions 
that further limit the rights of private plaintiffs in two important 
ways. The Court has narrowed the class of wrongdoers who can be held 
liable in court, and at the same time, it has expanded the pleading 
burdens that plaintiffs must satisfy to survive immediate dismissal of 
their claims. As Justice Stevens lamented in his dissent in Stoneridge, 
the Court has been on ``a continuing campaign to render the private 
cause of action under Section 10(b) toothless.'' \6\
---------------------------------------------------------------------------
     \6\ Stoneridge Investment Partners, LLC v. Scientific-Atlanta, 
Inc., 128 S. Ct. 761, 779 (2008).
---------------------------------------------------------------------------
    In short, the pendulum has swung too far in the direction of 
limiting private rights of action. Congress should therefore hold 
hearings to examine whether private plaintiffs with claims for 
securities fraud have fair access to the courts. In that process, 
Congress should re-evaluate the Private Securities Litigation Reform 
Act and should furthermore consider reversing some of the Supreme 
Court's most anti-investor decisions. One case that undoubtedly 
deserves to be revisited is the Court's holding in Central Bank of 
Denver, N.A. v. First Interstate Bank of Denver, N.A., 114 S.Ct. 1439 
(1994). The Court ruled that the private right of action under Section 
10(b) of the Securities Exchange Act of 1934 cannot be used to recover 
damages from those who aid and abet a securities fraud, only those who 
actually engage in fraudulent acts. The Court's decision insulates a 
huge class of wrongdoers from civil liability for their often critical 
role in support of a securities fraud.
    Other cases that warrant legislative re-evaluation include 
Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S. 
Ct. 761, 779 (2008) (severely limiting the application of Section 10(b) 
in cases involving fraudulent conduct); and Tellabs, Inc. v. Makor 
Issues & Rights, Ltd., 127 S. Ct. 2499 (2007) (establishing burdensome 
requirements for pleading scienter).
    It bears repeating that removing excessive restrictions on access 
to the courts would not only provide more fair and just compensation 
for investors, it would also benefit regulators by restoring a powerful 
deterrent against fraud and abuse: the threat of civil liability.
Restore Fairness and Balance in the Securities Arbitration System
    Every year thousands of investors file complaints against their 
stockbrokers. Almost every broker-dealer presently includes in their 
customer agreements a predispute mandatory arbitration provision that 
forces those investors to submit all disputes that they may have with 
the firm and/or its associated persons to mandatory arbitration.
    If these disputes are not settled with a given firm, investors are 
left with only one avenue to pursue their claims--arbitration--and for 
all practical purposes only one arbitration forum. This system, which 
is administered by an affiliate of FINRA, should be revised to ensure 
it is fair and transparent to all.
    The first step toward ensuring fundamental fairness is to make 
arbitration optional. Members of Congress have seen that the scales of 
justice have tilted away from consumers in arbitration proceedings. In 
an attempt to rectify this situation, the ``Arbitration Fairness Act of 
2007,'' was introduced. S. 1782, offered last year by Senator Russ 
Feingold (D-WI), had seven cosponsors and its House counterpart, H.R. 
3010, introduced by Congressman Hank Johnson (D-GA), is currently 
supported by 43 cosponsors. This proposal makes predispute mandatory 
arbitration agreements to arbitrate employment, consumer, franchise, or 
civil rights disputes unenforceable. NASAA supports this legislation 
and suggests that it be amended just to make clear that its provisions 
extend to securities arbitration.
    Even if the decision to participate in arbitration becomes truly 
voluntary, other changes are necessary to ensure that the arbitration 
process is fair. NASAA believes a major step toward improving the 
integrity of the arbitration system is the removal of the mandatory 
industry arbitrator. This mandatory industry arbitrator, with their 
industry ties, automatically puts the investor at an unfair 
disadvantage. State securities regulators believe Congress should also 
review other aspects of arbitration, to determine, for example, if 
there is sufficient disclosure of potential conflicts by panel members; 
if the selection, qualification, and composition of the panels is fair 
to the parties; if arbitrators receive adequate training; if 
explanations of awards are sufficient; and if the system is fast and 
economical for investors. Where deficiencies are found, Congress should 
act to ensure that the system is improved.

Conclusion
    State securities regulators believe that enhancing our securities 
laws and regulations and ensuring they are being vigorously enforced is 
the key to the restoring investor confidence in our markets. NASAA and 
its members are committed to working with the Committee to ensure that 
the Nation's financial services regulatory regime undergoes the 
important changes that are necessary to enhance Main Street investor 
protection, which state securities regulators have provided for nearly 
100 years.


                                 ______
                                 

                PREPARED STATEMENT OF RICHARD C. BREEDEN
                            Former Chairman,
                   Securities and Exchange Commission
                             March 26, 2009

    Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the 
Committee for the opportunity to offer my views on enhancing investor 
protection and improving financial regulation. These have been issues 
of concern to me for many years.
    In offering observations to the Committee today, I am drawing on 
past experience as SEC Chairman from 1989-1993, as well as my service 
as an Assistant to the President in the White House under President 
George H.W. Bush. During the savings and loan and banking crisis in the 
1980s, which involved more than $1 trillion in bank and thrift assets, 
I was one of the principal architects of the program to restructure the 
savings and loan industry and its regulatory system. That effort was 
extremely successful, and became the model for many other countries 
including the Nordic countries in dealing with later banking sector 
meltdowns.
    Early in my White House tenure, in 1982-1985 when the future 
President Bush was Vice President, I was staff director of a 3-year 
study of how to improve the effectiveness and efficiency of the entire 
federal financial regulatory system. We looked carefully at many ideas 
for improving the effectiveness of federal financial regulation, 
including possible consolidation of banking agencies, SEC/CFTC merger 
and other topics.
    From 2002-2005 I served as the ``corporate monitor'' of WorldCom, 
after being appointed to that position by the Hon. Jed S. Rakoff of the 
U.S. District Court for the Southern District of New York. Among other 
things, it was my job on behalf of the District Court to evaluate and 
approve or veto all compensation payments by WorldCom to any of its 
66,000 employees in more than 50 countries. We didn't call it an ``AIG 
Problem'', but Judge Rakoff was determined to prevent exactly the type 
of compensation abuses that have occurred in AIG. Even though taxpayer 
funds were not injected into WorldCom, Judge Rakoff did not believe 
that a company that had destroyed itself through fraud should be free 
to pay corporate funds to insiders without strict monitoring and 
controls. I ultimately blocked hundreds of millions in proposed 
compensation payments that could not be justified, while allowing the 
company to do what it needed to do to compete for critical personnel 
and to emerge successfully from bankruptcy.
    Over the years I have served on many corporate boards, including 
the boards of two major European corporations as well as U.S. 
companies. Today I serve as nonexecutive Chairman of the Board of H&R 
Block, Inc., and as a director of two other U.S. public companies. \1\ 
As a board chairman and as a director, I have personally had to grapple 
with the issues of corporate governance, including accountability for 
performance and excessive compensation, that helped cause so many of 
our recent financial institution collapses.
---------------------------------------------------------------------------
     \1\ The views expressed here today are solely my own. They do not 
represent the views of any investors in investment funds managed by 
Breeden Capital Management, or of any companies on whose boards I 
serve.
---------------------------------------------------------------------------
    Of all my prior experiences, however, perhaps the most relevant is 
my experience as an investor. For the past few years my firm, Breeden 
Capital Management, has managed equity investments that today total 
approximately $1.5 billion in the U.S. and Europe. Our investors are 
for the most part major pension plans, and we indirectly invest on 
behalf of several million retired schoolteachers, firemen, policemen, 
civil servants and others. Their retirement security is dependent in 
part on how successful we are in generating investment returns. While I 
was pretty intense about investor protection as SEC Chairman, I can 
assure you that there is nothing like having billions on the line in 
investments on behalf of other people to make you really passionate on 
that subject.

I. Overview
    By any conceivable yardstick, our Nation's financial regulatory 
programs have not worked adequately to protect our economy, our 
investors, or our taxpayers. In little more than a year, U.S. equities 
have lost more than $7 trillion in value. Investors in financial firms 
that either failed, or needed a government rescue, have had at least 
$1.6 trillion in equity wiped out. These are colossal losses, without 
any precedent since the Great Depression. Millions of Americans will 
live with reduced retirement incomes and higher taxes for many years as 
a result of misbehavior in our financial firms, failed oversight by 
boards of directors, and ineffective government regulation.
    To restore trust among investors in our financial system and 
government, we will need to make significant improvements in our 
existing regulatory programs. We also must make sure that ``new'' 
regulatory programs will actually be ``better'' than current programs. 
Any ``reforms'' worth the name must demand more effectiveness from 
government agencies, including the Federal Reserve and the SEC, that 
have responsibility for ``prudential supervision'' of banks and 
securities firms.
    It is worth noting that the disasters we have seen did not arise 
due to lack of resources for the Federal Reserve, the SEC or any of the 
other agencies that didn't perform as well as they needed to do. The 
U.S. regulatory system is enormous and powerful, and it generally has 
adequate, if not perfect, resources. When it comes to regulation, 
bigger doesn't mean smarter, better or more effective. Indeed, when 
agencies have too many resources they tend to become unwieldy, not more 
vigilant or effective.
    The problems also did not arise because of ``outdated laws from the 
1930s'' or, except in limited circumstances, from ``gaps'' in statutory 
authority in the banking or securities sectors. The fact is that some 
of the laws enacted in the 1930s in the wake of the Depression, like 
the Glass-Steagall Act, helped prevent leverage or conflict problems. 
When they were repealed in order to allow the creation of Citigroup, 
and to permit other financial firms to expand across traditional legal 
barriers, we may have gone too far in ``modernizing'' our system 
without incorporating adequate alternative limits on conflicts and 
leverage. Other laws from the 1930s, such as the Securities Act of 1933 
and the Securities Exchange Act of 1934, have been regularly updated 
over the years to maintain their relevance in modern markets.
    Many people are today pointing at ``gaps'' in the regulatory 
structure, including ``systemic risk authority''. If the Fed hasn't 
been worried about systemic risk all these years, then people really 
should be fired. The problems we have experienced grew in plain sight 
of all our regulators. For the most part, we lacked adequate leadership 
at major regulatory agencies, not legal jurisdiction. The banking and 
securities regulators generally had the tools to address the abusive 
practices, but just didn't use their powers forcefully enough or ask 
for new authority promptly when they needed it. Oversight of 
derivatives and swap markets is probably the major exception where 
firms like AIG were operating far outside of anyone's oversight 
authority. That is a good reason to refuse to bail out swap 
counterparties of AIG in my opinion, but we also ought to put formal 
oversight into place if we are going to force taxpayers to make good on 
defaulted swaps.
    Part of the problem was an excessive faith by some regulators in 
enlightened self interest by banks and securities firms, and an 
underestimation of the risks posed by compensation practices that 
encouraged unsustainable leverage. Short term profits went home with 
the CEOs, while long term risks stayed with the shareholders. There 
also was a too trusting acceptance of ``modern'' bank internal risk 
models, which were used to help rationalize dangerous levels of 
leverage. Some regulators acquiesced to stupid things like global banks 
running off balance sheet ``SIVs'' in order to try to boost profits and 
compensation, even if they involved serious potential liquidity risks. 
Unfortunately, the risk-adjusted Basle capital rules for banks proved 
too simplistic and ineffective. To be fair, the SEC at the highest 
levels could have cracked the whip harder on Bear, Lehman, and Merrill, 
but didn't do so.
    Rather than simply calling for more authority for people who didn't 
use the authority they already had, we need to reexamine why our 
regulators missed so many of the risks staring them in the face. My 
purpose is not to fault regulators who weren't perfect. I also don't 
want to obscure the fact that the greatest responsibility for the 
devastation of our economy should rightly fall on the executives of the 
firms engaging in wildly risky practices, and the boards that failed to 
provide effective oversight. However, we will never design sensible 
reforms if we aren't candid in acknowledging the performance failures 
all across the system. We can't fix things until we have a good handle 
on what went wrong.
    It isn't enough for regulators to write rules and give speeches. 
More time needs to be spent conducting examinations, analyzing results, 
discovering problems and, where necessary putting effective limits in 
place to prevent excessively risky activities. Directors and regulators 
need backbone, and a willingness to shut down a party that gets out of 
control. Regulators can't catch all the frauds any more than police can 
catch all the drug dealers. Nonetheless, when failures happen it 
shouldn't be acceptable to just ask for more resources without making 
the necessary corrections first. Regulators need accountability for 
performance failures just as much as any of us.
    While we need to demand better effectiveness from regulators, we 
must not shift the burden of running regulated businesses in a sound 
and healthy manner from management and the boards of directors that are 
supposed to oversee their performance. Excessive leverage, compensation 
without correlation to long term performance, misleading (or 
fraudulent) accounting and disclosure, wildly overstated asset values, 
failures to perform basic due diligence, wasteful capital expense and 
other factors contributed to the financial collapses that devastated 
investors and undermined confidence in the entire economy. These are 
all issues that boards are supposed to control, but over and over again 
boards at AIG, Fannie Mae, Lehman Brothers, Bank of America and other 
companies didn't address them adequately.
    In my experience, excessive entrenchment leads many directors to 
believe they don't need to listen to the shareholders they represent, 
and who have the most at stake if the board fails to do a good job. The 
national disaster of self-indulgence in compensation has been opposed 
by many shareholders, but too many boards feel free to disregard their 
concerns. It is frankly almost incomprehensible how few directors of 
firms requiring taxpayer assistance have been forced to step down, even 
after investors and taxpayers lost billions because directors didn't 
act prudently. If you allow your CEO to spend $35 billion on an 
acquisition without meaningful due diligence, for example, you should 
be replaced as a director without delay. The failure of boards to 
provide informed and independent oversight badly needs to be addressed 
both by Congress and the SEC.
    Taxpayers may have to protect our banking system, but they don't 
have to protect the bankers who caused their firms to fail or the 
directors who let them do it without proper oversight. Executives who 
gambled with the solvency of their firms and failed should be out of a 
job, and the same is true for the boards that didn't act as required. 
That is certainly how we handled the failures of the savings and loans. 
People who gambled and failed found new lines of work. There are few 
things today that would go farther to produce prudent behavior in the 
future than forcing the resignation of CEOs and directors when their 
firms have to take public funds to keep their doors open. It is long 
overdue to put accountability and personal responsibility front and 
center back into the system.
    Since we are going to need vast amounts of future savings and 
investment, the Committee's efforts to help develop answers to the many 
tough issues affecting our system could not be more important. I will 
try to address the issues raised by the Committee's thoughtful letter 
of invitation, as well as several of my suggestions for reform.

A. Investor Protection
    With $7 trillion in investor losses, it would appear that we have 
not done enough in the area of investor protection. This was ironically 
once one of the preeminent strengths of the U.S. market. Investors from 
around the world invested in the U.S. because we had stronger and 
better accounting rules, more timely and detailed disclosure, a 
commitment to openness in corporate governance and above all 
enforcement of the rules and liability for those that committed illegal 
practices. Over time our governance standards have come to be weaker 
than those of many other countries, and our commitment to accuracy in 
accounting and disclosure has slipped considerably. The SEC's 
enforcement program in recent years has not been as effective as the 
times demanded, with too many smaller cases and not enough focus on the 
largest problems. We frankly spent too much time worrying about the 
underwriting fees of Wall Street and not enough time worrying about 
protecting investors from false and misleading information.
    Investors, those quaint people worried about their retirement, need 
to stop seeing the savings they worked hard to accumulate wiped out 
because executives took irresponsible gambles. If we care about 
generating a higher national savings rate, we need to start paying more 
attention to the interests of individual and institutional investors 
and spend less time listening to the CEOs of the very banks who created 
this mess. We shouldn't ever ignore opportunities to reduce unnecessary 
regulatory costs, but we can't lose sight of the fact that people who 
lie, cheat and steal from investors belong in jail. We expect the cops 
on the beat to arrest street criminals, and we should equally expect 
the financial cops on the beat to use their muscle to protect the 
investing public.
    The record of the SEC in recent years has not been perfect. The 
Madoff case is a tragic situation that should have been caught sooner, 
for example. Chairman Schapiro has made a good start to reinvigorating 
the agency's enforcement programs, and she deserves strong support in 
beefing up the agency's programs.
    The SEC is a critical institution, and Congress should not throw 
away 75 years of SEC experience by stripping the agency of its 
responsibilities under the guise of creating a ``systemic regulator'' 
or for any other reason. Make no mistake, as great as it is (and the 
Fed really is a great institution), the Federal Reserve is not equipped 
to protect investors. Transferring SEC accounting, disclosure or 
enforcement programs to the Fed would be a recipe for utter disaster. A 
strong and effective SEC is good for investors, and good for the health 
of our economy. If the agency stops behaving like a tiger for investors 
we need to fix it, not abandon it.
    There are many things that go into ``investor protection''. To me, 
the most critical need is for timely and accurate disclosure of 
material information regarding the performance of public companies. 
That means issuers should provide robust disclosure of information, and 
scrupulously accurate financial statements. Overstating the value of 
assets is never in investor interests, and if the system doesn't 
require accurate values to be disclosed investors will simply withdraw 
from the market due to lack of confidence. There must be serious 
consequences if you falsify asset values and thereby mislead investors 
no matter how big your company.
    Good disclosure includes marking liquid securities to market 
prices, whether or not a bank wishes to hide its mistakes. While care 
is needed in marking positions to models where there isn't a liquid 
market, in general the people who try to blame mark to market for the 
problems of insolvent institutions are simply wrong. The problem is 
that people bought stuff without considering all the risks, including a 
collapse of demand or liquidity. That isn't the problem of the 
yardstick for measurement, it is a problem of incompetent business 
decisions. If I bought a share of stock at $100 and it falls to $50, 
that dimunition of value is real, and I can't just wish it away. We 
need accuracy in accounting, not fairy tales.
    ``Transparency'' of results to investors is the touchstone of an 
efficient market, and a vital protection to make sure that investors 
can accurately evaluate a company and its condition if the information 
is there and they are willing to do the work. It should never be 
allowable to lie or mislead investors, and people who do it should 
expect to be sued no matter what might happen to them in other 
countries. In my opinion there can be no ``opt-out'' of accountability 
for fraud and deliberate misstatements of material information. This is 
a bedrock value of our system and has to be defended even if business 
lobby groups find accurate disclosure inconvenient.
    Choice is another core protection for investors. Government 
shouldn't try to make investment choices for investors, or allocate 
capital as it might wish. Particularly when it comes to sophisticated 
pension funds and other institutional investors, they need the right to 
manage their portfolios as they believe will generate the best returns 
without artificial limitations. Historically some states have tried to 
impose ``merit'' regulation in which bureaucrats made investment 
choices for even the most sophisticated investors. Investment choice is 
a vital right of investors, subject of course to basic suitability 
standards, even though we know that investors will sometimes lose.
    Healthy corporate governance practices are also vital to investors. 
This means accountability for performance, enforcement of fiduciary 
duties, maintaining checks and balances, creating sensible and 
proportionate incentives and many other things. One area of weakness 
today is excessive entrenchment of boards, and the consequent weakening 
of accountability for boards that fail to create value. Better 
corporate governance will over time lead to a stronger companies, and 
more sustainable earnings growth and wealth creation.

B. Systemic Risk and Supervision of Market Participants
    There appears to be momentum in Washington for creating a 
``systemic risk'' regulator, whether the Federal Reserve or some other 
agency. To me, this is a bad idea, and one that will weaken the overall 
supervisory system as well as damaging Congressional oversight.
    There is no single person, and no single agency, that can be 
omniscient about risk. Risk crops up in limitless forms, and in the 
most unexpected ways. Risk is as varied as life itself. To me, our 
system is stronger if every agency is responsible for watching for, and 
acting to control, systemic risk in its own area of expertise. It needs 
to be every regulator's responsibility to control risks when they are 
small, before they get big enough to have ``systemic'' implications.
    Our current system involves multiple federal and state 
decisionmakers, and multiple points of view. Like democracy itself, the 
system is a bit messy and at times leads to unproductive debate or 
disagreement, particularly among the three different bank regulators. 
However, Congress and the public have the benefit of hearing the 
different points of view from the Fed, the Treasury, the FDIC or the 
SEC, for example. This allows informed debate, and produces better 
decisions than would be the case if those different points of view were 
concealed from view within a single agency expressing only one 
``official'' opinion.
    The alternative in some countries is a single regulator. Japan's 
Ministry of Finance, for example, traditionally brought banking, 
securities and insurance regulation under one roof. However, Japan 
still has had as many problems as other markets. Making agencies bigger 
often makes them less flexible, and more prone to complacency and 
mistakes. This can create inefficiency. More importantly, it can create 
systemic risk because if the regulatory ``czar'' proves wrong, every 
part of the system will be vulnerable to damage. Some regulators prove 
more effective than others, so a system with only one pair of eyes 
watching for risk is weaker than a system in which lots of people are 
watching. What counts is that somebody rings an alarm when problems are 
small enough to fix, not who pushes the button.
    Of course risk often comes about not just by the activity itself, 
but how it is conducted. Ultimately any economic activity can be 
conducted in a manner that creates risk, and hence there can be 
``systemic'' risk anywhere. It won't work to try to assign planning for 
every potential risk in the economy to a single agency unless we want a 
centrally planned economy like the old Soviet Union. This is an area 
where interagency cooperation is the better solution, as it doesn't 
create the enormous new risks of concentration of power and the dangers 
of a single agency being asleep or flat out wrong as would a ``systemic 
risk'' supervisor.
    Supervision of market participants is best left in the hands of 
agencies that have the most experience with the particular type of 
activity, just as doctors and dentists need to be overseen by people 
who understand the practice of medicine or dentistry. It is 
particularly hard for me to see a case that any single group of 
regulators did such a good job that they deserve becoming the Uber 
Regulator of the country. The bank regulators missed massive problems 
at Wachovia, WaMu, Citicorp and other institutions. Insurance 
regulators missed the problems at AIG. The SEC missed some of the 
problems at Bear, Lehman and Merrill. There have been enough mistakes 
to go around, and I don't see evidence that putting all supervision 
under a monopoly agency will improve insight or judgment. 
Unfortunately, the reverse effect is more likely.

C. Common Supervisory Rules
    During my time as SEC Chairman, I was pressured (mostly by foreign 
regulators) to agree to a new ``global'' capital rule that would have 
reduced the SEC's limits on leverage for the major U.S. securities 
firms by as much as 90 percent. The proposed new ``global'' capital 
rule on market risks represented a good theoretical endeavor, but it 
was too simplistic and unreliable in practice. It would have allowed 
firms that were long railroad stocks and short airline stocks to carry 
zero capital against those positions, even though they were not a true 
hedge.
    The ``netting'' arrangements in the proposed global rule weren't 
economically realistic, and as a result the rule itself was largely a 
rationalization for allowing firms to lever themselves to a much 
greater degree than the SEC allowed at that time. In addition, the rule 
didn't distinguish at all between securities firms that were marking 
securities portfolios to market, and banks that were using cost 
accounting, which meant that the capital required would vary 
dramatically from firm to firm for identical portfolio positions. The 
SEC staff and I believed that this new standard would have undercut the 
stability and solvency of the major U.S. securities firms. We didn't 
object to banking authorities adopting whatever standards they thought 
were appropriate, but we weren't willing to be stampeded into adopting 
something that we didn't believe would work.
    At the time, much of the force for pushing through a new rule came 
from the Basle banking committee, who wanted to be seen to be doing 
something relevant to market risk even if the proposed rule had 
problems. It was my rather contrarian view then, and remains so today, 
that adopting a ``global'' rule that is ineffective is worse than no 
global rule at all. This is because if all the world's major markets 
adopt the same rule and it fails, then financial contagion can spread 
throughout the world, not just one country.
    Global harmonization of standards creates some economic benefits by 
making operations in multiple countries more convenient and less 
complicated for global banks. These benefits must however be weighed 
against the risks that a ``one size fits all'' global rule may not work 
well in many individual markets because of differences in volatility, 
market size, the nature of the investor base or other economically 
relevant factors. Countries where the local regulator goes beyond the 
``global'' norms to impose tougher standards on local banks, as the 
Bank of Spain did with reserves for derivatives and certain types of 
loans in the past few years, are better protected than those that have 
only a ``global'' standard that was worked out in international horse 
trading.
    When we back tested this proposed new lower capital standard 
against historic trading data from the 1987 Crash, the SEC staff found 
that the theoretical asset correlations didn't always work. As a 
result, firms that had followed the proposed rule would have failed 
(unlike the actual experience, where major firms did not fail because 
the SEC capital standards gave enough buffer for losses to prevent 
failures) when the market came under unexpected and extreme stress.
    My colleagues and I simply said ``No'' and kept our capital 
standards high in that case because we didn't believe the proposed new 
standard was ready for use. Here my fellow Commissioners and I believed 
in the KISS principle. It is a certainty that over time markets will 
encounter problems of liquidity or valuation that nobody anticipated. 
If you have enough capital and are conservatively financed, you will 
survive and won't risk massive loss to your investors, clients or 
taxpayers.
    This experience illustrates to me the very real risks that will be 
created by a ``systemic'' regulator if we try to do that, as well as 
from further ``globalization'' of regulation that makes the job of 
writing rules targeted narrowly to control specific risks more 
cumbersome. Active coordination across agencies and borders is vital to 
make sure that information and perspectives on risk are effectively 
communicated. Colleges of regulators work, and add real value.
    However, going beyond that to impose uniformity, especially on 
something like ``systemic risk'' that isn't even defined, quite 
possibly will end up making regulation more costly, less flexible and 
potentially weaker rather than stronger. An agency will adopt rules 
that sound great, but just may not work for one of a million reasons. 
That is a particular danger if the ``systemic'' regulator is free to 
overrule other agencies with more specific knowledge. The first thing a 
czar of ``systemic risk'' is likely to do is to create new systemic 
risk because whatever that agency chooses to look at may take on 
immediate ``too big to fail'' perceptions, and the moral hazards that 
go with that status. My preference would be to have a unified or lead 
banking supervisory agency, and active dialogue and discussion among 
agencies rather than putting the entire economy in one agency's 
straightjacket.
    There will inevitably also be risks to the independence of the Fed 
if it performs a systemic regulator's role, because you cannot allow an 
agency to impose needless costs on the entire economy without political 
accountability. When they fail to do anything about the next subprime 
issue, inevitably the Fed's stature will be tarnished. To me, we would 
lose a great deal from distracting the Fed's focus from monetary policy 
and stability of prices to have them traipsing around the country 
trying to figure out what risks GE or IBM pose to the economy.

D. Reorganization of Failed Firms
    As SEC Chairman, I handled the 1990 closure and bankruptcy filing 
of Drexel Burnham Lambert, then one of the largest U.S. securities 
firms. We were able to prevent any losses to Drexel customers without 
cost to the taxpayers in our closure of Drexel. We froze and then sold 
the firm's regulated broker dealer, transferring customer funds and 
accounts to a new owner without loss. Having protected the regulated 
entity and its customers, we refused to provide assistance to the 
holding company parent that had a large ``unregulated'' portfolio of 
junk bonds financed by sophisticated investors (including several 
foreign central banks that were doing gold repos with Drexel's holding 
company parent).
    Though there were those who wanted us to bail Drexel out, we forced 
the holding company into Chapter 11 instead, and let the courts sort 
out the claims. A similar approach would work today for AIG and its 
unregulated derivative products unit, which could be left to sort out 
its claims from swaps customers in bankruptcy without taxpayer 
financing. This approach of stopping the safety net at regulated 
subsidiaries can be very helpful in unwinding failed firms where there 
are both regulated and unregulated entities at less cost and less 
damage to market disciplines than excessively broad bailouts.

E. Risk Management
    Risk management is an important responsibility of every firm, and 
every regulator. However, a dangerous by-product of belief that we can 
manage risk in a very sophisticated manner is a willingness to tolerate 
higher levels of risk. After all, as long as risk is being ``managed'' 
it ought to be ok to have more of it. Ultimately unanticipated problems 
arise that cause even highly sophisticated models to fail to predict 
real life accurately.
    Every risk management system, and every risk adjusted capital rule, 
needs a minimum standard that is simple and comprehensive. Tangible 
capital as a percentage of total assets is a more comprehensive, and 
more reliable, measure of capital than the highly engineered ``Tier 
One'' Basle capital standards. I believe Congress should seriously 
study mandating that U.S. banking regulators establish a minimum 
percentage of tangible capital to total assets even if international 
capital rules might allow a lower number. Creating a ``solvency floor'' 
would have prevented at least some of the failures we have experienced.

F. Credit Rating Problems
    The credit rating agencies failed in evaluating the risk of 
``structured products''. In part this reflects inherent conflicts of 
interest in the ``for profit'' structure of the rating agencies and 
their reliance on fees from people seeking ratings in order to generate 
their own earnings growth. Unfortunately a ``AAA'' rating acts as an 
effective laughing gas that leads many investors to avoid necessary due 
diligence or healthy levels of skepticism. If the structured mortgage 
instruments that devastated the economies of the western world had been 
rated BBB, or even A-, a great many of the people (including boards and 
regulators) who got clobbered would have looked more carefully at the 
risks, and bought less. There is a serious issue of conflict of 
interest in getting paid to legitimize the risk in a highly complex 
``structured'' product laced with derivatives.

G. Levered Short Selling
    Short selling doesn't have the same benefit to the public as normal 
long investing. While short selling creates liquidity and shouldn't be 
prohibited, it doesn't have to be favored by regulators either. In my 
opinion the SEC should never have eliminated the uptick rule, which 
inhibits to some degree the ability of short sellers to step on the 
market's neck when it is down. Beyond that, I believe that regulators 
should seriously consider imposing margin requirements as high as 100 
percent on short positions. Leveraging short positions simply creates 
extreme downward pressure on markets, and may seriously impair market 
stability.

H. Credit Default Swaps
    The CDS market is large, but it lacks transparency. It may also 
involve unhealthy incentives to buy securities without adequate capital 
or study on the false presumption that you can always buy 
``protection'' against default later. We don't appear to have enough 
capital for our primary financial institutions such as banks, insurance 
companies and brokerage firms, and there surely isn't enough capital 
available to ``insure'' every risk in the markets. But if the risks 
aren't really insured, then what are the swaps?
    Another thing that is troubling is the ability to use the CDS 
market for highly levered speculative bets that may create incentives 
to manipulate other markets. I can't buy fire insurance on my 
neighbor's house due to obvious concerns about not inciting arson. Yet 
hedge funds that didn't own any Lehman debt were free to hold default 
swap positions which would prove highly profitable if Lehman failed, 
and also to engage in heavy short selling in Lehman shares. I am 
concerned about allowing that much temptation in an unregulated and 
very opaque market, especially if taxpayers are supposed to underwrite 
it (although I can't comprehend that either).
    This is a market that certainly would benefit from greater 
oversight and transparency, particularly as to counterparty risk. It 
would be worthwhile for an interagency group to consider appropriate 
limits on issuance or reliance on credit default swaps by regulated 
firms within the ``official'' safety net. There are huge and very murky 
risks in this market, and it might be prudent to consider limiting the 
dependence of regulated firms on this opaque corner of the markets.

I. Regulatory Reform
    Immediately prior to my service as SEC Chairman, I served as 
Assistant to the President in the White House under President George 
H.W. Bush where I helped lead the Administration's highly successful 
1989 program to deal with the +$1 Trillion savings and loan crisis. 
This program was embodied in legislation called FIRREA that was passed 
by Congress in the summer of 1989. As some of you will remember, the 
savings and loan crisis, like our current crisis, had grown for years 
without effective government intervention to defuse the mortgage bomb 
of that era. Among other things, we created the Resolution Trust 
Corporation to take hundreds of billions in toxic mortgage assets out 
of bankrupt institutions, repackage them into larger and more coherent 
blocks of assets, and sell them back into private ownership as quickly 
as possible.
    We designed our intervention in the banking system to operate 
swiftly, and to recycle bad assets as quickly as possible rather than 
trying to hold assets hoping they would ultimately go up in value. 
Generally, troubled assets go down, not up, in value while under 
government ownership. Believing that the ice cube is always melting, we 
designed our intervention for speed. We also didn't believe that any 
zombie banks should be allowed to linger on government life support 
competing with healthier firms that had not bankrupted themselves. We 
didn't give bailouts to anyone, but we did provide fast funerals.
    One thing President Bush (41) was adamant about was that the 
taxpayers should never have had to divert hundreds of billions of 
dollars in tax revenues to paying for the mistakes and greed of 
bankers. I quite vividly remember his unambiguous instructions to me to 
design regulatory reforms to go along with the financial intervention 
so that ``as much as humanly possible we make sure this doesn't happen 
again.'' As part of that mandate, we imposed strict capital and 
accounting standards on the S&Ls, merged the FSLIC into the FDIC and 
beefed up its funding, established important new criminal laws (and the 
funding to enforce them), and abolished the former regulatory body, the 
Federal Home Loan Bank Board, which had failed in its supervisory 
responsibilities.
    Hopefully the Treasury's newly announced Public-Private Program for 
purchasing distressed bank assets will work as well as the RTC 
ultimately did. The principles of using private sector funding and 
workout expertise are similar, and this is an encouraging attempt to 
help unlock the current system. Hopefully we will also eventually look 
to marrying taxpayer TARP money with greater accountability and more 
effective oversight as we did then.

II. Specific Reforms
    In response to the Committee's request, set forth below are several 
specific changes in law that I believe would improve the current system 
of investor protection and regulation of securities markets.

    1. Merge the SEC, CFTC, and PCAOB into a single agency that 
oversees trading in securities, futures, commodities and hybrid 
instruments. That agency should also set disclosure standards for 
issuers and the related accounting and audit standards. Most 
importantly, this agency would be primarily focused on enforcing 
applicable legal standards as the SEC has historically done. These 
closely intertwined functions have nothing to do with bank regulation, 
but a great deal to do with each other. I do not suggest a merger out 
of any lack of respect for each of the three agencies. However, a 
merger would help eliminate overlap and duplication that wastes public 
resources, and also reduces effectiveness. If a similar consolidation 
occurred of the bank supervisory programs of the Fed, the Treasury and 
the FDIC, then we would have a strong agency regulating banks, and 
another strong agency regulating public companies, auditors, and 
trading markets.

    2. Allow the five (or ten) largest shareholders of any public 
company who have owned shares for more than 1 year to nominate up to 
three directors for inclusion on any public company's proxy statement. 
Overly entrenched boards have widely failed to protect shareholder 
interests for the simple reason that they sometimes think more about 
their own tenure than the interests of the people they are supposed to 
be protecting.
    This provision would give ``proxy access'' to shareholder 
candidates without the cost and distraction of hostile proxy contests. 
At the same time, any such nomination would require support from a 
majority of shares held by the largest holders, thereby protecting 
against narrow special interest campaigns. This reform would make it 
easier for the largest shareowners to get boards to deal with excessive 
risks, poor performance, excessive compensation and other issues that 
impair shareholder interests.

    3. Reverse or suspend the SEC decision to abandon U.S. accounting 
standards and to adopt so-called ``International Financial Reporting 
Standards'' for publicly traded firms headquartered in the U.S. At a 
time of the greatest investor losses in history and enormous economic 
stress, forcing every company to undergo an expensive transition to a 
new set of accounting standards that are generally less transparent 
than existing U.S. standards is not in investor's interests. This will 
avoid considerable unproductive effort at a time businesses need to 
minimize costs and focus on economic growth, not accounting changes. 
Investors need more transparency, not less, and the SEC should not 
abdicate its role of deciding on appropriate accounting and auditing 
standards for firms publicly traded in the U.S.

    4. Broaden the ability of shareowners to put nonbinding resolutions 
on any topic related to a company's business on its annual proxy 
statement, including any proposal by shareholders relating to the 
manner of voting on directors, charter amendments and other issues. 
Legislation would clarify the confusing law relating to the ability of 
shareholders to hold a referendum on whether a company should adopt 
majority voting for directors, for example. Shareholders own the 
company, and in the internet age there is no reason to limit what 
shareholders can discuss, or how they may choose to conduct elections 
for directors. SEC resources should no longer be devoted to arbitrating 
whether shareholders should be allowed to vote on resolutions germane 
to a company's business.

    5. Prohibit ``golden parachute'' payments to the CEO or other 
senior officers of any public company, in the same way that Sarbanes 
Oxley prohibits loans to such executives. Golden parachutes have proven 
to be extraordinarily abusive to shareholders, and boards have proven 
themselves unable to control excessive payouts. Eliminating 
supercharged severance will not unduly prejudice any company's ability 
to recruit since no company will be able to offer or make abusive 
awards to failed executives. This provision would NOT prohibit signing 
bonuses or annual bonuses, as it would solely apply to payouts to 
executives who are departing rather than continuing to work. The fact 
is that paying failed executives to walk out the door after damaging or 
destroying their company is wrong, and it is part of the culture of 
disregard of shareholder interests that needs to change.

    6. Split the roles of Chairman of the Board and CEO in any company 
that receives federal taxpayer funds, or that operates under federal 
financial regulation. The traditional model of a Chairman and CEO 
combined in one individual weakens checks and balances and increases 
risks to shareholders compared with firms that separate those 
positions. Splitting these roles and requiring a prior shareholder vote 
to reintegrate them would reduce risks and improve investor protection.

    7. Eliminate broker votes for directors unless any such vote is at 
the specific direction of a client. Brokers should not cast votes on an 
uninstructed basis to avoid unwarranted entrenchment of incumbents or 
tipping the outcome of elections under federal proxy rules. Indeed, it 
may be time to consider a broader Shareholder Voting Rights Act to 
address many barriers to effective shareholder exercise of the vote.

    8. Establish a special ``systemic bankruptcy'' court composed of 
federal District or Circuit Court judges with prior experience in large 
bankruptcy or receivership cases similar to the Foreign Intelligence 
Surveillance Court. This new Systemic Court would handle the largest 
and systemically important bankruptcies with enhanced powers for 
extraordinary speed and restructuring powers. Use of such a Systemic 
Court would help limit ad hoc decisions by administrative agencies 
including the Fed or Treasury in handling large financial institution 
failures and treatment of different types of classes of securities from 
company to company.
    Utilizing a court with enhanced and expedited reorganization powers 
would allow reorganization or conservatorship proceedings rather than 
nationalization, and would facilitate the ability to break up and 
reorganize the largest failed firms under highly expedited Court 
supervision. Fed and Treasury officials would be able to focus on 
liquidity assistance under the aegis of the Systemic Court, which would 
allow enhanced priorities for taxpayer funds and control of 
compensation and other nonessential expenses. The Systemic Court should 
be authorized to appoint a corporate monitor in any case pending before 
it to control compensation expense or other issues.

    9. Establish effective and meaningful limitations on leverage in 
purchases of securities and derivative instruments where any person or 
entity is borrowing from a federally supervised bank or securities 
firm, or where such firms are establishing positions for their own 
account.

    10. Establish a permanent insurance program or liquidity facility 
for money market funds. Given recent experience, the uninsured nature 
of MMFs is an uncomfortably large risk to market stability.

    11. Establish strict liability for any rating agency if it awards a 
AAA or comparable other top rating grade to a security of a 
nonsovereign issuer that defaults within 3 years of issuance. While I 
would not create private rights of action for any other rating 
decisions, rating agencies should appreciate that awarding a AAA 
overrides many investor's normal diligence processes, such that 
liability is warranted if the agency proves to be wrong. The SEC should 
generally revoke commercial ratings as an element of its disclosure or 
other regulations.

    12. Eliminate the deductibility of mortgage interest and replace it 
with deductibility of mortgage principal payments with appropriate 
overall limits. This would create incentives for paying off family 
debt, not perpetuating the maximum possible level of mortgage debt. At 
the same time, such a provision would result in significant new 
liquidity for banks as borrowers repaid performing mortgage loans. 
Middle class families would see real wealth increase if deductibility 
allows the effective duration of home mortgage loans to be reduced from 
30 years to 15 years, for example, saving an average family hundreds of 
thousands of dollars in interest. Federal assistance would help 
families reduce the level of their debt, thereby strengthening the 
economy and boosting savings.
    Thank you for your consideration of these views and ideas.

                  PREPARED STATEMENT OF ARTHUR LEVITT
                            Former Chairman,
                   Securities and Exchange Commission
                             March 26, 2009

    Thank you, Chairman Dodd and Ranking Member Shelby, for the 
opportunity to appear before the Committee at this critical moment 
facing our markets, our economy, and our Nation.
    When I last appeared before this Committee, I focused my remarks on 
the main causes of the crisis we are in, and the significant role 
played by deregulation. Today, I would like to build upon that 
testimony and focus your attention on the prime victim of 
deregulation--investors. Because of failures at every level of our 
financial system, investors no longer feel that they receive correct 
information or enjoy meaningful protections. Their confidence in fair, 
open, and efficient markets has been badly damaged. And not 
surprisingly, our markets have suffered from this lack of investor 
confidence.
    Above all the issues you now face, whether it is public anger over 
bonus payments or the excesses of companies receiving taxpayer 
assistance, there is none more important than investor confidence. The 
public may demand that you act over some momentary scandal, but you 
must not give in to bouts of populist activism. Your goal is to serve 
the public not by reacting to public anger, but by focusing on a system 
of regulation which treats all market actors the same under the law, 
without regard to their position or status.
    In coming months, you will adopt specific regulatory and policy 
solutions to the problems we face, yet none of that work will matter 
much unless we find a way to restore investor confidence. If at the end 
of the process you don't place investor confidence at the heart of your 
efforts, no system of regulation and no amount of spending on 
regulatory agencies can be expected to succeed.

Core Principles
    You are focusing now on the issue of systemic risk, and therefore 
whatever response you take must be systemic as well. Specifically, some 
have suggested that we should re-impose Glass-Steagall rules regarding 
the activities and regulation of banks. Those rules kept the Nation's 
commercial banks away from the kinds of risky activities of investment 
banks. But by 1999, the law no longer had the same teeth--multiple 
workarounds had developed, and it no longer was practical to keep it in 
place. Perhaps we were too hasty in doing away with it, and should have 
held onto several key principles that made Glass-Steagall an effective 
bulwark against systemic risk in America's banking sector. That does 
not mean we should pursue ``turn-back-the-clock'' regulation reforms 
and re-impose Glass-Steagall. The world of finance has changed greatly 
since 1999 and we have to change with it. But we can borrow some 
important principles from Glass-Steagall, apply them to today's 
environment, as we address the serious weaknesses of our current system 
of financial regulation.
    Those principles, in short, are:
    Regulation needs to match the market action. If an entity is 
engaged in trading securities, it should be regulated as a securities 
firm. If an entity takes deposits and holds loans to maturity, it 
should be regulated as a depository bank. Moreover, regulation and 
regulatory agencies must be suited to the markets they seek to oversee. 
Regulation is not one size fits all.
    Accounting standards serve a critical purpose by making information 
accessible and comprehensible in a consistent way. I understand that 
the mere mention of accounting can make the mind wander, but accounting 
is the foundation of our financial system. Under no circumstances 
should accounting standards be changed to suit the momentary needs of 
market participants. That principle supports mark-to-market accounting, 
which should not be suspended under any condition.
    The proper role of a securities regulator is to be the guardian of 
capital markets. There is an inherent tension at times between 
securities regulators and banking supervisors. That tension is to be 
expected and even desired. But under no circumstance should the 
securities regulator be subsumed--if your goal is to restore investor 
confidence, you must embolden those who protect capital markets from 
abuse. You must fund them appropriately, give them the legal tools they 
need to protect investors, and, most of all, hold them accountable, so 
that they enforce the laws you write.
    And finally, all regulatory reforms and improvements must be done 
in a coordinated and systemic way. The work of regulation is rarely 
done well in a piecemeal fashion. Rather, your focus should be to 
create a system of rules that comprise a complete approach, where each 
part complements the other, and to do it all at once.

Specific Reforms
    Allow me to illustrate how these principles can be put to work, in 
specific regulatory and policy reforms:
    First: Some have suggested that you create a single super-
regulator. I would suggest that a more diverse approach should be 
adopted, taking advantage of the relative strengths of our existing 
regulatory agencies. For example, the Federal Reserve, as a banking 
supervisor, has a deep and ingrained culture that is oriented towards 
the safety and soundness of our banking system. But when banks--or any 
financial institution--engage in securities transactions, either by 
making a market in securities, or by securitizing and selling loans, or 
by creating derivatives backed by equities or debt, they fundamentally 
require oversight from trained securities regulators.
    What serves the health of banks may run exactly counter to the 
interests of investors--and we have seen situations where bank 
regulators have kept information about poorly performing assets from 
the public in order to give a bank time enough to dispose of them. In 
that case, banking regulators will work at cross-purposes with 
securities regulators.
    Ultimately, the only solution to that tension is to live with it. 
When I was at the SEC, there was tension between banking regulators and 
securities regulators all the time. This creative tension served the 
ultimate goal of reducing overall risk to our economy, even if it 
occasionally was frustrating for the regulators and the financial 
institutions themselves. And so we should not be surprised if 
regulatory reforms yield a bit of regulatory overlap. That is both 
natural, considering the complexity of financial institutions, and even 
desirable.
    Second: Mark to market or fair value standards should not be 
suspended under any circumstance. Some have come forward and suggested 
that these are unusual times, and we need to make concessions in our 
accounting standards to help us through it. But if we obscure investor 
understanding of the value of assets currently held by banking 
institutions, we would exacerbate the crisis, and hurt investors in the 
bargain. Unfortunately, recent steps taken by the FASB, at the behest 
of some politicians, weaken fair value accounting.
    Those who argue for a suspension of mark-to-market accounting argue 
this would punish risk-taking. I strongly disagree. Our goal should be 
to make sure risk can be priced accurately.
    Failure to account for risk, and failure to present it in a 
consistent way, makes it impossible to price it, and therefore to 
manage it. And so any effort that seeks to shield investors from 
understanding risk profiles of individual banks would, I believe, be a 
mistake, and contribute to greater systemic risk.
    I would add that mark-to-market accounting has important value for 
internal management of risk within a firm. Mark-to-market informs 
investment bank senior managers of trading performance, asset prices, 
and risk factor volatilities. It supports profit and loss processes and 
hedge performance analyses, facilitates the generation and validation 
of risk metrics, and enables a controlled environment for risk-taking. 
If treated seriously by management, mark-to-market is a force for 
internal discipline and risk management, not much different than a 
focus on internal controls. Yes, valuing illiquid or complex structured 
products is difficult. But that doesn't mean the work should not be 
done. I would argue that it has to be done, both inside the firm and by 
those outside it, to reduce risk throughout our system.
    And so I agree with the Chairman of the Federal Reserve, and the 
heads of the major accounting firms, that the maintenance of mark-to-
market standards is essential.
    Third: As this Committee and other policymakers seek to mitigate 
systemic risk, I would suggest taking a broad approach to the 
challenge. It would be a mistake, I believe, to designate only one 
agency to focus on systemic risk, because systemic risk emanates in 
multiple ways. You may find the task best accomplished by enacting a 
series of complementary regulatory enhancements aimed at promoting 
transparency and information discovery across multiple markets.
    Those remaining pockets of financial activity covered by self-
regulation and protected from litigation should be brought in under a 
more vigorous regulatory structure with fully independent regulators 
and legal remedies. For years, credit ratings agencies have been able 
to use legal defenses to keep from the SEC from inspecting the way they 
do their ratings the way the PCAOB is empowered to examine the way 
audits are done, even though these agencies dispense investment advice 
and sit at a critical nexus of financial information and potential 
risk. In addition, these ratings agencies cannot be fined by the SEC 
and they operate with significant protections from private rights of 
action. These protections from regulatory review and legal remedies 
need to be reconsidered. The credit ratings agencies have an abysmal 
record of performance in recent years and their failure has had an 
outsized impact on the health of our entire financial system. They are 
not merely expressing views that would ordinarily receive legal 
protections. They are playing a much larger role, and their activities 
should be treated in the same way as other market actors who are 
subject to SEC review and regulation.
    In the same manner, the SEC should have a far greater role in 
regulating the municipal bond market, which consists of state and local 
government securities. This is the market where Wall Street and Main 
Street collide. Since the New York City crisis of 1975, this market has 
grown to a size and complexity that few anticipated.
    It now includes not-for-profit institutions and even for-profit 
business corporations who sell securities through government conduit 
entities. The debt and derivative products sold are substantially the 
same as those sold in the corporate market. Small investors make up a 
substantial part of this market and because of the Tower Amendment many 
participants--insurers, rating agencies, financial advisors to issuers, 
underwriters, hedge funds, money managers and even some issuers--have 
abused the protection granted by Congress from SEC regulation.
    This market has shown that self-regulation by bankers and brokers 
through the Municipal Services Rulemaking Board all too often has come 
at the expense of the public interest. The New York City debacle in 
1975, the San Diego pension fund fraud in 2006, the Orange County 
California derivatives crisis in 1994, the Washington Public Power 
System defaults in 1980, the auction securities settlements of 2008, 
and the current investigations into derivatives, bid rigging, pay to 
play and other scandals--this is an industry prone to scandal.
    In recent months, we have even seen several well-documented 
scandals where small municipalities and public agencies were encouraged 
to float bonds even though the money was not to be spent on public 
purposes, but rather used as an investment pool. We may not want to 
treat municipals like we do other securities--but we do need to level 
the playing field between the corporate and municipal markets and 
address all risks to the financial system. Municipal issuers are ill-
equipped and some are reluctant to do this on their own. We may have to 
develop ways protect small municipal issuers from over regulation just 
as we do for small corporations, so long as we do not develop a double 
standard for principles of disclosure, transparency, finance and 
compliance with market rules. Former Chairman Cox has suggested 
granting the SEC authority to regulate the municipal bond industry to 
promote integrity, competition and efficiency, and I agree.
    In addition, I would also recommend amending the Investment 
Advisers Act to give the SEC the right to oversee specific areas of the 
hedge fund industry and other pockets of what some have called the 
``shadow markets''--those areas of finance beyond the oversight of 
regulators. In particular, I would urge that you require banks and 
hedge funds create an audit trail and clearinghouse for all trades, to 
create a better awareness of investment products that could pose risks 
to overall markets. I would also recommend placing hedge funds under 
SEC regulation in the context of their role as money managers and 
investment advisors.
    There will be some who argue that SEC oversight of some aspects of 
hedge funds will come at the expense of financial market innovation. In 
fact, such regulation could help improve the environment for financial 
innovation. For example, we know that new investment vehicles can be a 
source for risk even as they supply investors with a desired financial 
product. How do we balance those competing qualities? Perhaps the SEC 
could increase the margin requirement for the purchase of new products, 
until those products are road-tested and have developed a strong 
history of performance in different economic conditions.
    Nor are all forms of regulation going to simply involve more 
disclosure requirements. I could see a greater focus on better 
disclosure, so that investors and regulators receive information that 
has more value. For example, a system that allows financial 
institutions to make their own risk assessments, or relies on credit 
rating agencies for purposes of determining how much capital they 
should have, lacks adequate independence and credibility. At the same 
time, adopting a one size fits all approach is likely to be 
shortsighted and ineffective.
    As SEC Chairman, I favored risk-based principles for regulation, 
and think greater application of those principles is needed. Such a 
system should be forward-looking, independent and free of bias in its 
assessment of risks and liquidity needs within an entity, overseen by a 
regulator with a mission, culture and necessary resources to do the 
job, and finally, be fully transparent not only to regulators but also 
to investors, taxpayers and Congress. Such a system would be far more 
useful than our current system. And it would contribute greatly to our 
awareness of potential sources of systemic risk.
    These steps would require OTC derivative market reform, the outcome 
of which would be the regulation by the SEC of all credit and 
securities derivatives. To make this regulation possible and efficient, 
it would make sense to combine the resources and responsibilities of 
the SEC and CFTC. In today's financial markets, the kinds of financial 
instruments regulated by these two agencies share much in common as 
economic substitutes, and this change would allow regulators to share 
their skillsets, coordinate their activities, and share more 
information, thus providing a deeper level of understanding about risk.
    Supporting all these activities will require an appropriately 
funded, staffed and empowered SEC. Under the previous administration, 
SEC funding and staffing either stayed flat or dropped in significant 
areas--enforcement staff dropped 11 percent from 2005 to 2008, for 
example. We have seen that regulators are often overmatched, both in 
staffing and in their capacity to use and deploy technology, and they 
can't even meet even a modest calendar of regular inspections of 
securities firms. Clearly, if we are to empower the SEC to oversee the 
activities of municipal bond firms and hedge funds, we will need to 
create not only a stronger agency, but one which has an adequate and 
dedicated revenue stream, just as the Federal Reserve does.
    My final recommendation relates to something you must not do. Under 
no condition should the SEC lose any of its current regulatory 
responsibilities. As the primary guardian of capital markets, the SEC 
is considered the leading investor representative and advocate. Any 
regulatory change you make that reduces the responsibility or authority 
of the SEC will be viewed as a reduction in investor protections. That 
view will be correct, because no agency has the culture, institutional 
knowledge, staff, and mission as the SEC to protect investors.

Conclusion
    These actions would affirm the core principles which served the 
Nation's financial markets so well, from 1933 to 1999--regulation 
meeting the realities of the market, accounting standards upheld and 
strengthened, regulators charged with serving as the guardians of 
capital markets, and a systemic approach to regulation. The resulting 
regulatory structure would be flexible enough to meet the needs of 
today's market, and would create a far more effective screen for 
potential systemic risks throughout the marketplace. Financial 
innovations would continue to be developed, but under a more watchful 
eye from regulators, who would be able to track their growth and follow 
potential exposure. Whole swaths of the shadow markets would be exposed 
to the sunlight of oversight, without compromising the freedom 
investors have in choosing their financial managers and the risks they 
are willing to bear.
    Most importantly, these measures would help restore investor 
confidence by putting in place a strong regulatory structure, enforcing 
rules equally and consistently, and making sure those rules serve to 
protect investors from fraud, misinformation, and outright abuse.
    These outcomes won't come without a price to those who think only 
of their own self-interest. As we have seen in the debate over mark-to-
market accounting rules, there will be strong critics of strong, 
consistent regulatory structure. The self-interested have reasons of 
their own to void mark-to-market accounting, but that does not make 
them good reasons for all of us. Someone must be the guardian of the 
capital market structure, and someone must think of the greater good. 
That is why this Committee must draw on its heritage of setting aside 
partisanship and the concerns of those with single interests, and 
maintain a common front to favor the rights of the investor, whose 
confidence will determine the health of our markets, our economy, and 
ultimately, our Nation.
                                 ______
                                 

                  PREPARED STATEMENT OF PAUL S. ATKINS
                          Former Commissioner,
                   Securities and Exchange Commission
                             March 26, 2009

    Thank you very much, Mr. Chairman, Ranking Member Shelby, and 
Members of the Committee, for inviting me to appear today at your 
hearing. It is an honor and privilege for me to provide information for 
your deliberations on possible legislation regarding the U.S. financial 
markets. This Committee has a long history of careful study and 
analysis of matters relating to the financial markets and the financial 
services industry.
    There are multiple, complex, and interrelated causes to the current 
situation in the global financial markets. These causes have been 
decades in the making. Those who would tell you otherwise are simply 
misguided, have ulterior motives, or are unaware of the intricacies of 
global finance. These causes are more than the competence or 
incompetence of individuals in particular roles, but have more to do 
with fundamental principles of organizational behavior and incentives.
    Your topic for today is rather broad, so I would like to touch on a 
few specific items that go to the heart of an agency that I know very 
well--the Securities and Exchange Commission. I have been working in 
and around the SEC for all of my professional career. I have spent 
almost 10 years as a staff member and as a Commissioner. In 15 years of 
private practice I have applied the Commission's regulations in 
transactions and in real business situations. In the course of my work, 
I have interacted with every one of the SEC's divisions and offices in 
one way or another.
    With respect to the subject of regulatory reform, I would suggest 
that you ask very hard questions in subsequent hearings: For example, 
why has the SEC in the course of the past dozen years or so experienced 
catastrophic failures in every one of its four core competencies--
rulemaking, filing review, enforcement, and examinations? What led to 
failures at the SEC and other regulatory agencies--both in the United 
States and globally--to discern the increasing risk to financial 
institutions under their jurisdiction? What led to failures at 
financial institutions to recognise the inadequacy of their own risk 
management systems and strategy in time to avert a collapse? How did 
many investors get lulled into complacency and not adequately do their 
own due diligence? What is the proper role of credit rating agencies, 
and has regulation fostered an oligopoly by recognizing the opinions of 
a few as being more privileged than the rest?
    Your challenge in formulating laws and regulations is that every 
action leads to a reaction, just as in physics. Just as investors 
should know that there is no riskless or easy way to make money, 
policymakers should know that there is no riskless or easy way to 
oversee the financial markets. I respectfully submit that changes to 
the securities laws should be made carefully and with the knowledge 
that modern financial services is a quickly evolving industry. Sooner 
or later the markets will stabilize, depending on what actions 
governments take. The goal should be a balance, using the facts as they 
best can be discerned, through a robust analysis of the costs and 
benefits of various potential actions and how those actions might 
affect human behavior. The current situation is certainly no time to 
``wing it'' or act on ``gut'' instinct. The weighing of costs and 
benefits is vital, because investors ultimately pay for regulation. If 
regulations impose costs without commensurate benefits, investors 
suffer the costs of lack of effectiveness and efficiency, not only 
through higher prices but also through constrained investment 
opportunities. That ultimately hurts them in their investment 
performance, because it means less opportunity for diversification.
    Why should we care about the capital markets? Despite all of the 
recent gloomy and tragic news of the past couple of years, we must not 
forget that one of the most important underlying purposes of our 
capital markets is to allow entrepreneurs with great new ideas to make 
their dreams possible by raising capital, thereby helping the economy 
grow by creating jobs, improving the lives of consumers through 
producing innovative products, and providing a return to investors who 
have risked their savings to help finance that entrepreneur's dream. 
This is the role--and genius--of the United States capital markets that 
has helped our economy to be the engine of the world's growth and made 
our standard of living the best in the world.
    Notwithstanding the current economic conditions, I feel confident 
that the role of the United States capital markets will return to what 
it was, barring ill-advised legislation or regulatory actions. An 
example of legislation that had a detrimental effect on the 
attractiveness of U.S. markets was the so-called Interest Equalization 
Tax, a short-lived tax imposed in 1963 on borrowing by U.S. and foreign 
companies in the U.S. The goal was to encourage capital to stay in this 
country and to equalize the costs between selling debt and equity 
securities. It essentially backfired when U.S. companies found that 
they could issue dollar-denominated debt in London, avoiding the tax 
and increasing yields. The London markets, which had yet to fully 
recover after World War II, experienced a boom in size and credibility 
that eventually led them to eclipse the U.S. in some benchmarks by 
2007.
    We should not forget that just prior to the recent problems in the 
credit markets, which began more or less in June 2007 when a small fund 
was closed to redemptions, setting off a world-wide reassessment of the 
creditworthiness of U.S. housing-related debt securities, public 
offerings of securities in the United States were on the decline, 
compared to offerings in the private markets. In fact, in 2006, the 
value of Rule 144A unregistered offerings in the U.S. for the first 
time exceeded the value of public offerings.
    All of this is to suggest that Congress be especially deliberative 
and pragmatic in legislating in this area. The worrisome thing to me is 
that if care is not taken to have solid analysis, the wrong lessons may 
be gleaned from this latest crisis that hurt investors. It takes a long 
time to change legislation in this area. We still have not dug 
ourselves out of some of the mistakes and false premises that drove the 
decision making during the 1930s and 1940s. For example, it took 40 
years for Congress and the SEC to end fixed commissions for brokerage 
services that were essentially imposed by law in the 1930s, and we 
still have many aspects of the so-called ``managed competition'' 
philosophy that led to that policy. We still have the alphabet soup of 
regulators and self-regulatory organizations in the financial services 
industry, with all of the distortions and inefficiencies that have 
contributed to the current crisis and become so painfully evident to 
the world. Many have complained about this situation for years, but 
others have opposed any restructuring as ``dangerously deregulatory,'' 
and ignored the inherent systemic risks, overlapping jurisdiction, turf 
wars, and wasted resources of the current structure.
    In the wake of the stock market crash of 1929, over the next decade 
this Committee and others held many hearings and explored the abuses in 
the marketplace including conflicts of interest, shady transactions 
with affiliates, less-than-adequate disclosure, and squirrelly 
valuations. Congress responded by passing the Securities Act of 1933, 
the Securities Exchange Act of 1934, the Public Utility Holding Company 
Act of 1935 (``PUHCA''), the Trust Indenture Act of 1939, the 
Investment Advisers Act of 1940, and the Investment Company Act of 
1940, among other laws.
    Many provisions of these laws were helpful to the market and to 
investors and stood the test of time. But, as time passed, it became 
clear that some laws were counter-productive. For example, by the end 
of the 20th century, PUHCA was cited as a reason for a relative paucity 
of investment in the electric and gas utility industry. In fact, for 
the first 25 years of its existence, the SEC's main task was to break 
up interstate investor-owned electric and gas utilities by using PUHCA. 
This was the investment management division's primary job, and more 
people were devoted to this mission than any other at the SEC for more 
than 20 years. By the end of the 1950s, this mission was mostly 
accomplished. Finally, Congress repealed PUHCA in 2006.
    What lesson can we draw from PUHCA? Congress passed the Act because 
of the self-dealing and manipulation concerning interstate utility 
holding companies in the1920s. Instead of focusing on the problematic 
practices and addressing them directly, Congress reshaped the entire 
industry. What were the unintended consequences? After repeal, for 
example, alternative energy technologies are easier to finance. In 
addition, What would our power industry be like today if a different 
legislative strategy had been pursued originally? What would our 
capital markets be like today if the SEC had spent more of its energy 
for those three decades focusing on more general problems of the 
capital markets?

Forthright Analysis Needed
    Certainly, many mistakes were made by business people, investors, 
and regulators during the past decade, but too many these days are 
looking in hindsight to pass judgement or blame. What we need is an 
analysis to determine how we can efficiently and effectively promote 
honesty and transparency in our markets and ensure that criminality is 
not tolerated.
    For example, some have claimed that ``deregulation'' over the past 
4, 8, or 10 years has led to the current problems in the financial 
markets. One can hardly say that the past 8 to 10 years have been 
deregulatory. The enactment of the Sarbanes-Oxley Act in 2002 led to 
the promulgation by the SEC of more rules in a shorter amount of time 
than ever before. In addition, the last 7 years have seen many new SEC 
and self-regulatory organization rules regarding compliance and 
trading, which have certainly been very regulatory. The Financial 
Accounting Standards Board, the Public Company Accounting Oversight 
Board (``PCAOB''), and the Municipal Securities Rulemaking Board have 
promulgated a host of new rules, standards, and interpretations.
    This attitude that blames our current problems on ``deregulation'' 
is not only completely wrong, but dangerous because it is off the mark. 
If that is what policy makers think is the reason for the current 
situation, then they will have learned the wrong lesson and their 
solutions will cause more problems than they will solve.
    More regulation, for regulation's sake, is not the answer. We need 
smarter regulation. Some say that we need to trust less in the 
marketplace and more in the capabilities of regulators, including a 
putative ability to foresee bubbles and intervene to stop them. That is 
much easier said than done. This assertion ignores the reality that 
what may seem to be a bubble to one person may be another person's 
honest livelihood. What if the regulator is wrong? How will you ever 
know the opportunity cost to individuals or to society as a whole for 
curtailing some particular activity? It is always easier in hindsight 
to say what should have been done. How can you build public policy for 
years in the future on hoped-for brilliance or luck of individual, 
fallible human beings, especially if they are independent, nonelected, 
and essentially unaccountable?
    This global crisis has primarily affected regulated (versus 
nonregulated) entities all around the world, not just in the supposedly 
deregulatory United States. How did so many regulators operating under 
vastly different regimes with differing powers and requirements all get 
it wrong? Indeed, how did so many firms with some of the best minds in 
the business get it wrong? The housing bubble occurred in the US as 
well as the United Kingdom, Ireland, and Spain. Heavily regulated 
financial institutions had problems with their housing-related 
investments not only in the US but also in Germany, Switzerland, 
France, Belgium, Netherlands, Ireland, the United Kingdom, and many 
others.
    We must recognize that businesses ultimately are better than 
governments at business, because both can and do make mistakes. In 
addition, by removing risk management from firms and placing it in the 
hands of government, there is a danger that firms will become careless 
and take on additional risk, believing regulators are protecting them. 
If they believe that the government is backstopping their losses, then 
they may take greater risks, reap the rewards of taking those risks, 
and avoid the consequences if things go awry. This is the moral hazard 
that we all try to avoid. Regulators have a legitimate interest in 
setting capital standards to control this risk taking, but the ultimate 
risk management function must remain in the hands of the firms that 
face the risk.

What Caused the SEC's Operational Failures?
    During the past dozen years, the SEC has experienced catastrophic 
operational failures in its four core functions of filing review, 
rulemaking, enforcement, and examinations. Enron's corporate filings 
were not reviewed for years in the late 1990s; Congress addressed this 
issue in Sarbanes-Oxley by mandating that the SEC review each issuer's 
filings on a periodic basis. In enforcement and examinations, tips were 
not pursued regarding Bernard Madoff and late trading of mutual funds. 
In rulemaking, the Commission proposed in December 1997 and again in 
April 2005 regulations regarding credit rating agencies, but never 
adopted any. This Committee led the effort to reform the SEC's approach 
to nationally recognized statistical rating organizations (``NRSROs'') 
that culminated in the Credit Agency Reform Act of 2006, but 
unfortunately this statute came too late to affect the crisis in the 
financial markets and the 30-year history of NRSRO regulation.
    The SEC to its credit and benefit has attracted many hard-working, 
bright, energetic staff members over its history. But, these mistakes 
were caused by failures of senior management, rather than by staff 
members. First, management applied faulty motivational and review 
criteria. Second, since resources are always limited, there is an 
opportunity cost in choosing to spend time and resources on one thing, 
because there is less time and fewer resources to spend on other 
things. Unfortunately, the SEC suffered from poor prioritization 
decisions during the critical years of 2003-2005 when the market for 
collateralized debt obligations and credit default swaps started to 
explode and its trajectory could have been diverted.
    Some argue that low pay or poor morale contributed to these 
failures. Thanks to this Committee through the Sarbanes-Oxley Act, pay 
caps were removed from SEC staff pay in 2002. When I left the SEC, more 
than half of the 3,500 employees earned more than I did as a 
commissioner and many earn more than the chairman. Today, a staff 
attorney or accountant (SK-14) earns nearly $168,000 in Washington, DC 
($177,000 in New York), and senior managers earn well in excess of 
$200,000.
    As with anyone else, I am sure that SEC employees would like more 
pay, but how much should they be paid? As much as PCAOB board members, 
who earn more than the President? As with most government employees, 
the vast majority of SEC employees go to work because they like their 
job and they are committed to the agency's mission. In addition, they 
have job security and other benefits that cannot be duplicated in the 
private sector.
    Management Failures. Management philosophies like Total Quality 
Management and Six Sigma teach that in any organization, measurement 
drives human behavior because the incentive is to try to meet the 
measurement criteria (``You get what you measure'').
    Essentially, Enron was not reviewed for years because review 
personnel were judged by how many filings they reviewed, not 
necessarily by the quality of their review. The incentive was to 
postpone review of the complicated Enron filing because one could 
review many others in the time it would take to review Enron. By the 
late 1990s, this focus on numbers more than quality had decreased staff 
morale so much that employees began to organize to form a union. 
Despite management's campaign to thwart it, in July 2000 SEC employees 
voted overwhelmingly to unionize the workforce.
    The emphasis on numbers over quality also affects behavior in the 
enforcement division and examination office. Every enforcement attorney 
knows that statistics (or ``stats'') help to determine perception and 
promotion potential. The statistics sought are cases either brought and 
settled or litigated to a successful conclusion, and amount of fines 
collected. These statistics do not necessarily measure quality (such as 
an investigation performed well and efficiently, but the evidence 
ultimately adduced did not indicate a securities violation). Thus, the 
stats system does not encourage sensitivity to due process.
    In addition, the stats system tends to discourage the pursuit of 
penny stock manipulations and Ponzi schemes, which ravage mostly retail 
investors. These frauds generally take a long time and much effort to 
prove--the perpetrators tend to be true criminals who use every effort 
to fight, rather than the typical white-collar corporate violator of a 
relatively minor corporate reporting requirement who has an incentive 
to negotiate a settlement to put the matter behind him and preserve his 
reputation and career. Thus, over the years several staff attorneys 
have told me that their superiors actively discourage them from 
pursuing Ponzi schemes and stock manipulations, because of the 
difficulty in bringing the case to a successful conclusion and the lack 
of publicity in the press when these cases are brought (with the 
exception of Madoff, these sorts of cases tend to be small). Some 
senior enforcement officers openly refer to these sorts of cases as 
``slip-and-fall'' cases, which disparages the real effect that these 
cases have on individuals, who can lose their life savings in them. 
Because of the interstate and international aspect of many of these 
cases, if the SEC does not go after them, no one can or will.
    During my tenure as commissioner, I emphasized the need to focus 
from an enforcement perspective on microcap fraud, including Ponzi 
schemes, pump-and-dump schemes, and other stock manipulations. I was a 
strong advocate for the formation of the Microcap Fraud Group in the 
Enforcement Division, which as finally formed in 2008. I also strongly 
support the good efforts of the Office of Internet Enforcement, 
established under Chairman Levitt in the late 1990s, which works 
closely with other law enforcement agencies to tackle internet and 
other electronic fraud.
    There are many intelligent, competent, dedicated, hard-working 
people at the SEC. It is the management system and how it determined 
priorities over the past decade that has let them down. Last year in an 
article published in the Fordham Journal of Corporate and Financial 
Law, \1\ I called for the SEC to follow the example from 1972 of 
Chairman William Casey, who formed a committee to review the 
enforcement division--its strategy, priorities, organization, 
management, and due-process protections. Thirty-seven years later, and 
especially after the Madoff incident, this sort of review is long 
overdue.
---------------------------------------------------------------------------
     \1\ See Paul S. Atkins and Bradley J. Bondi, ``Evaluating the 
Mission: A Critical Review of the History and Evolution of the SEC 
Enforcement Program,'' 8 Fordham Journal of Corp. & Fin. Law 367 
(2008).
---------------------------------------------------------------------------
    The Opportunity Cost of Misplaced Priorities. I believe that the 
SEC was distracted by controversial, divisive rulemaking that lacked 
any grounding in cost-benefit analysis during a critical period. In 
2003-2005, the agency pushed through three controversial rules 
regarding mutual fund governance, hedge fund registration, and the so-
called National Market System rules. In these cases, the SEC did not 
conduct an adequate analysis of the costs versus the benefits of these 
proposed rules. The hedge fund and mutual fund rules were invalidated 
by the courts after long litigation and much distraction for the agency 
and the industry. In each of these cases, former Commissioner Cynthia 
A. Glassman and I offered alternatives and compromises, but we were 
presented with a take-it-or-leave-it choice that left no alternative 
but dissent.
    These controversies now sound rather trivial in light of the 
current situation in the financial markets. However, important legal 
principles were involved, including lack of authority to promulgate the 
hedge fund rule and lack of observing a legislative mandate for 
analyzing costs and benefits in connection with the mutual fund 
governance rule. Hedge funds ultimately were not the problem in the 
current financial crisis; risk management at regulated entities was the 
problem. Moreover, Regulation NMS cost the securities industry more 
than $1.5 billion to try to implement a rule to address a theoretical 
problem that did not exist. Ultimately, after much effort and 
distraction, many exemptions and exceptions have been issued by the SEC 
staff that effectively have gutted the rule.
    Because life is full of choices, if you devote resources to one 
thing, you have less to devote to another. And, the one risk that you 
have not focused on just may blow up in your face.
    That, in fact, is just what happened to the SEC. During this 
critical 2003-2005 time period when so much effort was wasted on these 
quixotic detours, the market for collateralized debt obligations (CDOs) 
and credit default swaps (CDSs) was taking off.
    What might the SEC have done, had it not been so distracted by 
other false priorities? Sometimes the issues are a lot more basic than 
we think. With respect to CDOs and CDSs, the SEC did not have 
jurisdiction to regulate them as instruments. But, one of the critical 
factors that developed as market interest in them grew was the 
inadequate documentation for these OTC derivatives. While the SEC was 
trying to devise complex solutions to nonexistent problems, it 
neglected a real risk management issue in the fundamental 
infrastructure that enables the markets to work smoothly. For example, 
in the failure of the hedge fund Amaranth in 2006, I was told that it 
took a couple of hundred people several weeks to sort through the OTC 
derivatives documentation issues and figure out valuation. One of the 
primary difficulties has been the lack of standardized documentation, 
which has often resulted in lengthy confirmations. At the time, I and 
others had called for this to be addressed. I am happy that the 
industry and regulators are making progress in this area.
    The incomplete and inaccurate documentation in this area was a 
legitimate risk management issue, especially since no centralized, 
automated trade processing existed for these instruments. As we have 
witnessed over the past year, valuation is a challenge, because these 
instruments are complicated and not standardized. Novations create a 
huge challenge to follow the chain of ownership.
Proposals for Financial Services Reform
    Several general proposals have been made recently for structural 
reforms to the financial services regulatory framework. Since these 
have not yet become concrete proposals, I have a few general comments 
in this regard.
    Systemic Risk Regulator. This concept was raised last year in the 
Treasury Department's Blueprint for a Modernized Regulatory Structure. 
As a theory, it has some general appeal, but as a practical matter it 
raises many questions. Just who would be the systemic risk regulator? 
The Treasury, the Federal Reserve, some newly created entity, or a 
council of regulators (such as the President's Working Group)? What 
would its powers be? Would it be a merit regulator of new products? If 
it is the Treasury, what would its role be with respect to other 
independent agencies?
    Issues of systemic risk can be raised in many different contexts. 
For example, in the 1990s, the Federal Reserve and the SEC disagreed 
over the levels of loan loss reserves taken by certain banks. The Fed 
argued on the basis of safety and soundness concerns, and the SEC was 
worried about earnings management and disclosure.
    Merit regulation of new products is always problematic, because a 
government agency is making determinations for investors as to 
appropriateness. What standards would the systemic regulator use to vet 
the new products? The time for review adds to the cost of the new 
products and adds to uncertainty
    Although the federal rules with respect to public offerings of 
securities are based on disclosure, some states have a merit-regulatory 
regime. An illustrative example of how government officials can make 
incorrect determinations, with the best intentions of investor 
protection, is the initial public offering of Apple Computer. The SEC 
approved Apple's registration statement under the federal Securities 
Act, but Massachusetts prohibited the offering of Apple shares because 
they were ``too risky.'' Texas approved the sale after an extensive 
review, but its securities regulator called his decision ``a close 
call,'' and Apple did not even bother to offer its shares in Illinois 
due to strict state laws on new issues. The subsequent performance of 
Apple stock is a matter of history.
    With respect to CDOs and CDSs, would a systemic regulator have 
identified the potential problems of documentation and trading?
    Merger of the SEC and CFTC. If this merger is to be effected, it 
should be done with care. The statutes and rules governing the 
securitie
    s and futures markets are different, and the approaches that the 
two agencies take are different. The futures markets are mostly dealer 
markets, while the securities markets have a large retail investor 
component. A merger cannot simply be the combining of two agencies 
under one roof; it would be a complicated task.
    Short of merger, Congress could help by laying out guidelines for 
the two agencies to resolve conflicts regarding products that have 
indicia of both securities and futures. This issue has existed since 
the 1980s, and the two agencies have periodically tried to address the 
conflicts. In fact, this issue would still exist even if the agencies 
were combined, just as issues exist between SEC divisions.
    Credit Rating Agencies. Thanks to the hard work of this Committee, 
Congress passed the Credit Rating Agency Reform Act of 2006, which set 
out a regulatory regime for the SEC's staff-designated NRSROs through a 
frustratingly slow process that had the effect of limiting competition 
in issuing credit ratings. The 2006 legislation made the application 
process speedier and more transparent.
    The subprime problems made it clear that many investors relied on 
credit ratings without performing their own due diligence. Government 
agencies relied on credit ratings to their detriment as well. Even if 
conflicts of interest are addressed and fully disclosed, we still have 
the problem that opinions of certain institutions are given great 
regulatory weight. Thus, few realized the great systemic risk inherent 
in the holdings of CDOs by financial institutions, because they were 
deemed to be the highest-rated instruments. Over the past 30 years or 
so, references to NRSRO ratings have become embedded in many federal 
and state statutes and SEC and other agency rules. Has this created a 
perception that the government endorses the process by which NRSROs 
produce their ratings? That would be an incorrect perception; the SEC 
or any government agency can never be equipped to assess the quality of 
NRSRO ratings or the procedures by which they are devised. I would 
argue that it would be a mistake to ask any government agency to 
attempt to do so. Is it time to remove these ratings from our statutes 
and rulebooks? Can we create alternatives to this flawed system that 
accords undue weight to informed, albeit potentially flawed, opinions?
    The rating agency industry over the years had become an oligopoly--
three large firms control 90 percent of the market, and two of them 
control 80 percent. This concentration was a direct result of a 
nontransparent, arcane SEC oversight system.
    The consequence was a lack of competition and lack of new entrants. 
For example, a non-U.S. rating agency waited 16 years before its 
application was finally approved. The 2006 enactment of the Credit 
Rating Agency Reform Act directed the SEC to open up the process, 
encourage competition, and increase transparency and oversight of the 
credit rating firms to protect against conflicts of interest. Would 
more voices in the rating industry have averted the problems with 
ratings of structured products?
    SEC Strategic and Risk Assessment. Congress should encourage 
Chairman Schapiro to engage in a thorough strategic and risk 
assessment, especially if the agency is to receive more resources and 
authority. In the past 10 years, the agency's budget has more than 
doubled and its staffing has increased commensurately. However, the 
internal organization and management structure is essentially the same.
    Would today's crisis have occurred if the SEC had had a real risk 
evaluation capability? Former Chairman Harvey Pitt undertook an 
extensive review of the SEC's organization and functionality in 2001 
with a view to modernize it. He conceived of a risk assessment office 
that would work closely with the operating divisions. The plan was to 
give it its own personnel, but also to have personnel seconded to it in 
order to generate buy-in from the operating divisions. Unfortunately, 
when his successor established the office, it did not have adequate 
resources and it did not have any secondments. Thus, the group was not 
integrated into the flow of the agency's operations and became an 
orphaned group filling a niche role with very limited effectiveness.
    In addition, should the examination function continue in its 
current form? In the aftermath of the Madoff affair, the structure and 
function of the Office of Compliance Inspections and Examinations 
should be reviewed. If Congress chooses to require that hedge funds and 
private equity firms register as advisors under SEC oversight, the 
burden added to the agency's examiners would be enormous. The current 
paradigm of periodic inspections of funds by government examiners 
cannot endure, unless the agency increases tremendously in size, 
inevitably leading to more managerial problems. One solution could be 
to re-integrate the examination function into the operating divisions 
and to establish the opportunity for registered advisors to submit to 
independent reviews, which would be overseen by the SEC.
    In conclusion, regulation of financial markets needs to be 
modernized and rationalized. But, it must be done in an informed way, 
taking into account costs and benefits and being mindful of potential 
unintended consequences. Financial markets are global, integrated, and 
quickly changing, and the legislative process is not as responsive. I 
stand ready to assist the Committee going forward as you deliberate 
these issues and if you develop any legislation.
    Thank you again for extending me the privilege of appearing before 
you today. You have a momentous task before you. I wish you all the 
best in your work.







































































































                                 ______
                                 

                PREPARED STATEMENT OF RICHARD G. KETCHUM
                 Chairman and Chief Executive Officer,
               Financial Industry Regulatory Association
                             March 26, 2009

    Chairman Dodd, Ranking Member Shelby, and Members of the Committee: 
I am Richard Ketchum, Chairman and CEO of the Financial Industry 
Regulatory Authority, or FINRA. On behalf of FINRA, I would like to 
thank you for the opportunity to testify today.
    I commend you, Mr. Chairman, for holding today's hearing on the 
critically important topic of reforming our regulatory structure for 
financial services. As someone who has spent the great majority of my 
career as a regulator, dedicated to protecting investors and improving 
market integrity, I am deeply troubled by our system's recent failures.
    The credit crisis and scandals of the last year have painfully 
demonstrated how the gaps in our current fragmented regulatory system 
can allow significant activity and misconduct to occur outside the view 
and reach of regulators. The fallout of this has been massive, and for 
many investors, tragic. Investor protection is the core of FINRA's 
mission, and we share your commitment to identifying existing 
regulatory gaps and weaknesses as well as changes to the regulatory 
framework that would close those gaps and improve the system for all 
investors.

FINRA
    FINRA was created in 2007 through the consolidation of NASD and the 
member regulation, enforcement, and arbitration divisions of the New 
York Stock Exchange. With a staff of 2,800, FINRA regulates the 
practices of nearly 4,900 firms, about 174,000 branch offices and more 
than 650,000 registered securities representatives. As an independent 
regulatory organization, FINRA provides the first line of oversight for 
broker-dealers.
    FINRA augments and deepens the reach of the federal securities laws 
with detailed and enforceable ethical rules and a host of comprehensive 
regulatory oversight programs. FINRA admits to and excludes from the 
industry both firms and individuals; adopts and enforces rules to 
protect investors and the financial markets; examines broker-dealers 
for compliance with its own rules as well as federal securities laws 
and rules of the Municipal Securities Rulemaking Board (MSRB); informs 
and educates the investing public; provides industry utilities and 
administers the largest dispute resolution forum for investors and 
registered firms. Significantly, FINRA is funded by regulatory fees--
not taxpayer dollars. Yet FINRA's Board of Governors is comprised of a 
majority of nonindustry representatives. The uniquely balanced 
structure of our Board ensures a paramount focus on investor protection 
and the opportunity for input from a diverse variety of perspectives.

FINRA's Core Investor Protection Programs
Examinations
    FINRA has a robust and comprehensive examination program with 
dedicated resources of more than 1,000 employees. Routine examinations 
are conducted on a regular schedule that is established based on a 
risk-profile model. This riskprofile model is very important: It 
permits us to focus our resources on the sources of most likely harm to 
average investors. We apply our risk-profile model to each firm, and 
our exams are tailored accordingly. In performing its risk assessment, 
FINRA considers a firm's business activities, methods of operation, 
types of products offered, compliance profile and financial condition, 
among other things.
    During routine examinations, FINRA examines a firm's books and 
records to determine if they are current and accurate. Sales practices 
are analyzed to determine whether the firm has dealt fairly with 
customers when making recommendations, executing orders and charging 
commissions or markups and markdowns. Antimoney laundering, business 
continuity plans, financial integrity and internal control programs are 
scrutinized.
    In addition, FINRA conducts more narrow examinations based on 
information that we receive, including investor complaints, referrals 
generated by our market surveillance systems, terminations of brokerage 
employees for cause, arbitrations and referrals from other regulators. 
In 2008, FINRA conducted almost 2,500 routine examinations and nearly 
6,500 targeted examinations.

Enforcement
    FINRA's Enforcement Department is dedicated to vigorous and 
evenhanded enforcement of the federal securities laws and FINRA and 
MSRB rules. FINRA brings disciplinary actions against firms and their 
employees that may result in sanctions ranging from cautionary actions 
for minor offenses to fines, suspensions from the business and, in 
egregious cases, expulsion from the industry. FINRA frequently requires 
firms to provide restitution to harmed investors and often imposes 
other conditions on a firm's business to prevent repeated wrongdoing.
    In 2008, FINRA issued 200 formal complaints and 1,007 decisions 
were issued in formal disciplinary cases. FINRA collected over $28 
million in fines, either ordered or secured agreements in principle for 
restitution in excess of $1.8 billion, expelled or suspended 19 firms, 
barred 363 individuals from the industry and suspended 321 others. Over 
the past decade, FINRA issued 12,158 decisions in formal disciplinary 
cases, expelled or suspended 208 firms and barred or suspended 7,496 
individuals.

Registration, Testing, and Continuing Education
    Persons employed by a broker-dealer that engage in a securities 
business must register with FINRA. As part of the registration process, 
applicants must disclose their prior employment and disciplinary 
history, since certain prior conduct may prevent registration. FINRA 
also develops and administers qualification examinations that 
securities professionals must pass to demonstrate competence in the 
areas in which they will work. FINRA further administers a continuing 
education program that every registered person must satisfy. FINRA 
administers 28 qualifications exams to over 275,000 people every year, 
including examinations that support the MSRB, States and National 
Futures Association programs.
    FINRA maintains the Central Registration Depository (CRD), the 
central licensing and registration system for the U.S. securities 
industry and its regulators. CRD contains the qualification, employment 
and disciplinary histories of firms and brokers, making it the world's 
largest and most sophisticated online registration and reporting 
system.
    FINRA's BrokerCheck system makes publicly available, free of 
charge, certain information about firms and brokers, including 
disciplinary histories that can inform an investor's decision as to 
which firm or broker to use.
    FINRA also developed, for the SEC, the Investment Adviser 
Registration Depository, a utility that allows federal- and state-
regulated investment advisers to satisfy mandated licensing 
requirements. FINRA makes information about investment adviser firms 
publicly available.
    Under contract with the Conference of State Bank Supervisors, FINRA 
also developed the Nationwide Mortgage Licensing System (NMLS). NMLS is 
a webbased system that allows state-licensed mortgage lenders, mortgage 
brokers and loan officers to apply for, amend, update or renew licenses 
online for participating state agencies using a single set of uniform 
applications. Twenty-three states are currently participating in the 
NMLS system. Encouraged by the passage of the Housing and Economic 
Recovery Act of 2008, 10 additional states plan to participate in the 
system during 2009; 14 more have indicated plans to participate 
beginning in 2010.

Advertising
    FINRA operates an extensive program to ensure that communications 
by firms to the public are not misleading. FINRA rules require that 
advertisements, Web sites, sales brochures and other communications 
present information in a fair and balanced manner. Some communications-
those related to mutual funds, variable products and options, for 
example-must be filed with FINRA. In 2008, FINRA reviewed more than 
99,000 pieces of communication and completed 476 investigations 
involving 2,378 separate communications.

Investor Education
    Investor education is a critical component of investor protection 
and FINRA is uniquely positioned to provide valuable investor education 
primers and tools. FINRA sponsors numerous investor forums and outreach 
programs, and its Web site (www.finra.org) is a rich source of such 
material, including investor alerts, unbiased primers on investing and 
interactive financial planning tools.
    In addition to the investor education activities of FINRA itself, 
the FINRA Investor Education Foundation is the largest foundation in 
the United States dedicated to investor education. Its mission is to 
provide underserved Americans with the knowledge, skills and tools 
necessary for financial success throughout life. The Foundation awards 
grants to fund educational programs and research aimed at segments of 
the public who could benefit from additional resources. Since the FINRA 
Foundation's inception in December 2003, it has approved more than $45 
million in financial education and investor protection initiatives 
through a combination of grants and targeted projects. Many of those 
initiatives have focused on particularly vulnerable investors, such as 
seniors and military personnel and their families.

Gaps in the Current Regulatory System
    While regulators continue to look back and attempt to unravel the 
events and scandals of the past year, all of us must move ahead to 
aggressively revamp and modernize the regulatory framework. The 
failures that have rocked our financial system have laid bare the 
regulatory gaps that must be fixed if investors are to have the 
confidence to re-enter the markets. There are critical questions that 
should be considered as part of any new regulatory approach.
    First, what protections should be provided to investors? Our 
current system of financial regulation leads to an environment where 
investors are left without consistent and effective protections when 
dealing with financial professionals. Investors deserve a system where 
they can be confident they will receive certain basic protections 
regardless of what product they buy or what license their financial 
professional holds. At the very least, our system should provide 
investors with the following protections:

    every person who provides financial advice and sells a 
        financial product should be tested, qualified and licensed;

    the advertising for financial products and services should 
        be subject to requirements that it is not misleading;

    every product marketed to a particular investor is 
        appropriate for recommendation to that investor; and

    there should be full and comprehensive disclosure for the 
        services and products being marketed.

    Unfortunately, not all financial products come with these important 
attributes or protections.
    Second, what products, activities and services should be regulated, 
and how? There are a number of gaps across our system, both in terms of 
similar products and services being regulated quite differently. Where 
we can identify these regulatory gaps that compromise investor 
protection and pose risk to the financial system, they should be 
thoughtfully filled.
    One example is hedge funds. Hedge funds play a significant role in 
the financial system, but they are an unregulated part of it. The 
absence of transparency about hedge funds and their investment 
positions is a concern. First, as we have seen from the recent 
redemptions by fund investors and the de-leveraging of funds in 
response, they have significant ability to directionally move markets. 
Secondly, such funds are significant traders of over-the-counter 
derivative products that are unregulated and system regulation requires 
an understanding of these positions by regulators. Finally, although 
these funds are generally marketed only to investors deemed 
sophisticated, public pension funds, endowments and other fiduciary-
type funds have exposure to hedge funds and absent some level of 
regulation, we cannot gain comfort that only investors with the 
appropriate risk tolerances and sophistication are invested in these 
unregulated vehicles.
    Apart from their use by any class of investor or type of fund, 
over-the-counter (OTC) derivatives need much greater regulatory 
consideration. As trading in the credit default swap market has 
demonstrated, derivative trading can have tremendous impact on the 
pricing of the underlying security or index. The lack of transparency 
and the potential impacts these products can have on regulated markets 
and the broader financial system is cause for concern. Some of these 
products allow substantial leverage that directly interacts with and 
impacts equity and debt markets. For instance, positions in OTC 
derivatives can impact the viability of broker-dealers through freezing 
their funding even when positions in those products are booked in other 
parts of the holding company. In addition, many OTC derivatives 
encounter great counterparty settlement risk because they do not clear 
through an established centralized clearing system that greatly reduces 
the risk of default in the settlement of contractual obligations. FINRA 
is pleased to have filed a proposed margining structure with the 
Securities and Exchange Commission that would enable its regulated 
firms that are members of the Chicago Mercantile Exchange to settle 
credit default swaps through that exchange's newly developed central 
clearing system for those products.
    Finally, I'd like to highlight the regulatory gap that, in our 
view, is among the most glaring examples of what needs to be addressed 
in the current system-the disparity between oversight regimes for 
broker-dealers and investment advisers. The lack of a comprehensive, 
investor-level examination program for investment advisers impacts the 
level of protection for every member of the public that entrusts funds 
to an adviser.
    In fact, the Madoff Ponzi scheme highlighted what can happen when a 
regulator like FINRA has only free rein to see one side of a business. 
Fragmented regulation provides opportunities to those who would 
cynically game the system to do so at great harm to investors.
    So what can be done to try to prevent this from happening in the 
future? The regulatory regime for investment advisers should be 
expanded to include an additional component of oversight by an 
independent regulatory organization, similar to that which exists for 
broker-dealers.
    The SEC and state securities regulators play vital roles in 
overseeing both broker-dealers and investment advisers, and they should 
continue to do so. But it's clear that dedicating more resources to 
regular and vigorous examination and day-to-day oversight of investment 
advisers could improve investor protection for their customers, just as 
it has for customers of broker-dealers.
    As the SEC has noted, the population of registered investment 
advisers has increased by more than 30 percent since 2005. Investment 
advisers now number 11,300-more than twice the number of broker-
dealers. While the SEC has attempted to use risk assessment to focus 
its resources on the areas of greatest risk, the fact remains that the 
number and frequency of exams relative to the population of investment 
advisers has dwindled. Consider the contrast: FINRA oversees nearly 
4,900 broker-dealer firms and conducts approximately 2,500 regular 
exams each year. The SEC oversees more than 11,000 investment advisers, 
but in 2007 conducted fewer than 1,500 exams of those firms. The SEC 
has said recently that in some cases, a decade could pass without an 
examination of an investment adviser firm.
    There are differences in the current rules and standards that apply 
to brokerdealers and investment advisers, reflective of some of the 
differences that exist in the services provided by each class of 
professionals. And while the two channels have converged over the 
years, there remain some differences that need to be taken into account 
when enhancing oversight and exams to make that oversight fit the 
activity and services in each.
    Broker-dealers are subject to a very detailed set of rules 
established and enforced by FINRA that pertain to safety of customer 
cash and assets, advertising, sales practices, limitations on 
compensation, financial responsibility, and trading practices. FINRA 
ensures firms are following the rules with a comprehensive examination 
and enforcement regime.
    Investment advisers are subject to provisions of the Investment 
Advisers Act of 1940 that pertain to registration, disclosure, record-
keeping, custody and compensation. Importantly, investment advisers are 
also subject to a fiduciary standard with regard to their clients. In 
designing a more regular oversight and examination program for 
investment advisers, these rules and standards should be taken into 
account.
    Simply put, FINRA believes that the kind of additional protections 
provided to investors through its model are essential. Does that mean 
FINRA should be given that role for investment advisers? That question 
ultimately must be answered by Congress and the SEC, but FINRA is 
uniquely positioned from a regulatory standpoint to build an oversight 
program for investment advisers quickly and efficiently. We have a 
strong track record in our examination and enforcement oversight, as 
well as in our other core programs. Certainly in the registration area, 
with regard to investment advisers and mortgage brokers, we have two 
success stories of adapting our infrastructure to meet needs in areas 
beyond the realm of broker-dealers.
    In FINRA's view, the best oversight system for investment advisers 
would be one that is tailored to fit their services and role in the 
market, starting with the requirements that are currently in place for 
advisory activity. Simply exporting in wholesale fashion the broker-
dealer rulebook or current governance would not make sense. That said, 
as I noted earlier, where applicable, we do believe that enhanced 
regulatory consistency is in the best interest of investors, especially 
in the four areas I mentioned-licensing, advertising, sales practice 
and disclosure.
    We believe that regular and frequent exams are a vital component of 
effective oversight of financial professionals, and that the absence of 
FINRA-type oversight of the investment adviser industry leaves 
investors without that critical component of protection. In our view, 
it simply makes no sense to deprive investment adviser customers of the 
same level of oversight that broker-dealer customers receive. And quite 
simply, as we learned from the Madoff scandal, it would not make sense 
for two, separate independent regulatory bodies to oversee investment 
advisers and broker-dealers, especially when they exist in the same 
legal entity. Again, there would be no single regulator with a complete 
picture of the business.
    One of the primary issues raised about investor protection 
differences between the broker-dealer and investment adviser channels 
is the difference between the fiduciary standard for investment 
advisers and the rule requirements, including suitability, for broker-
dealers. As this the process moves forward, this is the kind of issue 
that should and will be on the table as we all look at how best to 
reform our regulatory system and strengthen investor protections. In 
keeping with our view there should be increased consistency in investor 
protections across financial services, we believe it makes sense to 
look at the protections provided in various channels and choose the 
best of each.
    We stand ready to work with Congress and the SEC in exploring 
whether a properly designed fiduciary standard could be applied to 
broker-dealers' selling activities, and if there are problems raised, 
make a strong effort to resolve those problems.

Conclusion
    It has become painfully clear that the current regulatory structure 
is weakened by gaps and inconsistencies that should be remedied.
    The individual investor is the most important player in the 
financial markets, and unfortunately, our system has not sufficiently 
protected these individuals. We need to earn back the confidence of 
those investors by closing the gaps in our current system and 
strengthening oversight.
    As I have stated, FINRA believes that one of the most important 
gaps to close in terms of investor protection is the disparity in 
oversight between broker-dealers and investment advisers. The addition 
of a comprehensive and regular oversight program with more frequent 
exams and strong enforcement would enhance protections provided to all 
customers of investment advisers.
    More broadly, investors deserve a consistent level of protection no 
matter which financial professionals or products they choose. Creating 
a system of consistent standards and vigorous oversight of financial 
professionals-no matter which license they hold-would enhance investor 
protection and help restore trust in our markets.
    FINRA is committed to working with other regulators and this 
Committee as you consider how best to restructure the U.S. financial 
regulatory system.
                                 ______
                                 

                 PREPARED STATEMENT OF RONALD A. STACK
                                 Chair,
                 Municipal Securities Rulemaking Board
                             March 26, 2009

    Good morning Chairman Dodd, Ranking Member Shelby, and Members of 
the Committee. I am Ronald Stack, Chair of the Municipal Securities 
Rulemaking Board (``MSRB'' or ``Board''). I am pleased to testify today 
on behalf of the MSRB at the Committee's second hearing on Enhancing 
Investor Protection and the Regulation of the Securities Markets. Part 
I of my testimony provides a summary of the MSRB's structure, 
authority, rules, information systems, and market transparency/ 
surveillance activities. Part II provides background on the municipal 
securities market. Part III is a discussion of what the MSRB is doing 
now to promote transparency in the municipal marketplace. Part IV 
points out significant gaps in the regulation of municipal market 
participants and discusses the manner in which the MSRB could further 
assist in enhancing investor protection and the regulation of the 
securities market, if its jurisdiction were expanded by the Congress. 
Finally, Part V is an executive summary of our major recommendations.

I. Background on the MSRB's Structure, Authority, Rules, Information 
        Systems, and Market Transparency/ Surveillance Activities

A. MSRB Structure
    The MSRB is a self-regulatory organization (``SRO'') established by 
the Congress in the Securities Acts Amendments of 1975 to develop rules 
for brokers, dealers, and banks (collectively ``dealers'') engaged in 
underwriting, trading, and selling municipal securities. In furtherance 
of our investor protection mandate, the Board also operates information 
systems designed to promote transaction price transparency and access 
to municipal securities issuer disclosure documents. The MSRB stands as 
a unique SRO for a variety of reasons. The MSRB was the first SRO 
specifically established by Congress. Also unique is the fact that the 
legislation, codified in section 15B of the Securities Exchange Act 
(``Exchange Act''), dictates that the MSRB Board shall be composed of 
members who are equally divided among public members (individuals not 
associated with any dealer), individuals who are associated with and 
representative of banks that deal in municipal securities (``bank 
dealers''), and individuals who are associated with and representative 
of securities firms. \1\ At least one public member serving on the 
Board must represent investors and at least one must represent issuers 
of municipal securities. Further, the MSRB was created as a product-
specific regulator, unlike most other securities regulatory bodies. 
Members of the MSRB meet throughout the year to make policy decisions, 
approve rulemaking, enhance information systems and review developments 
in the municipal securities market. Day-to-day operations of the MSRB 
are handled by a full-time independent, professional staff. The 
operations of the Board are funded through assessments made on dealers, 
including fees for underwritings and transactions. \2\
---------------------------------------------------------------------------
     \1\ Under MSRB Rule A-3, the Board is composed of 15 member 
positions, with five positions each for public, bank dealer, and 
securities firm members.
     \2\ These fees are set forth in MSRB Rules A-12 through A-14.
---------------------------------------------------------------------------
B. MSRB Authority
    The substantive areas of the MSRB's rulemaking authority are 
described in Section 15B(b)(2) of the Exchange Act, which lists several 
specific purposes to be accomplished by Board rulemaking with respect 
to the municipal securities activities of dealers in connection with 
their transactions in and provides a broad directive for rulemaking 
designed to:

        prevent fraudulent and manipulative acts and practices, to 
        promote just and equitable principles of trade, to foster 
        cooperation and coordination with persons engaged in 
        regulating, clearing, settling and processing information with 
        respect to and facilitating transactions in municipal 
        securities, to remove impediments to and perfect the mechanism 
        of a free and open market and, in general, to protect investors 
        and the public interest.

    Like other SROs, the MSRB must file its proposed rule changes with 
the Securities and Exchange Commission (``SEC'') for approval prior to 
effectiveness.
    Although the MSRB was created to write rules that govern dealer 
conduct in the municipal securities market, the Exchange Act directs 
that inspection of dealers for compliance with, and the enforcement of, 
MSRB rules be carried out by other agencies. For securities firms, the 
Financial Industry Regulatory Authority (``FINRA''), along with the 
SEC, performs these functions. For bank dealers, the appropriate 
federal banking authorities, in coordination with the SEC, have this 
responsibility. \3\ The MSRB works cooperatively with these regulators 
and maintains frequent communication to ensure that: (1) the MSRB's 
rules and priorities are known to examining officials; (2) general 
trends and developments in the market discovered by field personnel are 
made known to the MSRB; and (3) any potential rule violations are 
immediately reported to the enforcement agencies.
---------------------------------------------------------------------------
     \3\ These federal banking authorities consist of the Board of 
Governors of the Federal Reserve System, the Federal Deposit Insurance 
Corporation, and the U.S. Treasury Department through its Office of the 
Comptroller of the Currency and Office of Thrift Supervision, depending 
upon the specific bank dealer.
---------------------------------------------------------------------------
    While Section 15B of the Exchange Act provides the MSRB with 
authority to write rules governing the activities of dealers in 
connection with their transactions in municipal securities, it does not 
provide the MSRB with authority to write rules governing the activities 
of other participants in the municipal finance market such as issuers 
and their agents (e.g., independent financial advisors, swap advisors, 
guaranteed investment contract brokers, trustees, bond counsel, etc.). 
Municipal securities also are exempt from the registration and 
prospectus delivery requirements of the Securities Act of 1933 and are 
exempt from the registration and reporting requirements of the Exchange 
Act.
    In adopting Section 15B of the Exchange Act, Congress provided in 
subsection (d) specific provisions that restrict the MSRB and the SEC 
from regulating the disclosure practices of issuers in certain ways. 
Paragraph (1) of subsection (d) prohibits the MSRB (and the SEC) from 
writing rules that directly or indirectly (i.e., through dealer 
regulation) impose a pre-sale filing requirement for issues of 
municipal securities. Paragraph (2) of subsection (d) prohibits the 
MSRB (but not the SEC) from adopting rules that directly or indirectly 
require issuers to produce documents or information for delivery to 
purchasers or to the MSRB. Paragraph (2), however, specifically allows 
the MSRB to adopt requirements relating to such disclosure documents or 
information as might be available from ``a source other than such 
issuer.'' The provisions of subsection (d) commonly are known as the 
``Tower Amendment.''

C. MSRB Rules Overview
    The MSRB has adopted a substantial body of rules regulating dealer 
conduct that reflect the special characteristics of the municipal 
securities market and its unique regulatory needs These rules require 
dealers to observe the highest professional standards in their 
activities and relationships with customers. MSRB rules take into 
account the fact that rules for dealers in the municipal market--where 
issuers have significant discretion and nondealer market professionals 
are unregulated--must sometimes be crafted in ways that differ from 
rules for dealers in the corporate securities market, where bond 
issuers and other market participants are subject to regulation.
    MSRB rules represent a balance between broad, ``principles-based'' 
rules and specific prescriptive rules, depending on the nature of the 
specific subject of regulation. MSRB rules can generally be categorized 
as (1) fair practice rules (e.g., requirements for dealers to provide 
affirmative disclosures of material facts to investors; to ensure the 
suitability of dealer recommendations of municipal securities 
transactions; to price transactions fairly; to avoid conflicts of 
interest; and to publish fair and accurate advertisements and price 
quotations); (2) uniform practice rules (e.g., rules to ensure that 
standard procedures are followed in underwriting, clearing, confirming, 
and settling transactions in municipal securities; helping to ensure 
the efficiency of market operations while accommodating the differences 
between municipal securities and other debt instruments); (3) 
professional qualification rules (e.g., requirements for dealer 
personnel to pass tests demonstrating competency; continuing education 
requirement); (4) operational standards (e.g., rules regarding 
recordkeeping; supervision of professionals); and (5) marketplace 
disclosure rules (e.g., rules requiring dealer real-time reporting of 
trade prices; underwriter filing of issuer disclosure documents; and 
dealer disclosure of political contributions to the MSRB for public 
dissemination). These rules significantly exceed the general antifraud 
principles that are embodied in the federal securities laws.
    Maintaining municipal market integrity is an exceptionally high 
priority for the MSRB as it seeks to foster a fair and efficient 
municipal securities market through dealer regulation. The MSRB engages 
in an on-going review of its rules and market practices to ensure that 
the Board's overriding goal of protecting investors and maintaining 
market integrity is not compromised by emerging practices. As an 
example, the MSRB implemented rules to remove the conflict of interest 
that can arise when political contributions may be used by dealers to 
obtain municipal securities business. We also seek to coordinate our 
rules with FINRA rules in cases where similar requirements make sense.
    The MSRB also reminds dealers of its rules in times of market 
stress when the pace of events might cause some to lose sight of their 
significance. For example, during 2008, as bond insurer ratings were 
reduced frequently and significantly, we reminded dealers of their 
disclosure obligations concerning credit enhancement. \4\ We also 
issued an interpretive notice on transactions in auction rate 
securities that reminded dealers of their obligation to recommend 
investments that are suitable to their customers \5\ and provided 
guidance on reporting dealer buybacks of auction rate securities. \6\ 
When many issuers rushed to convert their high yielding auction rate 
securities to variable rate demand obligations, we reminded dealers of 
restrictions on underpricing of credit and tying the provision of 
letters of credit to the provision of underwriting services. \7\
---------------------------------------------------------------------------
     \4\ MSRB Notice 2008-04 on Bond Insurance Ratings (January 22, 
2008).
     \5\ MSRB Notice 2008-09 on Application of MSRB Rules to 
Transactions in Auction Rate Securities (February 19, 2008).
     \6\ MSRB Notice 2008-36 on Transactions Reporting of Dealer 
Buybacks of Auction Rate Securities: Rule G-14 (September 2, 2008).
     \7\ MSRB Notice 2008-34 on Bank Tying Arrangements, Underpricing 
of Credit and Rule G-17 on Fair Dealing (August 14, 2008).
---------------------------------------------------------------------------
D. Information Systems and Market Transparency/Surveillance
    In furtherance of our investor protection mandate, the MSRB also 
operates information systems to improve the availability of information 
in the market about municipal issues. These systems ensure that 
investors have information necessary to make investment decisions, that 
dealers can comply with MSRB rules, and that the inspection and 
enforcement agencies have the necessary tools to do their work.
    Since 1990, the Municipal Securities Information Library (``MSIL'') 
system has collected issuer primary market disclosure documents (i.e., 
official statements and advanced refunding documents) from underwriters 
and made them available to the market and the general public. The MSIL 
system also accepts and disseminates certain secondary market 
information provided by municipal issuers and trustees pursuant to SEC 
Rule 15c2-12. In order to further increase the accessibility of 
municipal market information by retail investors, the MSRB has 
developed a free, centralized database, named the Electronic Municipal 
Market Access system or EMMA, which is discussed further below and 
which will shortly replace the MSIL system.
    In 2005, the MSRB implemented a facility for real-time transaction 
reporting and price dissemination of transactions in municipal 
securities (the ``Real-Time Transaction Reporting System'' or 
``RTRS''). \8\ RTRS serves the dual role of providing transaction price 
transparency to the marketplace, as well as supporting market 
surveillance by the enforcement agencies. Surveillance data is made 
available to regulators with authority to enforce MSRB rules, including 
FINRA and the SEC. The market surveillance function of the MSRB's 
transaction reporting system provides enforcement agencies with a 
powerful tool in enforcing the Board's fair pricing rules. The MSRB 
offers a market-wide real-time feed of trade information and provides 
the data free of charge on EMMA, as discussed below. In addition, in 
January of this year, the MSRB implemented an enhancement to the system 
with the addition of free public access to interest rate reset 
information on municipal auction-rate securities, including information 
on the success or failure of individual auctions. Free interest rate 
and related information on variable-rate demand obligations will be 
added to the system next week. And, beginning July 1 of this year, 
continuing disclosure filings made by state and local governments will 
be available as well. Once completed in July, 2009, the MSRB's EMMA 
system will provide the most comprehensive and free database of 
municipal securities information as exists in any of the fixed income 
markets.
---------------------------------------------------------------------------
     \8\ The MSRB's transaction reporting rules require dealers to 
report transactions in municipal securities within 15 minutes of the 
time of trade execution.
---------------------------------------------------------------------------
    Currently, EMMA does not contain information about the credit 
ratings of municipal securities, although they are of considerable 
importance to investors. The MSRB would welcome the submission by the 
rating agencies of such ratings on a real-time basis. Given the large 
number of bond insurer downgrades in the last year, investors should 
have access to underlying ratings as well as ratings on the municipal 
securities themselves.

II. Background on the Municipal Securities Market

A. Market Overview
    When Section 15B of the Exchange Act was adopted in 1975, yearly 
issuance of municipal securities was approximately $58 billion. \9\ 
Much of this total represented general obligation debt, which reflected 
the simple, unconditional promise of a state or local government unit 
to pay to the investor a specific rate of interest for a specific 
period of time. The investors in these bonds tended to be commercial 
banks and property/casualty insurers interested in tax-exempt interest.
---------------------------------------------------------------------------
     \9\ See The Bond Buyer/Thomson Financial 2004 Yearbook at 10. 
Approximately half of this figure represents short-term debt maturing 
in less than 13 months.
---------------------------------------------------------------------------
    The municipal securities market has grown into a much larger and 
more complex market. Annual issuance of municipal securities has 
averaged $458 billion in recent years \10\ and a total of $2.7 trillion 
in principal value is outstanding. \11\ In addition to providing 
capital for governmental projects and operations, the municipal 
securities market helps to fund a variety of other public purposes, 
including transportation and environmental infrastructure, education, 
housing and healthcare.
---------------------------------------------------------------------------
     \10\ Source: Thomson Reuters (based on 2005-2008 data).
     \11\ December 2008 estimates. See Federal Reserve Flow of Funds 
(March 2009) available at www.federalreserve.gov. As a comparison, the 
outstanding principal value of marketable U.S. Treasury Securities was 
$5.8 trillion.
---------------------------------------------------------------------------
    Most municipal securities come to market with investment grade 
credit ratings, i.e., with ratings that are ``BBB-'' or above. \12\ 
Historically, investment grade municipal securities have been 
considered relatively safe investments, because of the very low rate of 
default. A 2002 report by Moody's Investor Service concluded that the 
default rate for investment grade municipal securities debt over a 10 
year period was .03 percent, compared to 2.32 percent for investment 
grade corporate debt. \13\ A low rate of default for investment grade 
municipal securities also has been observed in studies by Standard and 
Poor's and Fitch Ratings.
---------------------------------------------------------------------------
     \12\ Over 99 percent of rated long-term municipal securities 
coming to market in 2008 were rated investment grade by at least one 
rating agency.
     \13\ Moody's Rating Service, ``Special Comment: Moody's US 
Municipal Bond Rating Scale'' (November 2002), available at http://
www.moodys.com (also noting increased default risks for nonrated 
issues).
---------------------------------------------------------------------------
B. Issuers
    Issuers of municipal securities include towns, cities, counties, 
and states, as well as other state and local government agencies and 
authorities that issue securities for special purposes (e.g., hospitals 
and colleges). There are over 55,000 issuers of municipal securities 
that have outstanding approximately 1.23 million unique securities. 
Major issuer types, with the associated volume of issuance in 2008, are 
shown in Figure 1. \14\
---------------------------------------------------------------------------
     \14\ Source: Thomson Reuters (includes issuance of both long-term 
and short-term securities). 



    The market is unique among the world's major capital markets 
because the number of issuers is so large--no other direct capital 
market encompasses so many borrowers. The issues range from multi-
billion dollar financings of large state and city governments to issues 
less than $100,000 in size, issued by localities, school districts, 
fire districts, and various other issuing authorities. The purposes for 
which these securities are issued include not only financing for basic 
government functions, but also a variety of public needs such as 
transportation, utilities, health care, higher education, and housing 
as well as some essentially private functions to enhance industrial 
development. In the last two decades debt issuance has become an 
important management tool for many municipalities, allowing flexibility 
in arranging finances and meeting annual budget considerations 
according to local needs and local priorities. The terms and features 
of some municipal securities have evolved over time into highly complex 
structures to meet a multitude of issuer borrowing and investment 
needs. Differences in laws among the 50 states, as well in local 
ordinances and codes among the tens of thousands of localities, that 
affect borrowing authority, lending of credit, powers to impose taxes 
and special assessments, contracting powers, budgeting restrictions, 
and many other matters result in an enormous variety of financing 
structures across the country that defies commoditization of the 
municipal securities market.
    By contrast, there are only approximately 5,500 issuers of 
corporate debt and less than 50,000 corporate debt securities, \15\ 
even though the amount of corporate debt outstanding is $6.3 trillion. 
\16\
---------------------------------------------------------------------------
     \15\ Source: FINRA. Includes all TRACE-eligible securities.
     \16\ December 2008 estimates. See Federal Reserve Flow of Funds 
(March 2009), available at www.federalreserve.gov. Corporate debt 
outstanding excludes asset-backed securities and foreign issues held by 
U.S. residents.
---------------------------------------------------------------------------
C. Investors
    The municipal securities market has one of the highest levels of 
participation by individual investors, either through direct 
investments or through mutual funds, together representing the majority 
of total municipal securities holdings. The other major categories of 
investors in municipal securities include property and casualty 
insurers and commercial banks. Figure 2 shows the percentages of direct 
investments in municipal securities in categories tracked by the 
Federal Reserve Board. 



    The ``household'' category in Figure 2 includes both direct 
investments by individual investors as well as trusts and other 
accounts (e.g., some types of hedge fund accounts that do not fall into 
other tracked categories). The ``mutual funds'' category includes both 
municipal bond funds and money market funds. \17\
---------------------------------------------------------------------------
     \17\ Data collected by the Investment Company Institute (``ICI'') 
indicate that, as of September 24, 2008, the total net assets in tax-
exempt money market accounts were approximately $482 billion, which 
would account for more than half of the Federal Reserve estimates of 
mutual fund holdings of municipal securities at this time. Of the $482 
billion in tax-exempt money market funds tracked by the ICI in 
September, approximately $295 billion was held in retail money market 
funds and $187 billion was held in institutional money market funds. 
Source: ICI, ``Weekly Total Net Assets (TNA) and Number of Money Market 
Funds,'' available at www.ici.org.
---------------------------------------------------------------------------
D. Municipal Securities Dealers
    The municipal securities market is an over-the-counter, dealer 
market. There are no central exchanges, specialists, or formal market 
maker designations. At the end of 2008, approximately 2,040 securities 
firms and banks were authorized to act as brokers and dealers in 
municipal securities (collectively, ``dealers''). During a given year, 
approximately 1,430 dealers report transactions in municipal securities 
to the MSRB under its price transparency program. About 185 of these 
dealers serve as managing underwriters of new issues.

E. Market Activity
    In general, municipal securities investors tend to be ``buy and 
hold'' investors. Trading patterns for municipal securities with fixed 
interest rates typically involve relatively frequent trading during the 
initial weeks after issuance, followed by infrequent or sporadic 
trading activity during the remaining life of the security. Issues with 
variable interest rates tend to trade more frequently. Of the 
approximately 1.23 million outstanding municipal securities, the 
likelihood of any specific security trading on a given day is about one 
percent. Less than 10 percent of outstanding municipal securities are 
likely to trade in any given month. \18\
---------------------------------------------------------------------------
     \18\ Source: MSRB transaction data.
---------------------------------------------------------------------------
    Notwithstanding the thin secondary market trading in individual 
municipal securities, aggregate daily trading activity in the market is 
substantial. During the period 2005-2008, an average of approximately 
36,000 transactions in municipal securities was reported to the MSRB 
each business day, resulting in par values averaging about $23.2 
billion per day. For the same period, nearly two-thirds of par value 
traded was variable rate securities, while fixed-rate securities 
accounted for almost 30 percent. Figure 3 shows the 30-day trailing 
average of daily transaction activity and volume in par (principal) 
amount traded for all types of municipal securities. \19\
---------------------------------------------------------------------------
     \19\ The MSRB provides statistical data on market activity on its 
Web site at www.msrb.org and through EMMA.


III. MSRB Actions To Promote Transparency in the Municipal Market

A. Primary Market Disclosure
    As noted above, since 1990, the MSRB has sought to improve the 
availability of municipal securities issuer disclosure documents to 
investors through its MSIL system. At that time, the SEC adopted its 
Rule 15c2-12 to, among other things, require the underwriter for most 
offerings of municipal securities to receive and review the issuer's 
official statement before underwriting the issue. In turn, MSRB Rule G-
36 requires underwriters to submit such official statements to the MSIL 
system. The MSIL system was the first comprehensive library of primary 
market disclosure documents in the municipal securities market. The 
MSRB developed the MSIL system to serve as a repository of disclosure 
documents and a ``wholesaler'' of these documents to market 
participants and information vendors. Since most disclosure documents 
in 1990 were made available in paper form, the MSIL system received 
such documents, scanned them, and provided electronic versions to 
subscribers for a minimal fee for use in information products provided 
to the market. More recently, many primary market disclosure documents 
are available in electronic form and the MSRB receives such documents 
and provides them directly to subscribers.
    In March 2008, the MSRB launched its Electronic Municipal Market 
Access (``EMMA'') pilot. EMMA is an Internet-based disclosure portal 
that provides free public access to primary market disclosure documents 
and real-time municipal securities trade price data for the municipal 
securities market, in a manner specifically tailored to retail 
investors. The EMMA Web site is accessible at www.emma.msrb.org. EMMA 
currently provides an easily navigable integrated display of primary 
market disclosures and transaction pricing data for a specific 
security, incorporating detailed user help and investor education 
information designed to make the information easily understood by 
retail investors. EMMA currently provides free access to the MSRB's 
full collection of issuer disclosure documents dating back to 1990, as 
well as to trade price information since January 2005.
    On Monday of this week, the MSRB filed with the SEC a proposal to 
continue operation of EMMA on a permanent basis and to provide for more 
rapid dissemination of primary market disclosures through a centralized 
electronic submission and public access service. The MSRB expects that 
this new phase of EMMA will be fully operational by the end of May of 
this year. At that time, all underwriters will be required to submit 
official statements and related documents and information to EMMA 
electronically for immediate free public access through the EMMA Web 
site portal. Users of the Web site will be able to sign up for free 
optional e-mail alerts to be notified of new and updated postings of 
disclosure documents and other information offered on EMMA. These 
documents will continue to be displayed in conjunction with real-time 
trade price information so that users viewing trading data for a 
specific municipal security will have immediate access to key 
disclosure information about that security. EMMA's search engine is 
designed to assist retail investors in quickly finding the right 
document and information for a particular security.
    EMMA is the central force in moving the municipal securities market 
from the old paradigm where only the buyer of a specific new issue 
municipal security could be assured of receiving a copy of the 
disclosure document for that security when the trade is completed to a 
new marketplace where the general public will have free ongoing 
immediate access to disclosure documents for all issues as soon as the 
documents become available. To further ensure broad access to the 
disclosures provided in official statements and advance refunding 
documents, the MSRB will make these documents available by subscription 
to information vendors and other bulk data users on terms that will 
promote the development of value-added services by subscribers for use 
by market participants.

B. Continuing Disclosure
    The SEC revised its Rule 15c2-12 in 1995 to require underwriters to 
ensure that issuers have contracted to provide certain continuing 
disclosure information, including annual financial and operating data 
and material events notices, to certain private-sector information 
services designated as Nationally Recognized Municipal Securities 
Information Repositories (``NRMSIRs''). In these amendments, the MSRB 
was included as an alternative recipient of material event notices 
only.
    During the last few years, however, the MSRB grew concerned about 
investor access to continuing disclosure documents through the current 
NRMSIR system. As a result, after consultation with the SEC and review 
of the SEC's White Paper to Congress on the municipal securities 
market, \20\ the MSRB began to plan for a continuing disclosure 
component of EMMA. This enhancement will combine continuing disclosure 
information with the primary market disclosure and trade information 
currently available to provide a central location for all such 
municipal securities market information.
---------------------------------------------------------------------------
     \20\ July 26, 2007, available at http://www.sec.gov/news/press/
2007/2007-148wp.pdf.
---------------------------------------------------------------------------
    On December 5, 2008, the SEC approved amendments to its Rule 15c2-
12 to make the MSRB the central location for issuer continuing 
disclosure documents, effective July 1, 2009. EMMA's continuing 
disclosure service will provide a user-friendly interface for free 
electronic submission of continuing disclosure documents by issuers, 
other obligated parties and their agents. As with official statements, 
these continuing disclosure documents will become immediately available 
for free to the general public through the EMMA Web site portal. Free 
optional e-mail alerts relating to new postings will also be made 
available in connection with continuing disclosure documents. In 
addition, the continuing disclosure documents will be integrated into 
the existing official statement and trade data display to produce an 
all-encompassing view of the relevant primary market, secondary market, 
and trade price information for each security in the marketplace easily 
accessible through EMMA's powerful search engine.
    The MSRB expects to file with the SEC next week a proposed rule 
that would permit EMMA to accept voluntary filings of continuing 
disclosure by issuers and obligors. We hope that this will encourage 
disclosure beyond that which is currently required by SEC Rule 15c2-12, 
such as quarterly financial information and information about related 
municipal derivative transactions.

C. Auction Rate Securities/Variable Rate Demand Obligation Transparency
    In 2009, the MSRB implemented its Short-term Rate Transparency 
(``SHORT'') System to increase transparency of municipal ARS and VRDOs. 
The SHORT System is the first centralized system for collection and 
dissemination of critical market information about ARS and VRDOs. 
Information collected by the SHORT System is made available to the 
public, free of charge, on EMMA.
    The SHORT System will be implemented in phases. The first phase, 
which became operational on January 30, 2009, collects and disseminates 
interest rate and related information about municipal ARS, including 
information about the success or failure of each auction. The SHORT 
System is scheduled to become operational for VRDOs on April 1, 2009. 
This interest rate information allows market participants to compare 
ARS and VRDOs across issues and track current interest rates. Included 
in this information is the current interest rate, the length of the 
interest rate reset period as well as characteristics of the security, 
such as the identities of broker-dealers associated with the operation 
of the securities.
    Later phases of this initiative to increase transparency of ARS and 
VRDOs include the collection and dissemination of ARS bidding 
information. This information will allow market participants to obtain 
important information about the liquidity of ARS and greater 
granularity into the results of the auction process. In addition, the 
MSRB plans to collect ARS documents that describe auction procedures 
and interest rate setting mechanisms as well as VRDO documents that 
describe the provisions of liquidity facilities, such as letters of 
credit and standby bond purchase agreements.

D. Market Statistics and Data
    EMMA provides market activity information, including transaction 
price data for the most recent daily trades and a daily summary of 
trading activity throughout the municipal securities market. EMMA's 
daily trade summary provides the type of trade (i.e., customer bought, 
customer sold or inter-dealer trades), the number of securities and the 
number of trades for each trade type and the par amount of the trades 
for all published trades disseminated by the MSRB for every trading day 
since May 2006. This information is provided on EMMA's market 
statistics pages and provides municipal securities investors with a 
market-wide view of the municipal securities market. An example of such 
information follows:



    Market statistics on EMMA also include the par amount traded for 
the most active sectors of the municipal securities market and trading 
volume by trade size, maturity, and source of repayment.



E. Investor Outreach and Education
    The MSRB is conducting an aggressive campaign to reach out to 
investors about all the information that is easily available to them 
through EMMA. We have also added important educational materials to the 
EMMA site to assist investors in their understanding of the municipal 
securities market. The MSRB is gratified that we have had over 53,000 
visitors to EMMA in its 12 months of pilot operation who have 
downloaded almost 4.0 terabytes of files and data. Messages we have 
received through the EMMA feedback and contact pages indicate a very 
positive response from users, which include retail and institutional 
investors, brokers, investment advisors, issuers, information services, 
researchers, media, and others. We plan to continue diligently to 
improve EMMA's service to both investors and issuers.
    The MSRB has long sought to improve investor access to municipal 
securities disclosure as well as to require, through its dealer 
regulation, that the municipal securities market continue to be fair to 
investors and efficient for all market participants. Once fully 
operational, EMMA will allow for more timely and accurate disclosures, 
valuations, and information regarding municipal securities, which will 
benefit all market participants. EMMA's free public access to real-time 
trade price information and to the key disclosure documents has already 
provided unprecedented transparency to this market. As we complete each 
new phase of EMMA, the MSRB will provide increasing levels of 
transparency that will greatly benefit both investors and issuers alike 
and which is unparalleled in other markets.

IV. An Expanded Role for the MSRB To Enhance Investor Protection and 
        Regulation of the Securities Markets

A. Unregulated Parties in the Municipal Securities Market.
    The current financial crisis has exposed gaps in the regulatory 
structure that governs U.S. financial institutions and the products 
they offer. It is clear that regulatory reform is necessary to address 
changes in the capital markets, such as the creation of new financial 
products and the emergence of firms providing advice regarding these 
products. The municipal securities marketplace has evolved from one in 
which states and municipalities offered traditional, fixed rate bonds 
to finance specific projects into a market that involves the use of 
complex derivative products and intricate investment strategies.
    Current federal law does not permit the MSRB to regulate the swap 
firms that assist in the creation of these derivative products for 
municipal issuers. The law also does not permit the MSRB to regulate 
other nondealer municipal market participants, such ``independent'' 
financial advisors that provide advice to issuers regarding bond 
offerings or investment brokers that assist issuers with investing bond 
proceeds. The MSRB believes regulation of these entities and other 
municipal advisors is essential to protect investors and ensure market 
integrity, and that the MSRB is in the best position to provide this 
regulation and therefore should be given such authority. The MSRB 
believes that its current regulatory structure for municipal securities 
dealers provides a ready model for oversight of municipal advisors, 
including financial advisors and investment brokers. The MSRB also 
believes that expanded oversight would be most effective in a dual 
regulatory structure with the SEC. Under this approach, firms would be 
required to register with the SEC, and the MSRB would provide more 
prescriptive rules applicable to these firms and their activities. With 
the expansion of its jurisdiction, the MSRB's composition should be 
reviewed to provide for appropriate representation of all types of 
regulated parties as well as to ensure expanded public representation.

    1. Financial Advisors and Investment Brokers and Other Municipal 
Market Participants. As federal lawmakers and policymakers are looking 
into unregulated participants throughout the financial markets such as 
mortgage brokers, so too should attention be paid to these participants 
in the municipal market. As municipal finance transactions have evolved 
and become more complex, there are many more advisors who work with 
municipal issuers, and brokers who act as intermediaries between 
issuers and others who provide necessary investment and other services. 
These participants have significant influence with issuers, earn 
significant fees, and many times, are not subject to any constraints on 
pay-to-play, as dealers have been since 1994. Unfortunately, the 
regulatory structure over the municipal market has not kept up with the 
evolving marketplace and nearly all of these participants are 
unregulated. At a minimum, municipal advisors such as financial 
advisors and investment brokers should be held to standards of conduct 
that protect municipal issuers, taxpayers, and investors in this 
market. The existing MSRB rulebook provides a ready model for the types 
of rules that could be developed for these market participants--
particularly in light of the fiduciary nature of many of the advisory 
services they provide. Preventing pay-to-play throughout the municipal 
market is even more important now as the Congress has recognized the 
importance of rebuilding the Nation's infrastructure and has supported 
that goal through the stimulus bill. Also, as Treasury seeks to find 
solutions to assist the municipal bond market through the financial 
crisis, ensuring that all market participants adhere to the highest 
professional standards is essential.
    Investors in the municipal securities market would be best served 
by subjecting unregulated market professionals to a comprehensive body 
of rules that (i) prohibit fraudulent and manipulative practices, (ii) 
require the fair treatment of investors, issuers, and other market 
participants, (iii) mandate full transparency, (iv) restrict real and 
perceived conflicts of interests, (v) ensure rigorous standards of 
professional qualifications, and(vi) promote market efficiencies. The 
municipal securities dealer community undertook the transition from 
being unregulated to becoming subject to such a body of rules and 
standards beginning in 1975 with the creation of the MSRB. The MSRB 
believes it is now time for the unregulated professionals in this 
market to undertake this same transition, and that the MSRB is the most 
appropriate regulatory body to provide this regulation.

    2. Current Regulation of Financial Advisors. It should be noted 
that many financial advisory firms are registered as broker-dealers or 
municipal securities dealers and are, therefore, subject to MSRB rules, 
including Rules G-23 and G-37. Rule G-23 is a disclosure rule designed 
to minimize the apparent conflict of interest that exists when a 
municipal securities professional acts as both financial advisor and 
underwriter with respect to the same issue. With respect to financial 
advisors that are not dealers (known as ``independent'' financial 
advisors), approximately fifteen states have some form of pay-to-play 
prohibition. Some states have very broad pay-to-play rules that cover 
most state and local contracts, including those for financial advisory 
services. Other states have very narrow rules that apply only to 
specific situations. Some municipalities also have enacted such rules. 
Additionally, certain states and municipalities and agencies have 
disclosure obligations. While some states and localities have such pay-
to-play laws, in many cases based on MSRB Rule G-37, the limited and 
patchwork nature of these state and local laws has not been effective 
in addressing in a comprehensive way the possibility and appearance of 
pay-to-play activities in the unregulated portions of the national 
municipal securities market. It is time for a coordinated and 
comprehensive approach to regulating municipal advisors, including 
``independent'' financial advisors.

    3. Number of Financial Advisors Active in the Marketplace. Given 
the unregulated nature of this market, it is difficult to identify with 
precision the number of financial advisors, the number of offerings in 
which they participated, or the nature and scope of their advice. 
Nevertheless, the MSRB has reached out to market participants and has 
reviewed data on financial advisors supplied by Thomson Reuters. The 
MSRB believes that this information provides a reasonable estimate of 
the size of the market, but does not capture the entirety of it.
    Based on the MSRB's review, of the 358 financial advisory firms 
that participated in at least one primary market transaction in 2008, 
only 98 were registered with the MSRB as dealers. It appears that the 
vast majority of active financial advisory firms currently are not 
regulated by the MSRB or, in general, anyone else.



    4. Volume of Municipal Debt Issued With the Assistance of Financial 
Advisors. According to data obtained by the MSRB, approximately 70 
percent of the total volume of municipal debt (by par amount) issued in 
2008 was issued with the assistance of financial advisors. The total 
amount of municipal debt issued in 2008 was $453 billion, and financial 
advisors provided advice in offerings that accounted for $315 billion 
of this total.



    This percentage has increased over the last 2 years. In 2007, 
financial advisors participated in 66 percent of the total volume of 
offerings and, in 2006, financial advisors participated in 63 percent 
of the total volume of offerings.



    The length of maturity of the offerings did not change the 
percentages significantly. In short-term offerings (maturities of less 
than 13 months) in 2008, financial advisors participated in 69.3 
percent of the offerings, and in long term offerings, financial 
advisors participated in 69.7 percent of the offerings. Hence, an 
overwhelming percentage of short and long term offerings were issued 
with the assistance of financial advisors.

    5. Percentage of Unregistered Firms That Participated in Offerings. 
Dealers participated as financial advisors in 38 percent of the total 
volume of offerings in which financial advisors provided assistance. 
Correspondingly, unregistered financial advisors participated in 62 
percent of those offerings, which represented $196 billion of the $315 
billion total.



    6. The Role of Swap Advisors. The municipal securities derivatives 
market emerged in the 1980s and is still evolving. This market is very 
complex, with a variety of derivative products such as floating-to-
fixed rate swaps, fixed-to-floating rate swaps, basis swaps, and 
swaptions. According to market participants, the vast majority of 
transactions are floating-to-fixed swaps, which are used to create 
synthetic fixed rate structures. These derivative products carry 
numerous embedded risks that may not be easily understood by less 
financially sophisticated issuers. Some such risks are interest rate 
risk, basis risk, tax risk, termination risk, and counterparty risk. 
Recent market conditions highlight this concern. Many sophisticated 
issuers face large swap termination fees due to changes in short-term 
interest rates. The extent to which many of these issuers may have 
underestimated the potential termination fees is of great concern to 
the MSRB.
    To assist issuers in understanding the characteristics, risks, and 
potential benefits of these products, many firms developed expertise as 
swap advisors. These firms, of which there are approximately four 
dozen, according to the Bond Buyer's Municipal Marketplace Directory 
2008, provide financial advice to issuers regarding swap policy 
development, transaction structuring, documentation, and pricing. Swap 
advisors now include boutique firms, registered broker-dealers, and 
banks. While many firms adhere to their own standards of professional 
conduct, their swap advisory services are, for the most part, 
unregulated.
    Also problematic is the lack of available public information 
regarding the size of the municipal securities derivative market. 
Market participants have suggested that the market is between $100 
billion and $300 billion, annually, in notional principal amount, but 
until these derivative transactions are formally tracked, the figures 
will be unreliable. Given the complexity of municipal derivative 
transactions, the variety of risks, the growth of the market, and the 
reliance by issuers on the expertise of swap advisors, the MSRB 
believes these municipal market professionals should also be regulated. 
Moreover, the MSRB believes that its rules provide an appropriate 
framework for such regulation.

    7. The Role of Investment Brokers. A small group of advisory firms 
also provide investment advice to issuers concerning funds that are 
available to invest. These funds are typically bond funds, construction 
funds, escrow funds, debt service reserve funds, or capitalized 
interest funds. Advisory firms may recommend a variety of investments 
to the issuer, including bank investment agreements, guaranteed 
investment contracts, repurchase agreements, or forward delivery 
agreements. These investments may be offered by banks, insurance 
companies, or broker-dealers, and are bid competitively. Firms that 
offer such investment advice to issuers are not, for the most part, 
regulated. Given the complexity of these investments, their integral 
relationship to the municipal securities transactions, and the 
investment advice provided by these firms, MSRB believes that these 
municipal market professionals should be regulated as well. At a 
minimum, given the investment advice they provide to clients, these 
firms should be registered as investment advisors with the SEC. 
Additionally, MSRB believes that its rules, which go significantly 
beyond the antifraud provisions of the federal securities laws, provide 
an appropriate model for regulation of these market professionals.

    8. Municipal Issuers. When considering a new regulatory structure 
for the municipal securities market, it is important to recognize that 
the municipal market is distinct from other securities markets due to 
the role of sovereign municipal issuers, the diversity of issuer types, 
federal tax law and state law requirements and restrictions that relate 
to the issuance and sale of municipal securities. As the regulator of 
municipal securities dealers, the MSRB is keenly attuned to its role at 
the boundary between the federal government (establishing an efficient 
national marketplace and uniform investor protections) and states and 
municipalities exercising their public trust to meet the unique needs 
of their citizens. In the service of these goals, the MSRB has sought 
to provide rulemaking that is based on an understanding of the products 
that are being created and sold, and the dynamics driving decisions and 
market practices of the issuers, investors, and dealers. This requires 
careful tailoring of basic securities regulation principles to achieve 
key investor protection objectives without unduly imposing direct or 
indirect restraints on municipal issuers.
    The SEC 's current jurisdiction includes authority to enforce 
antifraud laws with respect to issuers of municipal securities, and the 
SEC has brought enforcement actions in a number of high profile cases 
in the past few years. In addition, the associations representing state 
and local municipal issuers (Government Finance Officers Association 
and National Association of State Treasurers, in particular) also have 
an extensive body of recommended practices and an impressive 
educational outreach effort to help municipal issuers adhere to the 
highest standards of conduct. The MSRB is not suggesting the need for 
any additional federal regulation governing municipal issuers.
    We believe that the MSRB's new EMMA system is a key turning point 
in moving forward with considerably improved disclosure practices in 
the municipal securities market, and the issuer community 
wholeheartedly supports this evolution. The current system of 
continuing disclosure based on a limited number of private enterprises, 
through which disclosures are available for a fee and in most cases 
only through a laborious process that does not promote public access, 
fails to provide the sunshine on disclosure practices that EMMA soon 
will. Good and bad disclosure practices alike are largely obscured in 
the current restrictive continuing disclosure scheme. This will no 
longer be the case with the advent of the MSRB's continuing disclosure 
service through EMMA. The EMMA system will serve as a red flag for poor 
disclosure by issuers, while revealing good disclosure practices. It 
also will remove existing impediments to ensuring that investors buy 
and sell in securities based on the most up-to-date disclosures. The 
EMMA Web site will make it abundantly clear to investors when 
disclosures are less than satisfactory, as opposed to the current 
restrictive system. If investors are not satisfied with an issuer's 
disclosure standards, or if they are alerted to information of concern 
through disclosures, they will extract a penalty, and the issuer 
eventually will pay the price through higher borrowing costs. In 
partnership with the state and local government issuer community, the 
MSRB believes that recent improvements in the quality and timeliness of 
disclosures in the municipal securities market will accelerate.

B. Financial Markets Regulatory Structure
    The MSRB supports the concept of a multi-layered regulatory 
framework as a starting point for consideration of a new regulatory 
structure for the financial markets, as has been proposed by a number 
of governmental and nongovernmental bodies in recent months. \21\
---------------------------------------------------------------------------
     \21\ See, e.g., U.S. Government Accountability Office, ``Financial 
Regulation: A Framework for Crafting and Assessing Proposals to 
Modernize the Outdated U.S. Financial Regulatory System (GAO-09-216),'' 
January 8, 2009, available at http://www.gao.gov/new.items/d09216.pdf; 
Group of Thirty, ``Financial Reform: A Framework for Financial 
Stability,'' January 15, 2009, available at http://www.group30.org/
pubs/pub_1460.htm; U.S. Department of the Treasury, ``Blueprint for a 
Modernized Financial Regulatory Structure,'' available at http://
www.treas.gov/press/releases/reports/Blueprint.pdf.
---------------------------------------------------------------------------
    Such a multi-layered regulatory framework would consist of (1) a 
market stability regulator to address overall conditions of financial 
market stability that could impact the general economy; (2) a 
prudential financial regulator; and (3) a business conduct regulator 
(linked to consumer protection regulation) to address standards for 
business practices. The MSRB stands ready to work closely with any 
systemic regulator to gather and analyze data about the municipal 
market as it relates to systemic risk in the financial markets. As well 
as a repository for municipal market data, the MSRB can be even better 
equipped to proactively monitor market activity and assist aggressively 
in enforcement activities.
    A multi-layered regulatory approach, or in fact any scenario, 
requires that the regulatory entities have deep and extensive knowledge 
of all financial markets. The lack of municipal finance expertise at 
the federal level became apparent during the past year and resulted in 
a very late and limited recognition of the impact of the credit crisis 
on state and local municipal finances, and the failure of federal 
programs intended to alleviate the economic impact of the credit crisis 
to address the needs of state and local governments.
    To this end, the MSRB strongly recommends the creation of a 
Treasury Department office or other significant federal position 
charged with representing the unique needs of the municipal securities 
market. We have proposed to President Obama's Administration, as an 
alternative to such a federal position, the development of a senior 
level group to coordinate municipal finance issues among the White 
House, Department of the Treasury, Federal Reserve, SEC, MSRB, and 
other federal agencies and stakeholders.

C. Self-Regulatory Organizations
    The MSRB also believes that there is an important role for market-
specific, self-regulatory organizations in any comprehensive regulatory 
framework. These SROs would continue to adopt rules and standards, 
establish market mechanisms and systems and standards of operations, 
and adopt market-specific rules and standards for investor protection. 
These SRO activities can far exceed the antifraud standards of the 
federal securities laws and can extend to the regulation of the 
behavior of market intermediaries, thereby ensuring the goals of 
investor protection and integrity of the securities markets. SROs are 
also uniquely situated to work with the industry to develop effective 
rules and information systems, and can be vital links between the 
industry and the broader regulatory community. SRO jurisdiction must be 
flexible and broad enough to encompass new products, market 
developments, new market entrants, market movements, and other changes.

D. Enforcement
    Enforcement is key to an effective system of municipal regulation. 
Traditionally, enforcement activities have been spread across numerous 
federal and state governmental entities and self-regulatory 
organizations, consisting of the SEC, FINRA, various bank regulatory 
agencies, and state attorneys general, creating a patchwork of 
overlapping jurisdiction and inconsistent and uncoordinated enforcement 
activities. The SEC can be more effective if given additional resources 
for municipal enforcement. Further, while some coordination of 
enforcement activities currently exists, the MSRB strongly recommends 
that each of the entities that are charged with the enforcement of 
securities laws--regardless of the genesis of those laws--develop a 
more formal process to coordinate their regulatory and enforcement 
activities. Coordinated actions could avoid regulatory gaps, provide 
clearer statutory authority and promote an efficient and consistent 
enforcement mechanism for the industry.
    Finally, we recommend that Congress modify the MSRB's regulatory 
authority to include an enforcement and examination support function 
that would further strengthen enforcement in the municipal securities 
market. With an increased statutory mandate, the MSRB could better 
analyze the large amount of data that we collect to assist in 
surveillance of the market. The MSRB and its staff have a depth of 
expertise in all aspects of the municipal market that is found nowhere 
else in the federal government, and we stand ready to further assist, 
if given the congressional mandate.

E. Derivative Products
    While derivatives can be an important risk management tool, they 
can be dangerous if the state and local government issuers who purchase 
them do not understand the risks they may create. The current state of 
the law as articulated in the Commodities Futures Modernization Act of 
2000 prohibits regulation of swap agreements (which are broadly 
defined) with the exception of antifraud, and the issue of whether and 
how to regulate credit default swaps (``CDS'') and other derivative 
instruments remains controversial. While municipal derivatives play an 
important risk management role in the overall municipal securities 
market, municipal derivatives are only a fraction of the overall 
derivatives markets. The MSRB recognizes that the question of whether 
to regulate municipal derivative instruments should be answered by 
Congress in the context of the broader derivatives market and that, 
should Congress choose to place such derivative products under new 
regulations, the regulatory structure should encompass municipal 
derivatives as well.
    In particular, consideration should be given to the inclusion of 
municipal CDS in the types of CDS covered by central counterparties and 
clearinghouses. The application of central counterparties and 
clearinghouses to municipal CDS would address concerns about the 
problems of lack of minimum capitalization of CDS protection sellers. 
It would also address the lack of transparency in CDS pricing, which 
currently may disadvantage certain investors and dealers. Furthermore, 
it would provide municipal issuers with information about whether 
dealers who underwrite their securities are also selling CDS on their 
debt. Issuers who considered such a dual role to pose a conflict of 
interest could then take whatever actions they deemed appropriate. 
Should enhanced disclosures in derivative instruments be a part of any 
regulatory scheme, the MSRB is well poised with its EMMA system to 
provide disclosures of municipal derivative contracts and provide the 
necessary transparency for our market.

V. Executive Summary
    Since its creation in 1975, the MSRB has worked diligently to 
foster and preserve a fair and efficient municipal securities market 
that serves the public interest. The dual goals of investor protection 
and market integrity have guided this mission. However, the increased 
sophistication of our market, changing financial markets generally, and 
the importance of investor protection in the market require a review of 
the regulatory structure of this market.
    To that end, we make the following recommendations:

    We believe that financial advisors, investment brokers, and 
        other intermediaries in the municipal market should be brought 
        under a comprehensive regulatory scheme. Further, we believe 
        that the MSRB is the appropriate regulatory body to regulate 
        these unregulated municipal market participants, as part of a 
        dual regulatory structure with the SEC.

    We support a multi-layered overall regulatory framework for 
        the financial markets consisting of a market stability 
        regulator, a prudential financial regulator, and a business 
        conduct regulator.

    We believe that there is an important role for market-
        specific SROs that are charged with adopting rules and 
        standards, market mechanisms, information systems, and 
        standards of operations that embody and expand upon the basic 
        antifraud standards of the federal securities laws.

    We recommend the creation of a Treasury Department office 
        or other significant federal position charged with representing 
        the unique needs of the municipal securities market, or 
        alternatively, a senior-level multiple-agency group to 
        coordinate municipal finance issues among all market 
        stakeholders.

    We strongly recommend that federal and state entities 
        charged with the enforcement of securities laws develop a more 
        formal process to coordinate their regulatory and enforcement 
        activities.

    We believe that derivative instruments based on municipal 
        securities should be subject to the same comprehensive 
        regulatory framework that may be developed for swaps and other 
        types of derivative financial products in other markets. The 
        rules governing dealer activity developed by the MSRB over its 
        history provide an appropriate model for the comprehensive 
        regulation that should apply to all financial intermediaries 
        active in the municipal market.

    We stand ready to assist in this important work and are certain 
that investor protection will be served by increasing our mandate.
                                 ______
                                 

                  PREPARED STATEMENT OF RICHARD BAKER
                 President and Chief Executive Officer,
                       Managed Funds Association
                             March 26, 2009

    Managed Funds Association (``MFA'') is pleased to provide this 
statement in connection with the Senate Committee on Banking, Housing, 
& Urban Affairs hearing, ``Enhancing Investor Protection and the 
Regulation of Securities Markets--Part II'' held on March 26, 2009. MFA 
represents the majority of the world's largest hedge funds and is the 
primary advocate for sound business practices and industry growth for 
professionals in hedge funds, funds of funds and managed futures funds, 
as well as industry service providers. MFA's members manage a 
substantial portion of the approximately $1.5 trillion invested in 
absolute return strategies around the world.
    MFA appreciates the opportunity to express its views on the 
important subjects of investor protection and the regulation of 
securities markets. In considering theses issues, it is important to 
remember that vibrant, liquid markets are important to investors and 
that for these markets to work, financial institutions need to be able 
to perform their important market functions.
    Hedge funds play an important role in our financial system, as they 
provide liquidity and price discovery to capital markets, capital to 
companies to allow them to grow or turn around their businesses, and 
sophisticated risk management to investors such as pension funds, to 
allow those pensions to meet their future obligations to plan 
beneficiaries. Hedge funds engage in a variety of investment strategies 
across many different asset classes. The growth and diversification of 
hedge funds have strengthened U.S. capital markets and allowed 
investors means to diversify their investments, thereby reducing their 
overall portfolio investment risk. As investors, hedge funds help 
dampen market volatility by providing liquidity and pricing efficiency 
across many markets. Each of these functions is critical to the orderly 
operation of our capital markets and our financial system as a whole.
    In order to perform these important market functions, hedge funds 
require sound counterparties with which to trade and stable market 
structures in which to operate. The recent turmoil in our markets has 
significantly limited the ability of hedge funds to conduct their 
businesses and trade in the stable environment we all seek. As such, 
hedge funds have an aligned interest with other market participants, 
including retail investors, and policy makers in reestablishing a sound 
financial system. We support efforts to protect investors, manage 
systemic risk responsibly, and ensure stable counterparties and 
properly functioning, orderly markets.
    Hedge funds were not the root cause of the problems in our 
financial markets and economy. In fact, hedge funds overall were 
substantially less leveraged than banks and brokers, performed 
significantly better than the overall market and have not required, nor 
sought, federal assistance despite the fact that our industry, and our 
investors, have suffered mightily as a result of the instability in our 
financial system and the broader economic downturn. The losses suffered 
by hedge funds and their investors did not pose a threat to our capital 
markets or the financial system.
    Although hedge funds are important to capital markets and the 
financial system, the relative size and scope of the hedge fund 
industry in the context of the wider financial system helps explain why 
hedge funds did not pose systemic risks despite their losses. With an 
estimated $1.5 trillion under management, the hedge fund industry is 
significantly smaller than the U.S. mutual fund industry, with an 
estimated $9.4 trillion in assets under management, or the U.S. banking 
industry, with an estimated $13.8 trillion in assets. According to a 
report released by the Financial Research Corp., the combined assets 
under management of the three largest mutual fund families are in 
excess of $1.9 trillion. Moreover, because many hedge funds use little 
or no leverage, their losses did not pose the same systemic risk 
concerns that losses at more highly leveraged institutions, such as 
brokers and investment banks, did. A study by PerTrac Financial 
Solutions released in December 2008 found that 26.9 percent of hedge 
fund managers reported using no leverage. Similarly, a March 2009 
report by Lord Adair Turner, Chairman of the U.K. Financial Services 
Authority (the ``FSA''), found that the leverage of hedge funds was, on 
average, two or three-to-one, significantly below the average leverage 
of banks.
    Though hedge funds did not cause the problems in our markets, we 
believe that the public and private sectors (including hedge funds) 
share the responsibility of restoring stability to our markets, 
strengthening financial institutions, and ultimately, restoring 
investor confidence. Hedge funds remain a significant source of private 
capital and can continue to play an important role in restoring 
liquidity and stability to our capital markets. The value of hedge 
funds (and other private pools of capital) as private investors has 
been recognized by Treasury Secretary Geithner in his proposals for the 
recently announced Public Private Partnership Investment Program (the 
``PPIP'') and implementation of the Term Asset-Backed Securities Loan 
Facility, each of which is dependent on private investor participation 
to be successful. In addition to providing liquidity, managers of 
private pools of capital have significant trading and investing 
experience and knowledge that can assist policy makers as they continue 
to contemplate the best way to implement the Administration's Financial 
Stability Plan.
    MFA is supportive of the new PPIP. We share Secretary Geithner's 
commitment to promote efforts that will stabilize our financial markets 
and strengthen our Nation's economy. MFA and its members look forward 
to working with Secretary Geithner, Congressional leaders, and members 
of President Obama's economic team on this and other important issues 
in order to achieve the shared objective of restoring stability and 
investor confidence in our financial markets.
    Regulatory reform also will be an important part of stabilizing 
markets and restoring investor confidence, but it will not, in and of 
itself, be sufficient to do so. The lack of certainty regarding major 
financial institutions (e.g., banks, broker dealers, insurance 
companies) and their financial condition has limited the effectiveness 
of government intervention efforts to date. Investors' lack of 
confidence in the financial health of these institutions is an 
impediment to those investors' willingness to put capital at risk in 
the market or to engage in transactions with these firms, which, in 
turn, are impediments to market stability. The Treasury Department's 
plan to conduct comprehensive stress tests on the 19 largest bank 
holding companies is designed to ensure a robust analysis of these 
banks, thereby creating greater certainty regarding their financial 
condition. Treasury's announcement that it plans to involve private 
asset managers in helping to value illiquid assets held by banks as 
part of the PPIP recognizes the beneficial role that private asset 
managers can play in helping provide that certainty. We believe that, 
to achieve this certainty, it is also important for policy makers and 
regulators to ensure that accounting and disclosure rules are designed 
to promote the appropriate valuation of assets and liabilities and 
consistent disclosure of those valuations.
    Though ``smart'' regulation cannot, in and of itself, restore 
financial stability and properly functioning markets, it is a necessary 
component of any plan to achieve those ends. ``Smart'' regulation would 
include appropriate, effective, and efficient regulation and industry 
best practices that better monitor and reduce systemic risk and promote 
efficient capital markets, market integrity, and investor protection. 
Regulation that addresses these key issues is more likely to improve 
the functioning of our financial system, while regulation that does not 
address these key issues can cause more harm than good. We saw an 
example of the latter with the significant, adverse consequences that 
resulted from the SEC's bans on short selling last year.
    A smart regulatory framework should include comprehensive and 
robust industry best practices designed to achieve the shared goals of 
monitoring and reducing systemic risk and promoting efficient capital 
markets, market integrity, and investor protection. Since 2000, MFA has 
been the leader in developing, enhancing and promoting standards of 
excellence through its document, Sound Practices for Hedge Fund 
Managers (``Sound Practices''). As part of its commitment to ensuring 
that Sound Practices remains at the forefront of setting standards of 
excellence for the industry, MFA has updated and revised Sound 
Practices to incorporate the recommendations from the best practices 
report issued by the President's Working Group on Financial Markets' 
Asset Managers' Committee.
    Because of the complexity of our financial system, an ongoing 
dialogue between market participants and policy makers is a critical 
part of the process of developing smart, effective regulation. MFA and 
its members are committed to being active, constructive participants in 
the dialogue regarding the various regulatory reform topics.

I. Systemic Risk Regulation
    The first step in developing a systemic risk regulatory regime is 
to determine those entities that should be within the scope of such a 
regulatory regime. There are a number of factors that policy makers are 
considering as they seek to establish the process by which a systemic 
risk regulator should identify, at any point in time, which entities 
should be considered to be of systemic relevance. Those factors include 
the amount of assets of an entity, the concentration of its activities, 
and an entity's interconnectivity to other market participants.
    As an Association, we are currently engaged in an active dialogue 
with our members to better understand how these factors, among others, 
may relate to the systemic relevance of all financial market 
participants--including our industry and its members. 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. We are committed to 
being constructive participants in the dialogue regarding the creation 
of that framework.

A. Central Systemic Risk Regulator
    Under our current regulatory structure, systemic risk oversight is 
the responsibility of multiple regulatory entities, or worse, no one's 
responsibility. For systemic risk oversight to be effective, there must 
be oversight over the key elements of the entire financial system, 
across all relevant structures, classes of institutions and products, 
and an assessment of the financial system on a holistic basis. We 
believe that a single central systemic risk regulator should be 
considered to accomplish this goal. This central regulator should be 
responsible for oversight of the structure, classes of institutions and 
products of all financial system participants. MFA is engaged in 
discussions with its members with respect to which regulatory entity, 
whether new or existing, would be best suited for this role.
    We believe that having multiple regulators with responsibility for 
overseeing systemic risk likely would not be an effective framework. 
Jurisdictional conflicts, unintended gaps in regulatory authority, and 
inefficient and costly overlapping authorities likely would inhibit the 
effectiveness of such a regulatory framework. Moreover, in a framework 
with multiple systemic risk regulators, no one regulator would be able 
to assess potential systemic risks from a holistic perspective, as no 
regulator would oversee the entire system.

B. Confidential Reporting to Regulator
    MFA and its members recognize that for a systemic risk regulator to 
be able to adequately assess potential risks to our financial system, 
that regulator needs access to information. We support a systemic risk 
regulator having the authority to request and receive, on a 
confidential basis, from those entities that it determines (at any 
point in time) 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.
    In considering the appropriate scope of this authority, we believe 
that it is important for the systemic risk regulator to have sufficient 
authority and flexibility to adapt to changing conditions and take a 
forward-looking view toward risk regulation. Attempting to pre-
determine what information a regulator would need would not provide 
sufficient flexibility and likely would be ineffective as a tool to 
address potential future risks. We believe that granting the systemic 
risk regulator broad authority with respect to information gathering, 
along with ensuring that it has the appropriate resources and 
capabilities to effectively analyze that information, would be a more 
effective framework.
    While we support a systemic risk regulator having access to 
whatever information it deems necessary or advisable to assess 
potential systemic risks, we believe that it is critical for such 
information to be kept confidentially and granted full protection from 
public disclosure. We recognize the benefit of a regulator having 
access to all important data, even potentially sensitive or proprietary 
information from systemically relevant entities. A systemic risk 
regulator can fulfill its mandate to protect the financial system 
without publicly disclosing all the proprietary information of 
financial institutions. We do not believe that there is a public 
benefit to such information being publicly disclosed.
    Moreover, public disclosure of such information could be 
misleading, as it would likely be incomplete data that would be viewed 
by the public outside of the proper context. Public investors may be 
inclined to take action based on this data without fully understanding 
the information, which could lead to adverse consequences for those 
investors, for the investors in systemically relevant entities, and for 
the stability of the financial system as a whole. Public disclosure of 
proprietary information also harms the ability of market participants 
to establish and exit from investment positions in an economically 
viable manner. Such disclosure also could lead to systemically relevant 
entities being placed at an unfair competitive disadvantage compared to 
nonsystemically relevant entities, as sensitive and proprietary 
information of only the systemically relevant entities would be 
publicly available.

C. Mandate To Protect the Financial System
    Setting a clear and specific mandate is important for any regulator 
to be effective. This is particularly true in a regulatory framework 
that has multiple regulatory entities, as a lack of clarity in the 
mandates of regulators can lead to gaps in oversight, or costly and 
inefficient overlapping regulation. We believe that the systemic risk 
regulator's mandate should be the protection of the financial system. 
Investor protection and market integrity should not be part of its 
mandate, but should instead be addressed by other regulatory entities. 
Congress should be clear in stating that the risk regulator should 
collect information only for its mandate to protect the financial 
system, and should not use that authority for other purposes.
    To fulfill its mandate to protect the financial system, we 
recognize that the regulator would need to take action if the failure 
of a systemically relevant firm would jeopardize broad aspects of the 
financial system. Absent such a concern about broad systemic 
consequences, however, the systemic risk regulator should not focus on 
preventing the failure of systemically relevant entities. Systemically 
relevant market participants do not necessarily pose the same risks or 
concerns as each other. There likely are entities that would be deemed 
systemically relevant for purposes of reporting information, but whose 
failure would not threaten the broader financial system. For this 
reason, we believe that the systemic risk regulator should focus on 
preventing failures of market participants only when there is concern 
about the consequences to the broader financial system, and should not 
focus on preventing the failure of all systemically relevant entities.
    Consistent with this mandate, the systemic risk regulator should 
not equate systemically relevant entities with entities that are too 
big, or too interconnected, to fail. An entity that is perceived by the 
market to have a government guarantee, whether explicit or implicit, 
has an unfair competitive advantage over other market participants. We 
strongly believe that the systemic risk regulator should implement its 
authority in a way that avoids this possibility and also avoids the 
moral hazards that can result from a company having an ongoing 
government guarantee against its failure.

D. Scope of Regulatory Authority
    The last part of systemic risk regulation that I would like to 
address in my testimony is the scope of authority that a systemic risk 
regulator should have to fulfill its mandate to protect our financial 
system. There are a number of suggestions that various people have made 
as to the type of authority a systemic risk regulator should have. We 
continue to discuss with our members what the appropriate scope of 
authority should be for such a regulator.
    We believe that whatever authority the regulator has should ensure 
that the regulator has the ability to be forward-looking to prevent 
potential systemic risk problems, as well as the authority to address 
systemic problems once they have arisen. The systemic risk regulator's 
authority must be sufficiently flexible to permit it to adapt to 
changing circumstances and address currently unknown issues. An attempt 
to specifically define the regulator's authority must avoid 
unintentionally creating gaps in authority that would prevent the 
systemic risk regulator from being able to fulfill its mandate to 
protect the financial system in the future.
    We do believe that the systemic risk regulator needs the authority 
to ensure that a failing market participant does not pose a risk to the 
entire financial system. In the event that a failing market participant 
could pose such a risk, the systemic risk regulator should have the 
authority to directly intervene to ensure an orderly dissolution or 
liquidation of the market participant. The significant adverse 
consequences that resulted from the failure of Lehman Brothers, Inc. 
this past fall is an example of what can happen when there is not an 
intervention to prevent a disorderly dissolution of such a market 
participant. The continuing market disruption caused by the failure of 
Lehman Brothers also demonstrates the importance of ensuring that there 
is a coordinated global effort with respect to such interventions.
    Whatever the scope of authority that a systemic risk regulator has, 
its implementation of that authority will be critical to the 
effectiveness of any regulatory regime. We believe that the systemic 
risk regulator should implement its authority by focusing on all 
relevant parts of the financial system, including structure, classes of 
institutions and products. Because systemic risk concerns may arise 
from a combination of factors, rather than from the presence of any 
particular factor, a holistic approach is more likely to successfully 
identify and assess potential systemic risks.
    Recent coordinated efforts between the Federal Reserve Bank of New 
York (the ``New York Fed'') and industry participants provide a good 
example of how a systemic risk regulator could address systemic risk 
concerns posed by structural issues in our markets. In recent years, 
the New York Fed, working with MFA and other industry participants 
through the Operations Management Group (``OMG'') and other industry-
led initiatives has made notable progress in addressing concerns 
related to the over-the-counter (``OTC'') derivatives market. Some of 
the more recent market improvements and systemic risk mitigants have 
included: (1) the reduction by 80 percent of backlogs of outstanding 
credit default swap (``CDS'') confirmations since 2005; (2) the 
establishment of electronic processes to approve and confirm CDS 
novations; (3) the establishment of a trade information repository to 
document and record confirmed CDS trades; (4) the establishment of a 
successful auction-based mechanism actively employed in 14 credit 
events including Fannie Mae, Freddie Mac and Lehman Brothers, allowing 
for cash settlement; and (5) the reduction of 74 percent of backlogs of 
outstanding equity derivative confirmations since 2006 and 53 percent 
of backlogs in interest rate derivative confirmations since 2006.
    In addition to these efforts, MFA, its members and other industry 
participants have been working with the New York Fed to expedite the 
establishment of central clearing platforms covering a broad range of 
OTC derivative instruments. We believe a central clearing platform, if 
properly established, could provide a number of market benefits, 
including: (1) the mitigation of systemic risk; (2) the mitigation of 
counterparty risk and protection of customer collateral; (3) market 
transparency and operational efficiency; (4) greater liquidity; and (5) 
clear processes for the determination of a credit event (for CDS).

II. Prudential Regulation
    We recognize that, in addition to systemic risk regulation, some 
policy makers, regulators and authors of various reports (e.g., the 
Group of 30, Government Accountability Office and Congressional 
Oversight Panel) have contemplated the notion of a prudential 
regulatory framework, including mandatory registration for private 
pools of capital. There are a great many issues that should be 
considered in determining what, if any, such a framework should look 
like. As an Association, we are currently engaged in an active dialogue 
with our members on these critical issues and we are committed to being 
constructive participants as discussions on these issues progress.
    While many of the details regarding reform initiatives have yet to 
be proposed, we would like to share some initial thoughts with you on 
some of the key principles that we believe should be considered by 
Congress, the Administration and other policy makers as you consider 
prudential regulatory reform. Those principles are:

    The goal of regulatory reform should be to develop 
        intelligent regulation, which makes our system stronger for the 
        benefit of businesses and investors.

    Prudential regulation should address identified risks or 
        potential risks, and should be appropriately tailored to those 
        risks.

    Regulators should engage in ongoing dialogue with market 
        participants. Any rulemaking should be transparent and provide 
        for public notice and comment by affected market participants, 
        as well as a reasonable period of time to implement any new or 
        modified regulatory requirements. This public-private dialogue 
        can help lead to more effective regulation and avoid unintended 
        consequences, market uncertainty and increased market 
        volatility.

    Reporting requirements should provide regulators with the 
        right information to allow them to fulfill their oversight 
        responsibilities as well as to prevent, detect and punish fraud 
        and manipulative conduct. Overly broad reporting requirements 
        can limit the effectiveness of a reporting regime as regulators 
        may be unable to effectively review and analyze data, while 
        duplicative reporting requirements can be costly to market 
        participants without providing additional benefit to 
        regulators. I would add that it is critical that any reporting 
        of sensitive, proprietary information by market participants be 
        kept confidential. As discussed in the section above on 
        reporting to a systemic risk regulator, public disclosure of 
        such information can be harmful to members of the public that 
        may act on incomplete data, increase risk to the financial 
        system, and harm the ability of market participants to 
        establish and exit from investment positions in an economically 
        viable manner.

    We believe that any prudential regulatory construct should 
        distinguish, as appropriate, between different types of market 
        participants and different types of investors or customers to 
        whom services or products are marketed. While we recognize that 
        investor protection should not be limited only to retail 
        investors, we believe that a ``one-size fits all'' approach 
        will likely not be as effective as a more tailored approach.

    Lastly, we believe that industry best practices and robust 
        investor diligence should be encouraged and viewed as an 
        important complement to prudential regulation. Strong business 
        practices and robust diligence are critical to addressing 
        investor protection concerns.

III. Short Selling
    One issue in particular which has been the focus of a great deal of 
discussion recently is short selling, specifically the role of short 
selling in capital markets. Short selling, as recognized by the 
Securities and Exchange Commission (the ``SEC''), ``plays an important 
role in the market for a variety of reasons, including providing more 
efficient price discovery, mitigating market bubbles, increasing market 
liquidity, facilitating hedging and other risk management activities 
and, importantly, limiting upward market manipulations.'' \1\ 
Similarly, the FSA has noted that short selling is, ``a legitimate 
investment technique in normal market conditions,'' and ``can enhance 
the efficiency of the price formation process by allowing investors 
with negative information, who do not hold stock, to trade on their 
information.'' In addition, short selling can ``enhance liquidity by 
increasing the number of potential sellers,'' and increase market 
efficiency. \2\ We strongly agree with the SEC and the FSA that short 
selling, along with derivatives trading, provides capital markets with 
necessary liquidity and plays an important role in the price discovery 
process. Markets are more efficient, and securities prices are more 
accurate, because investors with capital at risk engage in short 
selling.
---------------------------------------------------------------------------
     \1\ Statement of Securities and Exchange Commission Concerning 
Short Selling and Issuer Stock Repurchases, SEC Release 2008-235 (Oct. 
1, 2008).
     \2\ Temporary Short Selling Measures, FSA Consultation Paper 09/1 
(Jan. 2009), at page 4.
---------------------------------------------------------------------------
    Short selling and other techniques, including listed and over-the-
counter derivatives trading, are important risk management tools for 
institutional investors, including MFA members, and essential 
components of a wide range of bona fide cash and derivatives hedging 
strategies that enable investors to provide liquidity to the financial 
markets.
    We are concerned that requirements that investors publicly disclose 
short position information, or that create the potential for public 
disclosure, would negatively reduce overall market efficiency by 
undermining the important role that short selling plays in providing 
liquidity and price discovery to markets. The risk of public disclosure 
could cause investors, including pension plans and endowments, with 
billions of dollars of assets to withdraw capital and further disrupt 
already stressed capital markets. In the long-term, pension, endowment 
and foundation investors would forego diversification and risk 
management benefits provided by alternative investment vehicles.
    We believe that concerns which have led some to propose public 
disclosure of short positions could be substantially mitigated through 
effective, comprehensive reporting of short sale information by prime 
brokers and clearing brokers. Regulators could require short sales and 
short position information to be provided by brokers on an aggregate 
basis. A regulator could request specific information as to short sales 
and short positions of individual investors if it suspected or became 
concerned about manipulation of a particular security. Such reporting 
also would provide regulators with a more effective means by which to 
identify manipulative activity.

Conclusion
    Hedge funds have important market functions, in that they provide 
liquidity and price discovery to capital markets, capital to companies 
to allow them to grow or turn around their businesses, and 
sophisticated risk management to investors such as pension funds, to 
allow those pensions to meet their future obligations to plan 
beneficiaries. MFA and its members acknowledge that smart regulation 
helps to ensure stable and orderly markets, which are necessary for 
hedge funds to conduct their businesses. We also acknowledge that 
active, constructive dialogue between policy makers and market 
participants is an important part of the process to develop smart 
regulation. We are committed to being constructive participants in the 
regulatory reform discussions and working with policy makers to 
reestablish a sound financial system and restore stable and orderly 
markets.
    MFA appreciates the opportunity to testify before the Committee. I 
would be happy to answer any questions that you may have.
                                 ______
                                 

                   PREPARED STATEMENT OF JAMES CHANOS
                               Chairman,
               Coalition of Private Investment Companies
                             March 26, 2009

    Chairman Dodd, Ranking Member Shelby, and Members of the Committee. 
My name is James Chanos, and I am President of Kynikos Associates LP, a 
New York private investment management company that I founded in 1985. 
\1\ I am appearing today on behalf of the Coalition of Private 
Investment Companies (CPIC), a group of about twenty private investment 
companies with a wide range of clients that include pension funds, 
asset managers, foundations, other institutional investors, and 
qualified wealthy individuals.
---------------------------------------------------------------------------
     \1\ Prior to founding Kynikos Associates LP, I was a securities 
analyst at Deutsche Bank Capital and Gilford Securities. My first job 
on Wall Street was as an analyst at the investment banking firm of 
Blyth Eastman Paine Webber, a position I took in 1980 upon graduating 
from Yale University with a B.A. in Economics and Political Science.
---------------------------------------------------------------------------
    I want to thank the Senators of this Committee for your efforts to 
develop and implement an approach to modernize financial regulation 
which would address the failures and inadequacies that contributed to 
the financial crisis confronting our country and our global economy. I 
am honored to have this opportunity to testify on behalf of CPIC and 
look forward to working with you and your staff in the months ahead.

I. Executive Summary
    This is a difficult time for our Nation. Overhauling our regulatory 
structure is necessary to regain investor confidence. Honesty and fair 
dealing are at the foundation of the investor confidence our markets 
enjoyed for so many years. A sustainable economic recovery will not 
occur until investors can again feel certain that their interests come 
first and foremost with the companies, asset managers, and others with 
whom they invest their money, and until they believe that regulators 
are effectively safeguarding them against fraud.
    In recent years, prior to the current economic downturn, many 
observers of the financial system believed that hedge funds and other 
private pools of capital would be the source of the next financial 
crisis. Of course, as we have all painfully learned, in fact, the 
greatest danger to world economies came not from those entities subject 
to indirect regulation, such as hedge funds, but from institutions such 
as banks, insurance companies, broker-dealers, and government-sponsored 
enterprises operating with charters and licenses granted by state and 
federal regulators and under direct regulatory supervision, 
examination, and enforcement. Indeed, Bernard Madoff used his firm, 
Bernard L. Madoff Investment Securities, LLC--which was registered with 
the SEC as a broker-dealer and investment adviser and subject to 
examination and regulation--to perpetrate his Ponzi scheme.
    Nonetheless, hedge funds and other private investment companies are 
important market players, and we recognize that a modernized financial 
regulatory system--one that addresses overall risk to the financial 
system and that regulates market participants performing the same 
functions in a consistent manner--will include regulation of hedge 
funds and other private pools of capital. We are ready to work with you 
as you seek to craft appropriate regulation for our industry.
    With respect to the new regime for monitoring systemic risk, CPIC 
would like to offer the following principles upon which to base 
legislative and regulatory action:

    First, regulation must be based upon activities, not 
        actors, and it should be scaled to size and complexity.

    Second, all companies that perform systemically significant 
        functions should be regulated.

    Third, regulators should have the authority to follow the 
        activities of systemically important entities regardless of 
        where in the entity that activity takes place.

    Fourth, as complexity of corporate structures and financial 
        products intensifies, so, too should regulatory scrutiny.

    Fifth, there should be greater scrutiny based upon the 
        ``Triple Play''--being an originator, underwriter/securitizer 
        and investor in the same asset.

    Sixth, and above all, the systemic risk regulator must 
        enforce transparency and practice it.

    With respect to increasing the functional regulation of hedge 
funds, CPIC offers the following for your consideration:

    Simply removing exemptions from the Investment Company Act 
        and the Investment Advisers Act upon which private investment 
        funds rely will prove unsatisfactory.

    Any new regulation should provide for targeted controls and 
        safeguards to provide appropriate oversight of private 
        investment companies, but should also preserve the flexibility 
        of their operations.

    More detailed requirements for large private investment 
        companies would address the greater potential for systemic risk 
        posed by such funds, depending on their use of leverage and 
        their trading strategies.

    Regulation should address basic common-sense protections 
        for investors in private investment companies, particularly 
        with respect to disclosure, custody of fund assets, and 
        periodic audits.

    Areas such as counterparty risk, lender risk, and systemic 
        risk should be addressed through disclosures to regulators and 
        counterparties.

    With respect to hedge funds as significant investors in the capital 
markets, CPIC believes that maximum attention should be paid to 
maintaining and increasing the transparency and accuracy of financial 
reporting to shareholders, counterparties, and the market as a whole.

II. The State of the Hedge Fund Sector
    Since I last testified before the Senate Banking Committee on May 
16, 2006, \2\ the hedge fund industry has undergone profound change in 
the face of unprecedented challenges. In 2006, the industry was 
continuing its rapid growth and evolution into new strategies and 
products, to offer qualified investors greater flexibility and 
opportunities for managing risks and achieving returns that exceeded 
equity and bond markets' performance. In 2006, the industry had an 
estimated $1.47 trillion in assets under management and there were an 
estimated 9,462 funds. A year later, total assets under management for 
an estimated 10,096 funds rose to about $1.87 trillion, culminating 18 
years of growth since 1990 at a cumulated average annual growth rate 
(CAGR) of 25 percent. In several markets, hedge funds became the main 
players, accounting for more than 50 percent of trading in U.S. 
convertible bonds, distressed debt, and credit derivatives. \3\ We 
experienced a host of new strategies to address investors' increasingly 
complex risk-management and asset growth demands, as the variety and 
complexity of financial instruments--and the global nature of those 
products--grew exponentially. The sheer variety of investment 
strategies that hedge funds employed strengthened capital markets, 
improved opportunities for price discovery, and facilitated the 
efficient allocation of capital. \4\
---------------------------------------------------------------------------
     \2\ Testimony of James Chanos, Chairman, Coalition of Private 
Investment Companies. U.S. Senate Committee on Banking, Housing, and 
Urban Affairs Subcommittee on Securities and Investment. Hearing on the 
Hedge Fund Industry. May 16, 2006. Available at: http://
banking.senate.gov/public/_files/ACF82BA.pdf.
     \3\ Kambhu, John, Schuermann, Til and Stiroh, Kevin J., Hedge 
Funds, Financial Intermediation, and Systemic Risk. Economic Policy 
Review, Vol. 13, No. 3, December 2007 (available at SSRN: http://
ssrn.com/abstract=1012348).
     \4\ Knowledge@Wharton, ``Hedge Funds Are Growing: Is This Good or 
Bad?'' June 29, 2005. Available at: http://knowledge.wharton.upenn.edu/
article.cfm?articleid=1225&CFID=4349082&CFTOKEN=6202640. Jeremy Siegel, 
Professor of Finance at the Wharton School of the University of 
Pennsylvania, observes that short selling contributes to the market's 
process of finding correct prices, and it's valuable to have hedge 
funds doing this. Sebastian Mallaby, ``Hands Off Hedge Funds,'' Foreign 
Affairs, January/February 2007. Available at: http://
www.foreignaffairs.org/20070101faessay86107/sebastian-mallaby/hands-
off-hedge-funds.html. The importance of hedge funds has been 
acknowledged by the President's Working Group on Financial Markets, the 
Commodities Futures Trading Commission, the Securities and Exchange 
Commission, two chairs of the Federal Reserve Board, and members of 
Congress.
---------------------------------------------------------------------------
    The attraction of hedge funds was a function, too, of their 
performance. According to Hedge Fund Research, Inc., hedge funds have 
returned an average of 11.8 percent annually during the period 1990 
through 2008, and an average 15.9 percent in the 12 months following 
the five largest historical declines. \5\
---------------------------------------------------------------------------
     \5\ Hedge Fund Research, Inc. ``Investors Withdraw Record Capital 
from Hedge Funds as Industry Concludes Worst Performance Year in 
History.'' Press Release. Available at: https://
www.hedgefundresearch.com/pdf/pr_01212009.pdf.
---------------------------------------------------------------------------
    As Andrew W. Lo, a professor at the MIT Sloan School of Management, 
testified on November 13, 2008, ``[t]he increased risk-sharing capacity 
and liquidity provided by hedge funds over the last decade has 
contributed significantly to the growth and prosperity that the global 
economy has enjoyed.'' \6\ It is a point that Treasury Secretary 
Timothy F. Geithner made as Federal Reserve Bank President and CEO in 
speeches in 2004 and 2005. \7\
---------------------------------------------------------------------------
     \6\ Written Testimony of Andrew W. Lo, Hedge Funds, Systemic Risk, 
and the Financial Crisis of 2007-2008, Prepared for the U.S. House of 
Representatives Committee on Oversight and Government Reform November 
13, 2008 Hearing on Hedge Funds.
     \7\ Mr. Geithner stated: ``Hedge funds play a valuable arbitrage 
role in reducing or eliminating mispricing in financial markets. They 
are an important source of liquidity, both in periods of calm and 
stress. They add depth and breadth to our capital markets. By taking 
risks that would otherwise have remained on the balance sheets of other 
financial institutions, they provide an importance source of risk 
transfer and diversification.'' Available at: http://www.ny.frb.org/
newsevents/speeches/2004/gei041117.html. Mr. Geithner also stated 
``Hedge funds, private equity funds and other kinds of investment 
vehicles help to disperse risk and add liquidity.'' See Keynote Address 
at the National Conference on the Securities Industry: Hedge Funds and 
Their Implications for the Financial System (November 17, 2004). 
Remarks at the Institute of International Bankers Luncheon in New York 
City (October 18,2005). Available at: http://www.ny.frb.org/newsevents/
speeches/2005/gei051018.html.
---------------------------------------------------------------------------
    Despite the rapid growth and size of hedge funds ($1.41 trillion), 
their relative size with the financial sector is small, accounting for 
0.7 percent of the $196 trillion invested in equities, tradable 
government and private debt, and bank deposits, according to McKinsey 
Global Institute. \8\
---------------------------------------------------------------------------
     \8\  McKinsey Global Institute, Mapping Global Capital Markets: 
Fifth Annual Report. October 2008. Available at: http://
www.mckinsey.com/mgi/reports/pdfs/fifth_annual_report/
fifth_annual_report.pdf.
---------------------------------------------------------------------------
    In the summer of 2007 and throughout 2008, financial markets began 
to unravel. Major regulated financial institutions collapsed or went 
bankrupt as the U.S. Treasury administered life support through both 
capital infusions and U.S.-backed guarantees to prevent the demise of 
banks, insurance companies, and others who were deemed ``too big to 
fail,'' and thereby stave off an imminent global economic collapse 
comparable to that of the Great Depression. A chain of interlinked 
securities--including derivatives and off-balance sheet vehicles--
sensitive to housing prices triggered a death spiral in financial 
markets worldwide, demonstrating the scale and intensity of 
interdependence in the global economy and the vulnerability it causes. 
\9\ As the problems became more severe, the crisis mushroomed beyond 
subprime debt to threaten less risky assets. Credit markets dried up, 
and equity markets in 2008 posted one of their worst years since the 
1930s. As a result, the value of financial assets held at banks, 
investment firms, and others collapsed, jeopardizing their survival as 
they sharply curtailed activities. Institutional investors rushed to 
the sidelines, seeking safe havens in cash investments. The downturn 
spread throughout our economy and worldwide, fueling job losses, 
prompting bankruptcies, and causing household wealth to erode. That is 
a greatly distilled and simplified recounting of the events in 2007-
2009. And, as might be expected with those events, the hedge fund 
industry experienced a sharp reversal. \10\
---------------------------------------------------------------------------
     \9\ There are many research papers and studies that examine the 
source of the financial crisis. One example: Gary B. Gorton, ``The 
Panic of 2007.'' August 25, 2008. Yale ICF Working Paper No. 08-24. 
Available at: http://ssrn.com/abstract=1255362.
     \10\ I would encourage you to read the trenchant analysis by Lord 
Adair Turner, Chairman of the U.K. Financial Services Authority 
(``FSA''), in which he eloquently recounts how developments in the 
banking and the near-bank system caused serious harm to the real 
economy. Lord Adair Turner, Chairman, FSA. ``The financial crisis and 
the future of regulation.'' January 21, 2009. The Economist's Inaugural 
City Lecture (available at http://www.fsa.gov.uk/pages/Library/
Communication/Speeches/2009/0121_at.shtml. A more extensive discussion 
is provided in: The Turner Review: A Regulatory Response to the Global 
Banking Crisis. March 18, 2009 (available at http://www.fsa.gov.uk/
pages/Library/Communication/PR/2009/037.shtml).
---------------------------------------------------------------------------
    As a consequence of the financial crisis, as was the case with 
other sectors of the financial services industry, the amount of money 
managed by hedge funds plummeted, reflecting an amalgam of sharp 
declines in asset values, the rise in client redemptions, and 
regulatory closures of margin accounts. Last year was easily among the 
worst in the industry's history, with total assets under management 
falling to $1.41 trillion--a decline of $525 billion from the all-time 
peak of $1.93 trillion reached mid-year 2008, with more than 1,471 
funds--a record in 1 year--liquidating. Investors withdrew a record 
$155 billion.
    Hedge funds on average in 2008 posted their worst performance since 
1990. The HFRI Fund Weighted Composite Index dropped 18.3 percent for 
all of last year, which was only the second calendar year decline since 
1990. \11\ That said, though, hedge fund losses on average were less 
than those of the S&P500, with 24 different hedge fund strategies 
performing better than the S&P 500 benchmark.
---------------------------------------------------------------------------
     \11\ According to Hedge Fund Research, Inc. ``during 2008, the 
industry experienced a period of six consecutive months of declines 
between June and November, interrupted only by December's 0.41 percent 
gain, including a concentrated, volatile two-month period in September 
and October in which the cumulative decline approached 13 percent.'' 
See supra n. 5.
---------------------------------------------------------------------------
III. Mitigation of Systemic Risk
    The financial crisis of the past 2 years has raised many questions 
about the extent to which systemic risks are effectively contained and 
ameliorated within the U.S. and global economies. As globalization has 
led to better risk sharing and increased market liquidity, shocks 
originating in one market are more quickly transmitted to other 
markets. Regulators and central banks say they need more information to 
understand the sources of risks and potential impact on markets and 
economies. Consensus is emerging among U.S. policy makers and in other 
countries for the need to strengthen systemic risk regulation. Towards 
that end, allow me to outline some basic principles to guide the 
thinking about establishing a regulator with responsibility for 
addressing systemic risks and the attendant laws and regulations to 
accomplish that objective.
    First, regulation must be based upon activities, not actors, and it 
should be scaled to size and complexity. Regulatory scrutiny should be 
triggered based upon any of the following: the overall scale of market 
participants, relative importance in a given market or markets, 
complexity of corporate structure, and complexity of financial 
instruments used for investment or dealer purposes. All participants 
undertaking a similar activity should be treated equally; for example, 
proprietary trading by financial institutions should not be treated in 
a different manner than trading by any other kind of entity. While the 
regulator should have broad and flexible authority to determine the 
basis upon which it wants to include systemically significant entities, 
it should be clear and transparent in disclosing the criteria upon 
which it seeks to include a specific market participant.
    Second, all companies that perform systemically significant 
functions should be regulated. The regulator should have the authority 
to examine and discipline market players such as credit rating agencies 
and financial guarantors, based on the importance of the integrity of 
their functions to the entire financial system.
    Third, the regulator should have the authority to follow the 
activities of systemically important entities regardless of where in 
the entity that activity takes place. No matter where the activity 
takes place in a corporation, regulators should be allowed to look into 
those activities. This point speaks against assigning regulators 
specific discrete parts of entities to cover and for an evolution of 
functional regulation.
    Fourth, as complexity of corporate structures and financial 
products intensifies, so, too should regulatory scrutiny. Greater 
regulatory scrutiny should be borne by complex enterprises--not just in 
the sense of adding additional functional regulation for each new piece 
of a diversified company but also in the sense of materially increasing 
the federal regulatory oversight exercised by any new systemic 
regulator. Entities should come under the ambit of a systemic regulator 
based upon the complexity, opacity, and system-wide interdependent 
nature of the instruments that they underwrite, produce, deal in or 
invest.
    Fifth, there should be greater scrutiny based upon the ``Triple 
Play''--being an originator, underwriter/securitizer, investor in the 
same asset. Greater regulatory scrutiny should be borne by those 
entities that endeavor to achieve the trifecta: that is, to own the 
``means of production'' of an asset, to act as a dealer in financial 
instruments created from those assets, and to be a direct investor in 
those instruments or assets. In other words, if a company were a 
mortgage originator, a dealer in mortgage-backed securities, and an 
investor for its own account in mortgage-backed securities, that 
``triple play'' would trigger oversight by the systemic regulator not 
only of the individual activities but also the management of the 
inherent conflicts of interest between those vertically integrated 
pieces.
    Sixth, and above all, a systemic risk regulator must enforce 
transparency and practice it. The regulatory structure should include 
reviews of how accurately entities make required disclosures of their 
true financial condition to their shareholders and/or counterparties 
and investors. The regulator, too, must be transparent; it should 
annually disclose the entities under its regulatory umbrella and the 
reason for their inclusion. The regulator should be accountable to 
Congress and the public. Although the markets alone are not up to the 
task of identifying and containing systemic risk, it is also the case 
that the government alone is not up to the task. The combined efforts 
of government regulators and market discipline brought about by 
transparent disclosure of risks are needed in any plan for future 
operation of our financial markets. Further, consideration should be 
given to modeling disclosure of regulatory or enforcement activity on 
those of the SEC or CFTC, rather than some of the other, more opaque, 
federal regulatory agencies.

IV. Hedge Funds and Functional Regulation
    Private investment companies of all types play significant, diverse 
roles in the financial markets and in the economy as a whole. Venture 
capital funds, for instance, are an important source of funding for 
start-up companies or turnaround ventures. Other private equity funds 
provide growth capital to established small-sized companies, while 
still others pursue ``buyout'' strategies by investing in 
underperforming companies and providing them with capital and/or making 
organizational changes to improve results. These types of funds may 
focus on providing capital in the energy, real estate, and 
infrastructure sectors. Hedge funds trade stocks, bonds, futures, 
commodities, currencies, and a myriad of other financial instruments on 
a global level. These flexibly structured pools of capital provide 
substantial benefits to their investors and to the markets more broadly 
in terms of liquidity, efficiency, and price discovery. In addition, 
they are a potential source of private investment to participate with 
the government in addressing the current financial crisis. \12\ It, 
therefore, is in all of our interests that private investment funds 
continue to participate in our financial markets.
---------------------------------------------------------------------------
     \12\ United States Department of the Treasury, Fact Sheet: Public-
Private Investment Program (Mar. 23, 2009) (available at http://
www.treas.gov/press/releases/reports/ppip_fact_sheet.pdf).
---------------------------------------------------------------------------
    While it often is said that private investment companies are 
``unregulated,'' they are, in fact, subject to a range of securities 
antifraud, antimanipulation, \13\ margin, \14\ and other trading laws 
and regulations that apply to other securities market participants. 
\15\ They also are subject to SEC enforcement investigations and 
subpoenas, as well as civil enforcement action and criminal prosecution 
if they violate the federal securities laws. However, private 
investment companies and their advisers are not required to register 
with the SEC if they comply with the conditions of certain exemptions 
from registration under the Investment Company Act of 1940 (the 
``Investment Company Act'') and the Investment Advisers Act of 1940 
(``Advisers Act''). \16\ Congress created exemptions under these laws 
because it determined that highly restrictive requirements of laws 
designed to regulate publicly offered mutual funds and investment 
advisers to retail investors were not appropriate for funds designed 
primarily for institutions and wealthy investors.
---------------------------------------------------------------------------
     \13\ See Section 10(b) of the Securities Exchange Act of 1934 
(Exchange Act) (15 U.S.C. 78j) and Rule 10b-5 thereunder (17 C.F.R.  
240.10b-5).
     \14\ 12 C.F.R. 220, 221, 224.
     \15\ See, e.g., Exchange Act 13(d), 13(e), 14(d), 14(e) and 
14(f) (15 U.S.C. 78m(d), 78m(e), 78n(d), 78n(e) and 78n(f)) and 
related rules (which regulate and require public reporting on the 
acquisition of blocks of securities and other activities in connection 
with takeovers and proxy contests).
     \16\ Section 3(c)(1) of the Investment Company Act excludes a 
company from the definition of an ``investment company'' if it has 100 
or fewer beneficial owners of its securities and does not offer its 
securities to the public. Under the Securities Act of 1933 and SEC 
rules, an offering is not ``public'' if it is not made through any 
general solicitation or advertising to retail investors, but is made 
only to certain high-net-worth individuals and institutions known as 
``accredited investors.'' ``Accredited investors'' include banks, 
broker-dealers, and insurance companies. The term also includes natural 
persons whose individual net worth or joint net worth with a spouse 
exceeds $1 million, and natural persons whose individual income in each 
of the past 2 years exceeds $200,0000, or whose joint income with a 
spouse in each of the past 3 years exceeds $300,000, and who reasonably 
expect to reach the same income level in the current year.
    Section 3(c)(7) of the Investment Company Act excludes a company 
from the definition of an ``investment company'' if all of its 
securities are owned by persons who are ``qualified purchasers'' at the 
time of acquisition and if the Company does not offer its securities to 
the public. Congress added this section to the Investment Company Act 
in 1996 after determining that there should be no limit on the number 
of investors in a private investment fund, provided that all of such 
investors are ``qualified purchasers.'' In brief, ``qualified 
purchasers'' must have even greater financial assets than accredited 
investors. Generally, individuals that own not less than $5 million in 
investments and entities that own not less than $25 million in 
investments are qualified purchasers.
    Section 203(b)(3) of the Advisers Act exempts from registration any 
investment adviser that, during the course of the preceding twelve 
months has had fewer than fifteen clients and that does not hold itself 
out as an investment adviser nor act as an investment adviser to any 
investment company. Advisers to hedge funds and other private 
investment companies are generally excepted from registration under the 
Advisers Act by relying upon Section 203(b)(3), because a fund counts 
as one client.
    In some cases, where these companies and their advisers engage in 
trading commodity futures, they also comply with exemptions from 
registration under the ``commodity pool operator'' and ``commodity 
trading advisor'' provisions of the Commodity Exchange Act (``CEA''). 
These exemptions generally parallel the exemptions from registration 
under the securities laws.
---------------------------------------------------------------------------
    To date, legislative proposals to regulate private investment 
companies have been directed at removing the exemptions from regulation 
of private investment companies under the Investment Company Act and 
Advisers Act and thus subjecting private investment companies to the 
requirements of those Acts. But, for policy makers who believe private 
investment companies and their managers should be subject to greater 
federal oversight, I would argue that simply eliminating the exemptions 
in either or both of these statutes will prove unsatisfactory. \17\
---------------------------------------------------------------------------
     \17\ In my testimony before the SEC's public roundtable on hedge 
funds in 2003, I recommended that, as a further condition to exemption 
under the Advisers Act, hedge funds should be subject to specific 
standards relating to investor qualifications, custody of fund assets 
(an issue on which there now is significant focus as a result of the 
Madoff scandal), annual audits and quarterly unaudited reports to 
investors, clear disclosure of financial arrangements with interested 
parties (such as the investment manager, custodian, prime broker, and 
others--in order to address conflicts issues), clear disclosure of 
investment allocation policies, and objective and transparent standards 
for valuation of fund assets that are clearly disclosed, not stale, and 
subject to audit. Statement of James Chanos, President, Kynikos 
Associates, SEC Roundtable on Hedge Funds (May 15, 2003) (available at 
http://sec.gov/spotlight/hedgefunds/hedge-chanos.htm).
    When I testified before this Committee in 2004, I expanded upon 
these points and recommended that the SEC require, as a condition to a 
hedge fund's exemption under the Advisers Act, that hedge funds file 
basic information with the SEC and certify that they met the standards 
outlined above. Testimony before the Senate Committee on Banking, 
Housing and Urban Affairs, Hearing on Regulation of the Hedge Fund 
Industry (Jul. 15, 2004) (available at http://banking.senate.gov/
public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=79b80b77-9855-
47d4-a514-840725ad912c). See also Letter from James Chanos to Jonathan 
Katz, SEC (Sept. 15, 2004) (available at http://www.sec.gov/rules/
proposed/s73004/s73004-52.pdf). This would have provided the SEC with 
hedge fund ``census'' data it has long said it needs; it also would 
have provided a basis for SEC enforcement action against any fund 
failing to meet the above standards. Had the SEC adopted this 
recommendation, the agency would have avoided the legal challenge to 
the rule it adopted later that year to change its interpretation of the 
term ``client'' under the Advisers Act in order to require hedge fund 
managers to register. See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 
2006).
    As this Committee knows, the SEC's hedge fund adviser registration 
rule was struck down in 2006, (id.) and the SEC decided not to appeal. 
Some hedge fund managers that had registered with the SEC under the 
rule withdrew their registrations. I decided that my firm should remain 
registered as an investment adviser (which we are still today), but, as 
I testified in 2006 before this Committee, the Advisers Act is ``an 
awkward statute for providing the SEC with the information it seeks . . 
. and for dealing with the broader issues that are outside the Act's 
purposes.'' Testimony of James Chanos, CPIC, before the Senate 
Committee on Banking, Housing and Urban Affairs, Subcommittee on 
Securities and Investment; Hearing on the Hedge Fund Industry, at 7 
(available at http://banking.senate.gov/public/--files/ACF82BA.pdf).
---------------------------------------------------------------------------
    The first lesson we all learned in shop class is you need to use 
the right tool for the job. Although you can use a pipe wrench to pound 
in a nail, or a claw hammer to loosen up a pipe, it is not a good idea 
to do so. Neither the Investment Company Act nor the Advisers Act is 
the right tool for the job of regulating hedge funds and other private 
investment companies. They do not contain the provisions needed to 
address the potential risks posed by the largest large private 
investment companies, the types of investments they hold, and the 
contracts into which they enter. At the same time, those laws each 
contain provisions designed for the types of businesses they are 
intended to regulate--laws that would either be irrelevant to oversight 
of private investment companies or would unduly restrict their 
operation. If Congress determines that legislation is needed, I believe 
a more tailored and targeted law should be drafted in order to address 
current public policy concerns about investor protection and systemic 
risks. Yet, Congress should avoid trying to shoehorn private investment 
companies into laws designed for retail investors.
    For example, the Investment Company Act and Advisers Act are 
designed purely for investor protection, and have no provisions 
designed to protect counterparties or to control systemic risk. 
Similarly, these acts are generally silent on methods for winding down 
an investment fund or client account, an area which the law should 
address in some detail for large private investment companies. Further, 
the Advisers Act custody provisions exclude certain types of 
instruments that are commonly owned by private investment funds, an 
exclusion that would deprive investors in those funds of the protection 
that a custody requirement provides.
    At the same time, many requirements of the Investment Company Act 
and the Advisers Act are irrelevant, or would be counterproductive, if 
applied to private investment companies. For example, current 
restrictions on mutual funds from engaging in certain types of 
transactions, such as trading on margin and short selling, would 
severely inhibit or foreclose a number of hedge fund trading strategies 
that are fundamental to their businesses and the markets. \18\ As 
another example, requirements for boards of directors imposed by the 
Investment Company Act and compensation restrictions imposed by the 
Advisers Act are not particularly well suited to the regulation of 
managers of investment pools with high net worth and institutional 
investors. Such investors are fully capable of understanding the 
implications of performance-based fees, and do not need regulatory 
attention to protect themselves. Likewise, client-trading restrictions 
under the Advisers Act that require client consent on a transaction-by-
transaction basis are unduly burdensome for private fund management. In 
sum, the Investment Company Act and Advisers Act, which were adopted in 
largely their current forms in 1940, are not well suited to being 
adapted for a new use in regulating investment structures and 
strategies developed primarily over the last 20 years.
---------------------------------------------------------------------------
     \18\ For example, convertible bond arbitrage relies on selling 
short the underlying equity security while buying the bond. This 
strategy provides an essential support for the convertible bond market, 
upon which many corporations rely for capital.
---------------------------------------------------------------------------
    Congress should think carefully as it considers the right tool for 
the task of regulating private investment companies. In my view, 
whatever legislation is developed should contain targeted controls and 
safeguards needed to provide appropriate oversight for the regulation 
of such entities, yet retain the flexibility of their operations. 
Congress may wish to consider more detailed requirements on large 
private investment companies (or families of private investment 
companies) in order to address the greater potential for systemic risk 
posed by such funds, depending upon their use of leverage and their 
trading strategies.
    Congress also may wish to consider giving legal effect to certain 
measures that were identified as ``best practices'' for fund managers 
in a report issued earlier this year by the Asset Managers' Committee 
(``AMC Best Practices'')--a group on which I served at the request of 
the President's Working Group on Financial Markets. \19\ For example, 
one of the most important of these recommendations is that managers 
should disclose more details--going beyond Generally Accepted 
Accounting Standards--regarding the portion of income and losses that 
the fund derives from Financial Accounting Standard (FAS) 157 Level 1, 
2, and 3 assets. \20\ Another recommendation is that a fund's annual 
financial statements should be audited by an independent public 
accounting firm that is subject to PCAOB oversight. Still another 
recommendation would assure that potential investors are provided with 
specified disclosures relating to the fund and its management before 
any investment is accepted. This type of information should include any 
disciplinary history and pending or concluded litigation or enforcement 
actions, fees and expense structure, the use of commissions to pay 
broker-dealers for research (``soft dollars''), the fund's methodology 
for valuation of assets and liabilities, any side-letters and side-
arrangements, conflicts of interest and material financial arrangements 
with interested parties (including investment managers, custodians, 
portfolio brokers, and placement agents), and policies as to investment 
and trade allocations.
---------------------------------------------------------------------------
     \19\ Report of the Asset Managers' Committee: Best Practices for 
the Hedge Fund Industry (January 15, 2009) (available at http://
www.amaicmte.org/Asset.aspx).
     \20\ In brief, under FAS 157, Level 1 assets are those that have 
independently derived and observable market prices. Level 2 assets have 
prices that are derived from those of Level 1 assets. Level 3 assets 
are the most difficult to price--theirs are derived in part by 
reference to other sources and rely on management estimates. Disclosure 
of profits and losses from these categories will allow investors to 
better assess the diversification and risk profile of a given 
investment, and to determine the extent to which fund valuations are 
based on the ``best guess'' of fund management.
---------------------------------------------------------------------------
    Congress also should require safeguards that I have advocated for 
many years--simple, common-sense protections relating to custody of 
fund assets and periodic audits.
    As I mentioned earlier, there are areas of importance to the 
financial system that the Investment Company Act and Advisers Act do 
not address, including counterparty risk, lender risk, and systemic 
risk. These types of issues can be addressed through required 
disclosures to regulators and to counterparties. Of course, Congress 
also will need to choose a regulator, and since the SEC already has 
regulatory responsibility over publicly-offered funds, the SEC is the 
logical choice. If Congress decides to establish an overall systemic 
risk regulator, that regulator also may have a role in overseeing the 
largest, systemically important funds.

V. Hedge Funds as Financial Investors
    One of the most important roles that hedge funds play in our 
economy is that of investor. Perhaps no other role played by hedge 
funds and other private investment vehicles, like venture capital 
funds, is more important to a return to economic growth than this one. 
From the point of view of an investor that provides capital to 
corporations by buying equity or debt, or of a potential purchaser of 
asset-backed securities in the secondary market, certain principles 
will be essential to encouraging investment in products that do not 
carry an explicit government and taxpayer guarantee against loss. One 
key principle is a generally accepted and respected valuation of 
assets.
    Mark-to-market (``MTM'') accounting is not perfect, but it does 
provide a compass for investors to figure out what an asset would be 
worth in today's market if it were sold in an orderly fashion to a 
willing buyer. Before mark-to-market accounting took effect, the 
Financial Accounting Standards Board (FASB) produced much evidence to 
show that valuing financial instruments and other difficult-to-price 
assets by ``historical'' costs, or ``mark to management,'' was folly.
    The rules now under attack are neither as significant nor as 
inflexible as critics charge. Mark-to-market accounting is generally 
limited to investments held for trading purposes, and to certain 
derivatives. For many financial institutions, these investments 
represent a minority of their total investment portfolio. For example, 
Bloomberg columnist David Reilly reports that of the 12 largest banks 
in the KBW Bank Index, only 29 percent of the $8.46 trillion in assets 
are at MTM prices. \21\
---------------------------------------------------------------------------
     \21\ David Reilly, Elvis Lives and Mark to Market Rules Fuel 
Crisis (Mar. 11, 2009), Bloomberg (available at http://
www.bloomberg.com/apps/news?pid=newsarchive&sid=aD11FOjLK1y4). ``Of the 
$8.46 trillion in assets held by the 12 largest banks in the KBW Bank 
Index, only 29 percent is marked to market prices, according to my 
analysis of company data. General Electric Co., meanwhile, said last 
week that just 2 percent of assets were marked to market at its General 
Electric Capital Corp. subsidiary, which is similar in size to the 
sixth-biggest U.S. bank. What are all those other assets that aren't 
marked to market prices? Mostly loans--to homeowners, businesses and 
consumers. Loans are held at their original cost, minus a reserve that 
banks create for potential future losses. Their value doesn't fall in 
lockstep with drops in market prices. Yet these loans still produce 
losses, thanks to the housing meltdown and recession. In fact, bank 
losses on unmarked loans are typically bigger than mark-to-market 
losses on securities like bonds backed by mortgages.''
---------------------------------------------------------------------------
    Why is that so? Most bank assets are in loans, which are held at 
their original cost using amortization rules, minus a reserve that 
banks must set aside as a safety cushion for potential future losses.
    MTM rules also give banks a choice. MTM accounting is not required 
for securities held to maturity, but you need to demonstrate a 
``positive intent and ability'' that you will do so. Further, an SEC 
2008 report found that ``over 90 percent of investments mark-to-market 
are valued based on observable inputs.'' \22\
---------------------------------------------------------------------------
     \22\ SEC, Office of the Chief Accountant, Report and 
Recommendations Pursuant to Section 133 of the Emergency Economic 
Stabilization Act of 2008: Study on Mark-To-Market Accounting 
(available at: http://www.sec.gov/news/studies/2008/
marktomarket123008.pdf). The report concludes: ``The Staff observes 
that fair value accounting did not appear to play a meaningful role in 
bank failures occurring during 2008. Rather, bank failures in the U.S. 
appeared to be the result of growing probable credit losses, concerns 
about asset quality, and, in certain cases, eroding lender and investor 
confidence. For the failed banks that did recognize sizable fair value 
losses, it does not appear that the reporting of these losses was the 
reason the bank failed.'' At 4.
---------------------------------------------------------------------------
    Obfuscating sound accounting rules by gutting MTM rules will only 
further reduce investors' trust in the financial statements of all 
companies, causing private capital--desperately needed in securities 
markets--to become even scarcer. Worse, decreased clarity will further 
erode confidence in the American economy, with dire consequences for 
many of the financial institutions who are calling for MTM changes.
    Greater transparency is also necessary in the over-the-counter 
derivatives markets. These markets play a critical role in the 
establishment of prices in almost every public or regulated market, 
from determining interest rates to share prices. Reducing the need for 
reliance on a few opaque counterparties, increasing regulatory access 
to price and volume and other transactional information, and fostering 
integrity in the price discovery function for OTC products that affect 
the borrowing costs of individual companies, are all objectives that 
should be aggressively pursued as part of this Committee's 
modernization of our financial regulatory structure.

VI. Conclusion
    Honesty and fair dealing are at the foundation of the investor 
confidence our markets enjoyed for so many years. A sustainable 
economic recovery will not occur until investors can again feel certain 
that their interests come first and foremost with the companies, asset 
managers, and others with whom they invest their money, and until they 
believe that regulators are effectively safeguarding them against 
fraud. CPIC is committed to working diligently with this Committee and 
other policy makers to achieve that difficult but necessary goal.
                                 ______
                                 

                  PREPARED STATEMENT OF BARBARA ROPER
                    Director of Investor Protection,
                     Consumer Federation of America
                             March 26, 2009

    Chairman Dodd, Ranking Member Shelby, and Members of the Committee: 
My name is Barbara Roper. I am Director of Investor Protection of the 
Consumer Federation of America (CFA). CFA is a nonprofit association of 
approximately 280 organizations. It was founded in 1968 to advance the 
consumer interest through research, advocacy, and education. I 
appreciate the opportunity to appear before you today to discuss needed 
steps to strengthen investor protection.
    The topic we have been asked to address today, ``Enhancing Investor 
Protection and the Regulation of Securities Markets,'' is broad. It is 
appropriate that you begin your regulatory reform efforts by casting a 
wide net, identifying the many issues that should be addressed as we 
seek to restore the integrity of our financial system. In response, my 
testimony will also be broader than it is deep. In it, I will attempt 
to identify and briefly describe, but not comprehensively detail, 
solutions to a number of problems in three general categories: 
responding to the current financial crisis, reversing harmful policies, 
and adopting pro-investor reforms. I look forward to working with this 
Committee and its members on its legislative response.

Introduction
    Before I turn to specific issues, however, I would like to take a 
few moments to discuss the environment in which this reform effort is 
being undertaken. I'm sure I don't need to tell the members of this 
Committee that the public is angry, or that investor confidence--not 
just in the safety of the financial markets but in their integrity--is 
at an all-time low. Perhaps you've seen the recent Harris poll, taken 
before the news hit about AIG's million-dollar bonuses, which found 
that 71 percent of respondents agreed with the statement that, ``Most 
people on Wall Street would be willing to break the law if they 
believed they could make a lot of money and get away with it.'' If not, 
you've surely heard a variant on this message when you've visited your 
districts or turned on the evening news.
    Right now, the public rage is unfocused, or rather it is focused on 
shifting targets in response to the latest headlines: Bernie Madoff's 
Ponzi scheme one day, bailout company conferences at spa resorts the 
next, AIG bonuses today. Imagine what will happen if the public ever 
really wakes up to the fact that all of the problems that have brought 
down our financial system and sent the global economy into deep 
recession--unsound and unsustainable mortgage lending, unregulated 
over-the-counter derivatives, and an explosive combination of high 
leverage and risky assets on financial institution balance sheets--were 
diagnosed years ago but left unaddressed by legislators and regulators 
from both political parties who bought into the idea that market 
discipline and industry self-interest were all that was needed to rein 
in Wall Street excesses and that preserving industry's ability to 
innovate was more important than protecting consumers and investors 
when those innovations turned toxic.
    Now, this Committee and others in Congress have begun the Herculean 
task of rewriting the regulatory rulebook and restructuring the 
regulatory system. That is an effort that CFA strongly supports. But, 
as the Securities Subcommittee hearing last week on risk management 
regulation made all too clear, those efforts are likely to have little 
effect if regulators remain reluctant to act in the face of obvious 
industry shortcomings and clear signs of abuse. After all, we might not 
be here today if regulators had done just that--if the Fed had used its 
authority under the Home Ownership and Equity Protection Act to rein in 
the predatory subprime lending that is at the root of this problem, or 
if SEC and federal banking regulators had required the institutions 
under their jurisdiction to adopt appropriate risk management practices 
that could have made them less vulnerable to the current financial 
storm.
    Before we heap too much scorn on the regulators, however, we would 
do well to remember that, in recent years at least, global 
competitiveness was the watchword, and regulators who took too tough a 
line with industry were more likely to be called on the carpet than 
those who were too lax. Even now, it is not clear how much that has 
changed. After all, just two weeks ago, the House Capital Markets 
Subcommittee subjected the Financial Accounting Standards Board (FASB) 
to a thorough grilling for doing too little to accommodate financial 
institutions seeking changes to fair value accounting, changes, by the 
way, that would make it easier for those institutions to hide bad news 
about the deteriorating condition of their balance sheets from 
investors and regulators alike. Unless something fundamental changes in 
the way we approach these issues, it is all too easy to imagine a new 
systemic risk regulator sitting in that same hot seat in a couple of 
years, asked to defend regulations industry groups complain are 
stifling innovation and undermining their global competitiveness. More 
than any single policy or practice, that antiregulatory bias among 
regulators and legislators is what needs to change if the goal is to 
better protect investors and restore the health and integrity of our 
securities markets.

I. Respond to the Current Financial Crisis
    It doesn't take a rocket scientist to recognize that, in the midst 
of a financial crisis of global proportions, the top investor 
protection priority today must be fixing the problems that caused the 
financial meltdown. Largely as the result of a coincidence in the 
timing of Bear Stearns' failure and the release of the Treasury 
Department's Blueprint for Financial Regulatory Reform, many people 
have sought solutions to our financial woes in a restructuring of the 
financial regulatory system. CFA certainly agrees that our regulatory 
structure can, and probably should, be improved. We remain convinced, 
however, that structural weaknesses were not a primary cause of the 
current crisis, and structural changes alone will not prevent a 
recurrence. We appreciate the fact that this Committee has recognized 
the importance of treating these issues holistically and has pledged to 
take an inclusive approach. As the Committee moves forward with that 
process, the following are among the key investor protection issues CFA 
believes must be addressed as part of a comprehensive response to the 
financial meltdown.

1. Shut down the ``shadow'' banking system
    The single most important step Congress can and should take 
immediately to reduce excessive risks in the financial system is to 
close down the shadow banking system completely and permanently. While 
progress is apparently being made (however slowly) in moving over-the-
counter credit default swaps onto a clearinghouse, this is just a 
start, and a meager start at that. Meaningful financial regulatory 
reform must require that all financial activities be conducted in the 
light of regulatory oversight according to basic rules of transparency, 
fair dealing, and accountability.
    As Frank Partnoy argued comprehensively and persuasively in his 
2003 book, Infectious Greed, a primary use of the ``shadow'' banking 
system--and indeed the main reason for its existence--is to allow 
financial institutions to do indirectly what they or their clients 
would not be permitted to do directly in the regulated markets. So, 
when Japanese insurers in the 1980s wanted to evade restrictions that 
prevented them from investing in the Japanese stock market, Bankers 
Trust designed a complex three-way derivative transaction between 
Japanese insurers, Canadian bankers, and European investors that 
allowed them to do just that. Institutional investors that were not 
permitted to speculate in foreign currencies could do so indirectly 
using structured notes designed by Credit Suisse Financial Products 
that, incidentally, magnified the risks inherent in currency 
speculation. And banks could do these derivatives deals through special 
purpose entities (SPEs) domiciled in business-friendly jurisdictions 
like the Cayman Islands in order to avoid taxes, keep details of the 
deal hidden, and insulate the bank from accountability.
    These same practices, which led to a series of mini-financial 
crises throughout the 1990s, are evident in today's crisis, but on a 
larger scale. Banks such as Citigroup were still using unregulated 
special purpose entities to hold toxic assets that, if held on their 
balance sheets, would have required them to set aside additional 
capital, relying on the fiction that the bank itself was not exposed to 
the risks. Investment banks such as Merrill Lynch sold subprime-related 
CDOs to pension funds and other institutional investors in private 
placements free from disclosure and other obligations of the regulated 
marketplace. And everyone convinced themselves that they were protected 
from the risks of those toxic assets because they had insured them 
using credit default swaps sold in the over-the-counter derivatives 
market, often by AIG, without the basic protections that trading on an 
exchange would provide, let alone the reserve or collateral 
requirements that would, in the regulated insurance market, provide 
some assurance that any claims would be paid.
    To be credible, any proposal to respond to the current crisis must 
confront the ``shadow banking system'' issue head-on. This does not 
mean that all investors must be treated identically or that all 
financial activities must be subject to identical regulations, but it 
does mean that all aspects of the financial system must be subject to 
regulatory scrutiny based on appropriate standards. One focus of that 
regulation should be on protecting against risks that could spill over 
into the broader economy. But regulation should also apply basic 
principles of transparency, fair dealing, and accountability to these 
activities in recognition of the two basic lessons from the current 
crisis: 1) protecting consumers and investors contributes to the safety 
and stability of the financial system; and 2) the sheer complexity of 
modern financial products has made former measures of investor 
``sophistication'' obsolete.
    The basic justification for allowing two systems to grow up side-
by-side--one regulated and one not--is that sophisticated investors do 
not require the protections of the regulated market. According to this 
line of reasoning, these investors are capable both of protecting their 
own interests and of absorbing any losses. That myth should have been 
dispelled back in the early 1990s, when Bankers Trust took 
``sophisticated'' investors, such as Gibson Greeting, Inc. and Procter 
& Gamble, to the cleaners selling them risky interest rate swaps based 
on complex formulas that the companies clearly didn't understand. Or 
when Orange County, California lost $1.7 billion, and ultimately went 
bankrupt, buying structured notes with borrowed money in what 
essentially amounted to a $20 billion bet that interest rates would 
remain low indefinitely. Or when a once-respected conservative 
government bond fund, Piper Jaffray Institutional Government Income 
Portfolio, lost 28 percent of its value in less than a year betting on 
collateralized mortgage obligations that involved ``risks that required 
advanced mathematical training to understand.'' \1\
---------------------------------------------------------------------------
     \1\ Frank Partnoy, Infectious Greed, How Deceit and Risk Corrupted 
the Financial Markets, Henry Holt and Company (New York), 2003, p. 123.
---------------------------------------------------------------------------
    All of these deals, and many others like them, had several 
characteristics in common. In each case, the brokers and bankers who 
structured and sold the deal made millions while the customers lost 
fortunes. The deals were all carried out outside the regulated 
securities markets, where brokers, despite their best lobbying efforts 
throughout much of the 1990s, still faced a suitability obligation in 
their dealings with institutional clients. Once the deals blew up, 
efforts to recover losses were almost entirely unsuccessful. And, in 
many cases, strong evidence suggests that the brokers and bankers 
knowingly played on these ``sophisticated'' investors' lack of 
sophistication. Partnoy offers the following illustration of the 
culture at Bankers Trust:

        As one former managing director put it, ``Guys started making 
        jokes on the trading floor about how they were hammering the 
        customers. They were giving each other high fives. A junior 
        person would turn to his senior guy and say, `I can get [this 
        customer] for all these points.' The senior guys would say, 
        `Yeah, ream him.' '' \2\
---------------------------------------------------------------------------
     \2\ Partnoy, p. 55, citing Brett D. Fromson, ``Guess What? The 
Loss is Now . . . $20 Million: How Bankers Trust Sold Gibson Greetings 
a Disaster,'' Washington Post, June 11, 1995, p. A1.

    More recent accounts suggest that little has changed in the 
intervening decades. As Washington Post reporter Jill Drew described in 
---------------------------------------------------------------------------
a story detailing the sale of subprime CDOs:

        The CDO alchemy involved extensive computer modeling, and those 
        who wanted to wade into the details quickly found that they 
        needed a PhD in mathematics.

        But the team understood the goal, said one trader who spoke on 
        condition of anonymity to protect her job: Sell as many as 
        possible and get paid the most for every bond sold. She said 
        her firm's salespeople littered their pitches to clients with 
        technical terms. They didn't know whether their pitches made 
        sense or whether the clients understood. \3\
---------------------------------------------------------------------------
     \3\ Jill Drew, ``Frenzy,'' Washington Post, December 16, 2008, p. 
A1.

    The sophisticated investor myth survived earlier scandals thanks to 
Wall Street lobbying and the fact that the damage from these earlier 
scandals was largely self-contained. What's different this time around 
is the harm that victimization of ``sophisticated'' investors has done 
to the broader economy. Much as they had in the past, ``sophisticated'' 
institutional investors have once again loaded up on toxic assets--in 
this case primarily mortgage-backed securities and collateralized debt 
obligations--without understanding the risks of those investments. In 
an added twist this time around, many financial institutions also 
remained exposed to the risk of these assets, either because they made 
a conscious decision to retain a portion of the investments or because 
they couldn't sell off their inventory after the market collapsed. As 
events of the last year have shown, the damage this time is not self-
contained; it has led to a 50 percent drop in the stock market, a 
freezing of credit markets, and a severe global recession. Meanwhile, 
the administration is still struggling to find a way to clear toxic 
assets from financial institutions' balance sheets.
    Once it has closed existing gaps in the regulatory system, Congress 
will still need to give authority to some entity--presumably whatever 
entity is designated as systemic risk regulator--to prevent financial 
institutions from opening up new regulatory loopholes as soon as the 
old ones are closed. That regulator must have the ability to determine 
where newly emerging activities will be covered within the regulatory 
structure. In making those decisions, the governing principle should be 
that activities and products are regulated according to their function. 
For example, where credit default swaps are used as a form of 
insurance, they should be regulated according to standards that are 
appropriate to insurance, with a focus on ensuring that the writer of 
the swaps will be able to make good on any claims. The other governing 
principle should be that financial institutions are not permitted to 
engage in activities indirectly that they would be prohibited from 
engaging in directly. Until that happens, anything else Congress does 
to reduce the potential for systemic risks is likely to have little 
effect.

2. Strengthen regulation of credit rating agencies
    Complex derivatives and mortgage-backed securities were the poison 
that contaminated the financial system, but it was their ability to 
attract high credit ratings that allowed them to penetrate every corner 
of the market. Over the years, the number of financial regulations and 
other practices tied to credit ratings has grown rapidly. For example, 
money market mutual funds, bank capital standards, and pension fund 
investment policies all rely on credit ratings to one degree or 
another. As Jerome S. Fons and Frank Partnoy wrote in a recent New York 
Times op ed: ``Over time, ratings became valuable . . . because they 
``unlock'' markets; that is, they are a sort of regulatory license that 
allows money to flow.'' \4\ This growing reliance on credit ratings has 
come about despite their abysmal record of under-estimating risks, 
particularly the risks of arcane derivatives and structured finance 
deals. Although there is ample historical precedent, never was that 
more evident than in the current crisis, when thousands of ultimately 
toxic subprime-related mortgage-backed securities and CDOs were awarded 
the AAA ratings that made them eligible for purchase by even the most 
conservative of investors.
---------------------------------------------------------------------------
     \4\ Jerome S. Fons and Frank Partnoy, ``Rated F for Failure,'' New 
York Times, March 16, 2009.
---------------------------------------------------------------------------
    Looking back, many have asked what would possess a ratings agency 
to slap a AAA rating on, for example, a CDO composed of the lowest-
rated tranches of a subprime mortgage-backed security. (Some, like 
economists Joshua Rosner and Joseph Mason, pointed out the flaws in 
these ratings much earlier, at a time when, if regulators had heeded 
their warning, they might have acted to address the risks that were 
lurking on financial institutions' balance sheets.) \5\ Money is the 
obvious answer. Rating structured finance deals pays generous fees, and 
ratings agencies' profitability has grown increasingly dependent in 
recent years on their ability to win market share in this line of 
business. Within a business model where rating agencies are paid by 
issuers, the perception at least is that they too often win business by 
showing flexibility in their ratings. Another possibility, no more 
attractive, is that the agencies simply weren't competent to rate the 
highly complex deals being thrown together by Wall Street at a 
breakneck pace. One Moody's managing director reportedly summed up the 
dilemma this way in an anonymous response to an internal survey: 
``These errors make us look either incompetent at credit analysis or 
like we sold our soul to the devil for revenue, or a little bit of 
both.'' \6\
---------------------------------------------------------------------------
     \5\ Joseph R. Mason and Joshua Rosner, How Resilient Are Mortgage 
Backed Securities to Collateralized Debt Obligation Market Disruptions? 
(preliminary paper presented at Hudson Institute) February 15, 2007.
     \6\ Gretchen Morgenson, ``Debt Watchdogs: Tamed or Caught 
Napping?'' New York Times, December 7, 2008.
---------------------------------------------------------------------------
    The Securities and Exchange Commission found support for both 
explanations in its July 2008 study of the major ratings agencies. \7\ 
It documented both lapses in controls over conflicts of interest and 
evidence of under-staffing and shoddy practices: assigning ratings 
despite unresolved issues, deviating from models in assigning ratings, 
a lack of due diligence regarding information on which ratings are 
based, inadequate internal audit functions, and poor surveillance of 
ratings for continued accuracy once issued. Moreover, in addition to 
the basic conflict inherent in the issuer-paid model, credit rating 
agencies can be under extreme pressure from issuers and investors alike 
to avoid downgrading a company or its debt. With credit rating triggers 
embedded in AIG's credit default swaps agreements, for example, a small 
reduction in rating exposed the company to billions in obligations and 
threatened to disrupt the CDS market.
---------------------------------------------------------------------------
     \7\ U.S. Securities and Exchange Commission, Summary Report of 
Issues Identified in the Commission Staff's Examinations of Select 
Credit Rating Agencies, July 2008.
---------------------------------------------------------------------------
    It is tempting to conclude, as many have done, that the answer to 
this problem is simply to remove all references to credit ratings from 
our financial regulations. This is the recommendation that Fons and 
Partnoy arrive at in their Times op ed. ``Regulators and investors 
should return to the tool they used to assess credit risk before they 
began delegating responsibility to the credit rating agencies,'' they 
conclude. ``That tool is called judgment.'' Unfortunately, Fons and 
Partnoy may have identified the only thing less reliable than credit 
ratings on which to base our investor protections.
    The other frequently suggested solution is to abandon the issuer-
paid business model. Simply moving to an investor-paid model suffers 
from two serious shortcomings, however. First, it is not as free from 
conflicts as it may on the surface appear. While investors generally 
have an interest in receiving objective information before they 
purchase a security--unless they are seeking to evade standards they 
view as excessively restrictive--they may be no more interested than 
issuers in seeing a security downgraded once they hold it in their 
portfolio. Moreover, we stand to lose ratings transparency under a 
traditional investor-paid model, since investors who purchase the 
rating are unlikely to want to share that information with the rest of 
the world on a timely basis. SEC Chairman Mary Schapiro indicated in 
her confirmation hearing before this Committee that she was exploring 
other payment models designed to get around these problems. We look 
forward to reviewing concrete suggestions that could form an important 
part of any comprehensive solution to the credit rating problem.
    While it is easier to diagnose the problems with credit ratings 
than it is to prescribe a solution, we believe the best approach is 
found in simultaneously reducing reliance on ratings, increasing 
accountability of ratings agencies, and improving regulatory oversight. 
Without removing references to ratings from our legal requirements 
entirely, Congress could reduce reliance on ratings by clarifying, in 
each place where ratings are referenced, that reliance on ratings does 
not substitute for due diligence. So, for example, a money market fund 
would still be restricted to investing in bonds rated in the top two 
categories, but they would also be accountable for conducting 
meaningful due diligence to determine that the investment in question 
met appropriate risk standards.
    At the same time, credit rating agencies must lose the First 
Amendment protection that shields them from accountability. Although we 
cannot be certain, we believe ratings agencies would have been less 
tolerant of the shoddy practices uncovered in the SEC study and 
congressional hearings if they had known that investors who relied on 
those ratings could hold them accountable in court. First Amendment 
protections based on the notion that ratings are nothing more than 
opinions are inconsistent with the ratings agencies' legally recognized 
status and their legally sanctioned gatekeeper function in our markets. 
Either their legal status or their protected status must go. As noted 
above, we believe the best approach is to retain their legal function 
but to add the accountability that is appropriate to that function.
    Finally, while we appreciate the steps Congress, and this Committee 
in particular, took in 2006 to enhance SEC oversight of ratings 
agencies, we believe this legislation stopped short of the 
comprehensive reform that is needed. New legislation should 
specifically address issues raised by the SEC study (a study made 
possible by the earlier legislation), such as lack of due diligence 
regarding information on which ratings are based, weaknesses in post-
rating surveillance to ensure continued accuracy, and inadequacy of 
internal audits. In addition, it should give the SEC express authority 
to oversee ratings agencies comparable to the authority the Sarbanes-
Oxley Act granted the PCAOB to oversee auditors. In particular, the 
agency should have authority to examine individual ratings engagements 
to determine not only that analysts are following company practices and 
procedures but that those practices and procedures are adequate to 
develop an accurate rating. Congress would need to ensure that any such 
oversight function was adequately funded and staffed.

3. Address risks created by securitization
    Few practices illustrate better than securitization the capacity 
for market innovations to both bring tremendous benefits and do 
enormous harm. On the one hand, securitization makes it possible to 
expand consumer and business access to capital for a variety of 
beneficial purposes. It was already evident by the late 1990s, however, 
that securitization had fundamentally altered underwriting practices in 
the mortgage lending market. By the middle of this decade, it was 
glaringly obvious to anyone capable of questioning the wisdom of the 
market that lenders were responding to those changes by writing huge 
numbers of unsustainable mortgages. Unfortunately, the Fed, which had 
the power to rein in unsound lending practices, was among the last to 
wake up to the systemic risks that they posed.
    In belated recognition that incentives had gotten out of whack, 
many are now advocating that participants in securitization deals be 
required to have ``skin in the game,'' in the form of some retained 
exposure to the risks of the deal. This is an approach that CFA 
supports, although we admit it is easier to describe in theory than to 
design in practice. We look forward to working with the Committee as it 
seeks to do just that. However, we also caution against putting 
exclusive faith in this approach. Given the massive fees that lenders 
and underwriters have earned, it will be difficult to design an 
incentive strong enough to counter the lure of high fees. Financial 
regulators will need to continue to monitor for signs that lenders are 
once again abandoning sound lending practices and use their authority 
to rein in those practices wherever they find them.
    Another risk associated with securitization has gotten less 
attention, though it is at the heart of the difficulties the 
administration now faces in restoring the financial system. Their sheer 
complexity makes it extremely difficult, if not impossible to unwind 
these deals. As a result, that very complexity becomes a source of 
systemic risk. New standards to counteract this design flaw should be 
included in any measure to reduce securitization risks.

4. Improve systemic risk regulation
    Contrary to conventional wisdom, the current crisis did not stem 
from the lack of a regulator with sufficient information and the tools 
necessary to protect the financial system as a whole against systemic 
risks. In the key areas that contributed to the current crisis--unsound 
mortgage lending, the explosive combination of risky assets and 
excessive leverage on financial institutions' balance sheets, and the 
growth of an unregulated ``shadow'' banking system--regulators had all 
the information they needed to identify the crucial risks that 
threatened our financial system but either didn't use the authority 
they had or, in the case of former CFTC Chair Brooksley Born, were 
denied the authority they requested to rein in those risks. Unless that 
reluctance to regulate changes, simply designating and empowering a 
systemic risk regulator is unlikely to have much effect.
    Nonetheless, CFA agrees that, if accompanied by a change in 
regulatory approach and adoption of additional concrete steps to reduce 
existing systemic threats, designating some entity to oversee systemic 
risk regulation could enhance the quality of systemic risk oversight 
going forward. Financial Services Roundtable Chief Executive and CEO 
Steve Bartlett summed up the problem well in earlier testimony before 
the Senate Banking Committee when he said that the recent crisis had 
revealed that our regulatory system ``does not provide for sufficient 
coordination and cooperation among regulators, and that it does not 
adequately monitor the potential for market failures, high-risk 
activities, or vulnerable interconnections between firms and markets 
that can create systemic risk.''
    In keeping with that diagnosis of the problem, CFA believes the 
goals of systemic risk regulation should be: 1) to ensure that risks 
that could threaten the broader financial system are identified and 
addressed; 2) to reduce the likelihood that a ``systemically 
significant'' institution will fail; 3) to strengthen the ability of 
regulators to take corrective actions before a crisis to prevent 
imminent failure; and 4) to provide for the orderly failure of nonbank 
financial institutions. The latter point deserves emphasis, because 
this appears to be a common misconception: the goal of systemic risk 
regulation is not to protect certain ``systemically significant'' 
institutions from failure, but rather to simultaneously reduce the 
likelihood of such a failure and ensure that, should it occur, there is 
a mechanism in place to allow that to happen with the minimum possible 
disruption to the broader financial markets.
    Although there appears to be near universal agreement about the 
need to improve systemic risk regulation, strong disagreements remain 
in some areas regarding the best way to accomplish that goal. Certain 
issues we believe are clear: (1) systemic risk regulation should not be 
focused exclusively on a few ``systemically significant'' institutions; 
(2) the systemic risk regulator should have broad authority to survey 
the entire financial system; (3) regulatory oversight should be an on-
going responsibility, not emergency authority that kicks in when we 
find ourselves on the brink of a crisis; (4) it should include 
authority to require corrective actions, not just survey for risks; (5) 
it should, to the degree possible, build incentives into the system to 
discourage private parties from taking on excessive risks and becoming 
too big or too inter-connected to fail; and (6) it should include a 
mechanism for allowing the orderly unwinding of troubled or failing 
nonbank financial institutions.
    CFA has not yet taken a position on the controversial question of 
who should be the systemic risk regulator. Each of the approaches 
suggested to date--assigning this responsibility to the Federal 
Reserve, creating a new agency to perform this function, or relying on 
a panel of financial regulators to coordinate systemic risk 
regulation--has its flaws, and it is far easier to poke holes in the 
various proposals than it is to design a fool-proof system for 
improving risk regulation. Problems that have been identified with 
assigning this role to the Fed strike us as particularly difficult to 
overcome. Regardless of the approach Congress chooses to adopt, it will 
need to take steps to address the weaknesses of that particular 
approach. One step we urge Congress to take, regardless of which 
approach it chooses, is to appoint a high-level advisory panel of 
independent experts to consult on issues related to systemic risk.
    Such a panel could include academics and other analysts from a 
variety of disciplines with a reputation for independent thinking and, 
preferably, a record of identifying weaknesses in the financial system. 
Names such as Nouriel Roubini, Frank Partnoy, Joseph Mason, and Joshua 
Rosner immediately come to mind as attractive candidates for such an 
assignment. The panel would be charged with conducting an ongoing and 
independent assessment of systemic risks to supplement the efforts of 
the regulators. It would report periodically to both Congress and the 
regulatory agencies on its findings. It could be given privileged 
access to information gathered by the regulators to use in making its 
assessment. When appropriate, it might recommend either legislative or 
regulatory changes with a goal of reducing risks to the financial 
system. CFA believes such an approach would greatly enhance the 
accountability of regulators and reduce the risks of group-think and 
complacency.
    The above discussion merely skims the surface of issues related to 
systemic risk regulation. Included at the back of this document is 
testimony CFA presented last week in the House Financial Services 
Committee that goes into greater detail on the various strengths and 
weaknesses of the different approaches that have been suggested to 
enhance systemic risk regulation and, in particular, the issue of who 
should regulate.

5. Reform executive compensation practices
    Executive pay practices appear to have contributed to excessive 
risk-taking at financial institutions. Those who have analyzed the 
issues have typically identified two factors that contributed to the 
problem: (1) a short-term time horizon for incentive pay that allows 
executives to cash out before the consequences of their actions are 
apparent; and (2) compensation practices, such as through stock 
options, that provide unlimited up-side potential while effectively 
capping down-side exposure. While the first encourages executives to 
focus on short-term results rather than long-term growth, the latter 
may make them relatively indifferent to the possibility that things 
could go wrong. As AFL-CIO General Counsel Damon Silvers noted in 
recent testimony before the House Financial Services Committee, this is 
``a terrible way to incentivize the manager of a major financial 
institution, and a particularly terrible way to incentivize the manager 
of an institution the Federal government might have to rescue.'' 
Silvers further noted that adding large severance packages to the mix 
further distorts executive incentives: ``If success leads to big 
payouts, and failure leads to big payouts, but modest achievements 
either way do not, then there is once again a big incentive to shoot 
for the moon without regard to downside risk.''
    In keeping with this analysis, we believe executive compensation 
practices at financial institutions should be examined for their 
potential to create systemic risk. Practices such as tying incentive 
pay to longer time horizons, encouraging payment in stock rather than 
options, and including claw-back provisions should be encouraged. As 
with other practices that contribute to systemic risk, compensation 
practices that do so could trigger higher capital requirements or 
larger insurance premiums as a way to make risk-prone compensation 
practices financially unattractive. At the same time, reforms that go 
beyond the financial sector are needed to give shareholders greater say 
in the operation of the companies they own, including through mandatory 
majority voting for directors, annual shareholder votes on company 
compensation practices, and improved proxy access for shareholders. 
This is the great unfinished business of the post-Enron era. Adoption 
of crucial reforms in this area should not be further delayed.

6. Bring enforcement actions for law violations that contributed to the 
        crisis
    CFA is encouraged by the changes we see new SEC Chairman Mary 
Schapiro making to reinvigorate the agency's enforcement program. 
Mounting a tough and effective enforcement effort is essential both to 
deterring future abuses and to reassuring investors that the markets 
are fair and honest. While we recognize that many of the activities 
that led to the current crisis were legal, evidence suggests that 
certain areas deserve further investigation. Did investment banks 
fulfill their obligation to perform due diligence on the deals they 
underwrote? Did they provide accurate information to credit rating 
agencies rating those deals? Did brokers fulfill their obligation to 
make suitable recommendations? In many cases, violations of these 
standards may be out of reach of regulators, either because the sales 
were conducted through private placements or the products sold were 
outside the reach of securities laws. Nonetheless, we urge the agency 
to determine whether at least some of what appear to have been rampant 
abuses were conducted in ways that make them vulnerable to SEC 
enforcement authority. Such an investigation would not only be crucial 
to restoring investor confidence that the agency is committed to 
representing their interests, it could also provide regulators with a 
roadmap to use in identifying regulatory gaps that increase the 
potential for systemic risks.

II. Reverse Harmful Policies
    Instead of identifying and addressing emerging risks that 
contributed to the current crisis, the SEC has devoted its energies in 
recent years to advancing a series of policy proposals that would 
reduce regulatory oversight, weaken investor protections, and limit 
industry accountability. In all but one case, these are issues that can 
be dealt with through a reversal in policy at the agency, and new SEC 
Chair Mary Schapiro's statements at her confirmation hearing suggested 
that she is both aware of the problems and prepared to take a different 
course. The role of the Committee in these cases is simply to provide 
appropriate support and oversight to ensure that those efforts remain 
on track. The other issue, where this Committee can play a more direct 
role, is in ensuring that the SEC receives the resources it needs to 
mount an effective regulatory and enforcement program.

1. Increase funding for the SEC
    The new SEC chairman inherited a broken and demoralized agency. By 
all accounts, she has begun to undertake the thorough overhaul that the 
situation demands. Some, but not all, of the needed changes can be 
accomplished within the agency's existing budget, but others (such as 
upgrading agency technology) will require an infusion of funds. 
Moreover, while we recognize this Committee played an important role in 
securing additional funds for the agency in the wake of the accounting 
scandals earlier in this decade, we are convinced that the agency 
remains under-funded and under-staffed to fulfill its assigned 
responsibilities.
    Perhaps you recall a study Chairman Dodd commissioned in 1988 to 
explore the possibility of self-funding for the SEC. It documented the 
degree to which the agency had been starved for resources during the 
preceding decade, a period in which its workload had undergone rapid 
growth. Although agency resources experienced more volatility in the 
1990s--with years that saw both significant increases and substantial 
cuts--the overall picture was roughly the same: a funding level that 
did not keep pace with either the market's overall growth or, of even 
greater concern, the dramatic increase in market participation by 
average, unsophisticated retail investors.
    After the Enron and Worldcom scandals, Congress provided a welcome 
and dramatic increase in funding. Certainly, the approximate doubling 
of the agency's budget was as much as the SEC could be expected to 
absorb in a single year. Operating under the compressed timeline that 
the emergency demanded, however, no effort was made at that time to 
thoroughly assess what funding level was needed to allow the agency to 
fulfill its regulatory mandate. The previous Chairman proved reluctant 
to request additional resources once the original infusion of cash was 
absorbed. We believe that the time has come to conduct an assessment, 
comparable to the review provided by this Committee in 1988, of the 
agency's resource needs. Once conducted, that review could provide the 
basis for a careful, staged increase in funding targeted at specific 
shortcomings in agency operations.

2. Halt mutual recognition negotiations
    Last August, the SEC announced that it had entered a mutual 
recognition agreement with Australia that would allow eligible 
Australian stock exchanges and broker-dealers to offer their services 
to certain types of U.S. investors and firms without being subject to 
most SEC regulation. At the same time, the agency announced that it was 
negotiating similar agreements with other jurisdictions. The agency 
adopted this radical departure in regulatory approach without first 
assessing its potential costs, risks and unintended consequences, 
without setting clear standards to be used in determining whether a 
country qualifies for mutual recognition and submitting them for public 
comment, and without offering any evidence that this regulatory 
approach is in the public interest.
    It is our understanding that, thanks in part to the intervention of 
members of this Committee, this agreement has not yet been implemented. 
We urge members of this Committee to continue to work with the new SEC 
Chair to ensure that no further actions are taken to implement a mutual 
recognition policy at least until the current financial crisis is past. 
At a bare minimum, we believe any decision to give further 
consideration to mutual recognition must be founded on a careful 
assessment of the potential risks of such an approach, clear 
delineation of standards that would be used to assess whether another 
jurisdiction would qualify for such treatment, and transparency 
regarding the basis on which the agency made that determination. CFA 
believes, however, that this policy is ill-advised even under the best 
of circumstances, since no other jurisdiction is likely to place as 
high a priority on protecting U.S. investors as our own regulators. As 
such, we believe the best approach is simply to abandon this policy 
entirely and to focus instead on promoting cooperation with foreign 
regulators on terms that increase, rather than decrease, investor 
protections.
    At the same time, we urge Congress and the SEC to work with the 
Public Company Accounting Oversight Board (PCAOB) to ensure that it 
does not proceed with its similarly ill-conceived proposal to rely on 
foreign audit oversight boards to conduct inspections of foreign audit 
firms that play a significant role in the audits of U.S. public 
companies. This proposal is, in some ways, even more troubling than the 
SEC's mutual recognition proposal, since the oversight bodies to be 
relied are, many of them, still in their infancy, lack adequate 
resources, and do not meet the Sarbanes-Oxley Act's standards for 
independence. Prior to issuing this proposal, the PCAOB had focused its 
efforts on developing a program of joint inspections that is clearly in 
the best interests of U.S. and foreign investors alike. This proposed 
change in policy at the PCAOB has thrown that program into jeopardy, 
and it is important that it be gotten back on track.

3. Do not approve the IFRS Roadmap
    In a similar vein, the SEC has recently proposed to abandon a long 
and fruitful policy of encouraging convergence between U.S. Generally 
Accepted Accounting Principles and International Financial Reporting 
Standards. In its place, the agency has proposed to move rapidly toward 
U.S. use of international standards. Once again, the agency has 
proposed this change in policy without adequate regard to the 
potentially enormous costs of the transition, the loss of transparency 
that could result, or the strong opposition of retail and institutional 
investors to the proposal. We urge the Committee to work with the SEC 
to ensure that we return to a path of encouraging convergence of the 
two sets of standards so that, eventually, as that convergence is 
achieved, financial statements prepared under the two sets of standards 
would be comparable.

4. Enhance investor representation on FASB
    In arguing against adoption of the IFRS roadmap, CFA has in the 
past cited IASB's lack of adequate due process and susceptibility to 
industry and political influence. Unfortunately, FASB's recent proposal 
to bow to industry pressure and weaken fair value accounting 
standards--and to do so after a mere two-week comment period and with 
no meaningful time for consideration of comments before a vote is 
taken--suggests that FASB's vaunted independence and due process are 
more theoretical than real. We recognize and appreciate that leaders of 
this Committee have long shown a respect for the independence of the 
accounting standard-setting process. Moreover, we appreciate the steps 
that this Committee took, as part of the Sarbanes-Oxley Act, to try to 
enhance FASB's independence. However, in light of recent events, CFA 
believes more needs to be done to shore up those reforms. Specifically, 
we urge you to strengthen the standards laid out in SOX for recognition 
of a standard-setting body by requiring that a majority of both the 
board itself and its board of trustees be investor representatives with 
the requisite accounting expertise.

5. Ignore calls to weaken materiality standards and lessen issuer and 
        auditor accountability for financial misstatements
    The SEC Advisory Committee on Improvements of Financial Reporting 
(CIFiR) released its final report last August detailing recommendations 
to ``increase the usefulness of financial information to investors, 
while reducing the complexity of the financial reporting system to 
investors, preparers, and auditors.'' While the report includes 
positive suggestions--including a suggestion to increase investor 
involvement in the development of accounting standards--it also 
includes anti-investor proposals to: (1) revise the guidance on 
materiality in order to make it easier to dismiss large errors as 
immaterial; (2) revise the guidance on when errors have to be restated 
to permit more material errors to avoid restatements; and (3) offer 
some form of legal protection to faulty professional judgments made 
according to a recommended judgment framework. Weakening investor 
protections in this way is ill-advised at any time, but it is 
particularly so when we find ourselves in the midst of a financial 
crisis of global proportions. While we are confident that the new SEC 
Chair understands the need to strengthen, not weaken, financial 
reporting transparency, reliability, and accountability, we urge this 
Committee to continue to provide oversight in this area to ensure that 
these efforts remain on track.

III. Adopt Additional Pro-Investor Reforms
    In addition to responding directly to the financial crisis and 
preventing a further deterioration of investor protections, there are 
important steps that Congress and the SEC can take to strengthen our 
markets by strengthening the protections we offer to investors. These 
include issues--such as regulation of financial professionals and 
restoring private remedies--that have already been raised in the 
context of financial regulatory reform. We look forward to a time, once 
the crisis is past, when we have the luxury of also returning our 
attention to additional issues, such as disclosure, mutual fund, and 
broker compensation reform, where a pro-investor agenda has languished 
and is in need of revival. For now, however, we will focus in this 
testimony only on the first set of issues.

1. Adopt a rational, pro-investor policy for the regulation of 
        financial professionals
    Reforming regulation of financial professionals has been a CFA 
priority for more than two decades, with precious little to show for 
it. Today, investment service providers who use titles and offer 
services that appear indistinguishable to the average investor are 
still regulated under two very different standards. In particular, 
brokers have been given virtually free rein to label their salespeople 
as financial advisers and financial consultants and to offer extensive 
personalized investment advice without triggering regulation under the 
Investment Advisers Act.
    As a result, customers of these brokers are encouraged to believe 
they are in an advisory relationship but are denied the protections 
afforded by the Advisers Act's fiduciary duty and obligation to 
disclose conflicts of interest. Moreover, customers still don't receive 
useful information to allow them to make an educated choice among 
different types of investment service providers. This inconsistent 
regulatory treatment and lack of effective pre-engagement disclosure 
are of particular concern given research that shows that the selection 
of an investment service provider is the last real investment decision 
many investors will ever make. Once they have made that choice, most 
are likely to rely on the recommendations they receive from that 
individual with little or no additional research to determine the costs 
or appropriateness of the investments recommended.
    Some now suggest that the efforts being undertaken by Congress to 
reform our regulatory system offer an opportunity to ``harmonize'' 
regulation of brokers, investment advisers, and financial planners. CFA 
agrees, but only so long as any ``harmonization'' strengthens investor 
protections. It is not clear that most proposals put forward to date 
meet that standard. Instead, the broker-dealer community appears to be 
trying to use this occasion to distract from the central issue--that 
brokers have over the years been allowed to transform themselves into 
advisers without being regulated as advisers--and to push an investment 
adviser SRO and a watered down ``universal standard of care.'' 
Unfortunately, this is one area where the new SEC Chairman's Finra 
background appears to have influenced her thinking, and she echoed 
these sentiments during her confirmation hearing. It will therefore be 
incumbent on members of this Committee to ensure that investor 
interests predominate in any reforms that may be adopted to 
``harmonize'' our system of regulating investment professionals.
    As a first principle, CFA believes that investment service 
providers should be regulated according to what they do rather than 
what type of firm they work for. Had the SEC implemented the Investment 
Advisers Act consistent with the clear intent of Congress, this would 
be the situation we find ourselves in today. That is water under the 
bridge, however, and we are long past the point where we can recreate 
the clear divisions that once was envisioned between advisory services 
and brokers' transaction-based services. Instead, we believe the best 
approach is to clarify the responsibilities that go with different 
functions and to apply them consistently across the different types of 
firms. \8\
---------------------------------------------------------------------------
     \8\ While we have discussed this approach here in the context of 
investment service providers, CFA believes this is an appropriate 
approach throughout the financial services industries: a suitability 
obligation for sales--whether of securities, insurance, mortgages or 
whatever--and an overriding fiduciary duty that applies in an advisory 
relationship.

    A Fiduciary Duty for Advice: All those who offer investment 
        advice should be required to place their clients' interests 
        ahead of their own, to disclose material conflicts of interest, 
        and to take steps to minimize those potential conflicts. That 
        fiduciary duty should govern the entire relationship; it must 
        not be something the provider adopts when giving advice but 
        drops when selling the investments to implement 
---------------------------------------------------------------------------
        recommendations.

    A Suitability Obligation for Sales: Those who are engaged 
        exclusively in a sales relationship should be subject to the 
        know-your-customer and suitability obligations that govern 
        brokers now.

    No Misleading Titles: Those who choose to offer solely 
        sales-based services should not be permitted to adopt titles 
        that imply that they are advisers. Either they should be 
        prohibited from using titles, such as financial adviser or 
        financial consultant, designed to mislead the investor into 
        thinking they are in an advisory relationship, or use of such 
        titles should automatically carry with it a fiduciary duty to 
        act in clients' best interests.

    Because of the obvious abuses in this area that have grown up over 
the years, we have focused on the inconsistent regulatory treatment of 
advice offered by brokers, investment advisers, and financial planners. 
If, however, there are other services that investment advisers or 
financial planners are being permitted to offer outside the appropriate 
broker-dealer protections, we would apply the same principle to them. 
They should be regulated according to what they do, subject to the 
highest existing level of investor protections.
    One issue that has come up in this regard is whether investment 
advisers should be subject to oversight by a self-regulatory 
organization. The underlying argument here is that, while the 
Investment Advisers Act imposes a higher standard for advice, it is not 
backed by as robust a regulatory regime as that which governs broker-
dealers. Finra has made no secret of its ambition to expand its 
authority in this area, at least with regard to the investment advisory 
activities of its broker-dealer member firms. There is at least a 
surface logic to this proposal. As Finra is quick to note, it brings 
significant resources to the oversight function and has rule-making 
authority that in some areas appears to go beyond that available to the 
SEC.
    Despite that surface logic, there are several hurdles that Finra 
must overcome in making its case. The first is that Finra's record of 
using its rule-making authority to benefit investors is mixed at best. 
Nowhere is that more evident than on this central question of the 
obligation brokers owe investors when they offer advice or portray 
themselves as advisers. For the two decades that this debate has raged, 
Finra and its predecessor, NASD regulation, have consistently argued 
this issue from the broker-dealer industry point of view. This is not 
an isolated instance. Finra has shown a similar deference to industry 
concerns on issues related to disclosure and arbitration. This is not 
to say that Finra never deviates from the industry viewpoint, but it 
does mean that investors must swim against a strong tide of industry 
opposition in pushing reforms and that those reforms, when adopted, 
tend to be timid and incremental in nature.
    This is, in our view, a problem inherent to self-regulation. Should 
Congress choose to place further reliance on bodies other than the SEC 
to supplement the agency's oversight and rulemaking functions, it 
should at least examine what reforms are needed to ensure that those 
authorities are not captured by the industries they regulate and 
operate in a fully transparent and open fashion. We believe the 
governance model at the PCAOB offers a better model to ensure the 
independence of any body on which we rely to perform a regulatory 
function.
    The second issue regarding expanded Finra authority relates to its 
oversight record. It is ironic at best, cynical at worst, that Finra 
has tried to capitalize on its oversight failure in the Madoff case to 
expand its responsibilities to cover investment adviser activities. 
There may be good reasons why Finra's predecessor, NASD Regulation, 
missed a fraud that operated under its nose for several decades. NASD 
Regulation was not, as we understand it, privy to the whistleblower 
reports that the SEC received. One factor that clearly was not 
responsible for NASD Regulation's oversight failure, however, was its 
lack of authority over Madoff's investment adviser operations. This 
should be patently obvious from the fact that there was no Madoff 
investment adviser for the first few decades in which the fraud was 
apparently being conducted. During that time, Madoff's regulatory 
reports apparently indicated that he was engaged exclusively in 
proprietary trading and market making and did not have clients. NASD 
Regulation apparently did not take adequate steps to verify this 
information, despite general industry knowledge and extensive press 
reports to the contrary.
    What concerns us most about this situation is not that Finra missed 
the Madoff fraud. Individuals and institutions make mistakes, and the 
problems that lead to those mistakes can be corrected. We are far more 
concerned by what we view as Finra's lack of honesty in accounting for 
this failure. That suggests a problem with the culture of the 
organization that is not as easily corrected. We have nothing but 
respect for new Finra President and CEO Rick Ketchum. However, the 
above analysis suggests he faces a significant task in overhauling 
Finra to make it more responsive to investor concerns, more effective 
in providing industry oversight, and more transparent in its dealings. 
Until that has been accomplished, we would caution against any 
expansion of Finra's authority or any increased reliance on self-
regulatory bodies generally.

2. Restore private remedies
    In an era in which investors have been exposed to constantly 
expanding risks and repeated frauds, they have also experienced a 
continual erosion of their right to redress. This has occurred largely 
through unfavorable court decisions that have undermined investors' 
ability to recover losses from those who aided the fraud and, with 
recent decisions on loss causation, even from those primarily 
responsible for perpetrating it. To restore balance and fairness to the 
system, CFA supports legislation to restore aiding and abetting 
liability, to eliminate the ability of responsible parties to avoid 
liability by manipulating disclosures, and to protect the ability of 
plaintiffs to aggregate small claims and access federal courts.
    CFA also supports the elimination of pre-dispute binding 
arbitration clauses in all consumer contracts, including those with 
securities firms. For many, even most investors, arbitration will 
remain the most attractive means for resolving disputes. However, not 
all cases are suitable for resolution in a forum that lacks a formal 
discovery process or other basic procedural protections. By forcing all 
cases into an industry-run arbitration process, regardless of 
suitability, binding arbitration clauses undermine investor confidence 
in the fairness of the system while making the system more costly and 
slower for all. While Finra has taken steps to address some of the 
worst problems, these reforms have been slow to come and have been 
incremental at best. We believe investors are best served by having a 
choice of resolution mechanisms that they are currently denied because 
of the nearly universal use of pre-dispute binding arbitration clauses.

Conclusion
    For roughly the past three decades, regulatory policy has been 
driven by an irrational faith that market discipline and industry self-
interest could be relied on to rein in Wall Street excesses. Regulation 
was seen as, at best, a weak supplement to these market forces and, at 
worst, a burdensome impediment to innovation. The recent financial 
meltdown has proven the basic fallacy of that assumption. In October 
testimony before the House Oversight and Government Reform Committee, 
former Federal Reserve Chairman Alan Greenspan acknowledged, in clearer 
language than has been his wont, the basic failure of this regulatory 
approach:

        Those of us who looked to the self-interest of lending 
        institutions to protect shareholders' equity, myself included, 
        are in a state of shocked disbelief. Such counterparty 
        surveillance is a central pillar of our financial markets' 
        state of balance . . . If it fails, as occurred this year, 
        market stability is undermined . . .

        I made a mistake in presuming that the self-interests of 
        organizations, specifically banks and others, were such that 
        they were best capable of protecting their own shareholders and 
        their equity in the firms.

    Former Chairman Greenspan deserves credit for this forthright 
acknowledgement of error.
    What remains to be seen is whether Congress and the Administration 
will together devise a regulatory reform plan that reflects this 
fundamental shift. A bold and comprehensive plan is needed that 
restores basic New Deal regulatory principles and recognizes the role 
of regulation in preventing crises, not simply cleaning up in their 
wake. This approach, adopted in response to the Great Depression, 
brought us decades of economic growth, free from the recurring 
financial crises that have characterized the last several decades. If, 
on the other hand, policymakers do not acknowledge the pervasive and 
deep-seated flaws in financial markets, they will inevitably fail in 
their efforts to reform regulation, setting the stage for repeated 
crises and prompting investors to question not just the integrity and 
safety of our markets, but the ability of our policymakers to act in 
their interest.
    Even as we testify here today, Treasury Secretary Geithner is 
reportedly scheduled to present the Administration's regulatory reform 
plan before another congressional committee. We will be subjecting that 
proposal and others that are developed as this process moves forward to 
a thorough analysis to determine whether it meets this standard: does 
the boldness and scope of the plan match the severity of the current 
crisis? We look forward to working with members of this Committee in 
the days and months ahead to craft a regulatory reform plan that meets 
this test and restores investors' faith in the integrity of our markets 
and the effectiveness of our government.

                                Appendix

Testimony of Travis Plunkett, Legislative Director, Consumer Federation 
        of America
                             March 17, 2009
    Mr. Chairman and Members of the Committee, my name is Travis 
Plunkett. I am Legislative Director of the Consumer Federation of 
America (CFA). CFA is a nonprofit association of 280 organizations 
that, since 1968, has sought to advance the consumer interest through 
research, advocacy, and education.
    I greatly appreciate the opportunity to appear before you today to 
testify about one of the most important issues Congress will need to 
address as it develops a comprehensive agenda to reform our Nation's 
failed financial regulatory system--how to better protect the system as 
a whole and the broader economy from systemic risks. Recent experience 
has shown us that our current system was not up to the task, either of 
identifying significant risks, or of addressing those risks before they 
spun out of control, or of dealing efficiently and effectively with the 
situation once it reached crisis proportions. The effects of this 
failure on the markets and the economy have been devastating, rendering 
reform efforts aimed at protecting the system against systemic threats 
a top priority.
    In order to design an effective regulatory response, it is 
necessary to understand why the system failed. It has been repeated so 
often in recent months that it has taken on the aura of gospel, but it 
is simply not the case that the systemic risks that have threatened the 
global financial markets and ushered in the most serious economic 
crisis since the Great Depression arose because regulators lacked 
either sufficient information or the tools necessary to protect the 
financial system as a whole against systemic risks. (Though it is true 
that, once the crisis struck, regulators lacked the tools needed to 
deal with it effectively.) On the contrary, the crisis resulted from 
regulators' refusal to heed overwhelming evidence and repeated warnings 
about growing threats to the system.

    Former Congressman Jim Leach and former CFTC Chairwoman 
        Brooksley Born both identified the potential for systemic risk 
        in the unregulated over-the-counter derivatives markets in the 
        1990s.

    Housing advocates have been warning the Federal Reserve 
        since at least the early years of this decade that 
        securitization had fundamentally changed the underwriting 
        standards for mortgage lending, that the subprime mortgages 
        being written in increasing numbers were unsustainable, that 
        foreclosures were on the rise, and that this had the potential 
        to create systemic risks.

    The SEC's risk examination of Bear Stearns had, according 
        to the agency's Inspector General, identified several of the 
        risks in that company's balance sheet, including its use of 
        excessive leverage and an over-concentration in mortgage-backed 
        securities.

    Contrary to conventional wisdom, these examples and others like 
them provide clear and compelling evidence that, in the key areas that 
contributed to the current crisis--unsound mortgage lending, the 
explosive combination of risky assets and excessive leverage on 
financial institutions' balance sheets, and the growth of an 
unregulated ``shadow'' banking system--regulators had all the 
information they needed to identify the crucial risks that threatened 
our financial system but either didn't use the authority they had or, 
in Born's case, were denied the authority they needed to rein in those 
risks.
    Regulatory intervention at any of those key points had the 
potential to prevent, or at least greatly reduce the severity of, the 
current financial crisis--either by preventing the unsound mortgages 
from being written that triggered the crisis, or by preventing 
investment banks and other financial institutions from taking on 
excessive leverage and loading up their balance sheet with risky 
assets, leaving them vulnerable to failure when the housing bubble 
burst, or by preventing complex networks of counterparty risk to 
develop among financial institutions that allowed the failure of one 
institution to threaten the failure of the system as a whole. This view 
is well-articulated in the report of the Congressional Oversight Panel, 
which correctly identifies a fundamental abandonment of traditional 
regulatory principles as the root cause of the current financial crisis 
and prescribes an appropriately comprehensive response.
    So what is the lesson to be learned from that experience for 
Congress's current efforts to enhance systemic risk regulation? The 
lesson is emphatically not that there is no need to improve systemic 
risk regulation. On the contrary, this should be among the top 
priorities for financial regulatory reform. But there is a cautionary 
lesson here about the limitations inherent in trying to address 
problems of inadequate systemic risk regulation with a structural 
solution. In each of the above examples, and others like them, the key 
problem was not insufficient information or inadequate authority; it 
was an unwillingness on the part of regulators to use the authority 
they had to rein in risky practices. That lack of regulatory will had 
its roots in an irrational faith among members of both political 
parties in markets' ability to self-correct and industry's ability to 
self-police.
    Until we abandon that failed regulatory philosophy and adopt in its 
place an approach to regulation that puts its faith in the ability and 
responsibility of government to serve as a check on industry excesses, 
whatever we do on systemic risk is likely to have little effect. 
Without that change in governing philosophy, we will simply end up with 
systemic risk regulation that exhibits the same unquestioning, market-
fundamentalist approach that has characterized substantive financial 
regulation to a greater or lesser degree for the past three decades.
    If the ``negative'' lesson from recent experience is that 
structural solutions to systemic risk regulation will have limited 
utility without a fundamental change in regulatory philosophy, there is 
also a positive corollary. Simply closing the loopholes in the current 
regulatory structure, reinvigorating federal regulators, and doing an 
effective job at the day-to-day tasks of routine safety and soundness 
and investor and consumer protection regulation would go a long way 
toward eliminating the greatest threats to the financial system.
The ``Shadow'' Banking System Represents the Greatest Systemic Threat
    In keeping with that notion, the single most significant step 
Congress could and should take right now to decrease the potential for 
systemic risk is to shut down the shadow banking system completely and 
permanently. While important progress is apparently being made (however 
slowly) in moving credit default swaps onto a clearinghouse, this is 
just a start, and a meager start at that. Meaningful financial 
regulatory reform must require that all financial activities be 
conducted in the light of regulatory oversight according to basic rules 
of transparency, fair dealing, and accountability.
    As Frank Partnoy argued comprehensively and persuasively in his 
2003 book, Infectious Greed, a primary use of the ``shadow'' banking 
system--and indeed the main reason for its existence--is to allow 
financial institutions to do indirectly what they or their clients 
would not be permitted to do directly in the regulated markets. So 
banks used unregulated special purpose entities to hold toxic assets 
that, if held on their balance sheets, would have required them to set 
aside additional capital, relying on the fiction that the bank itself 
was not exposed to the risks. Investment banks sold Mezzanine CDOs to 
pension funds in private placements free from disclosure and other 
obligations of the regulated marketplace. And everyone convinced 
themselves that they were protected from the risks of those toxic 
assets because they had insured them using credit default swaps sold in 
the over-the-counter market without the basic protections that trading 
on an exchange would provide, let alone the reserve or collateral 
requirements that would, in the regulated insurance market, provide 
some assurance that any claims would be paid.
    The basic justification for allowing two systems to grow up side-
by-side--one regulated and one not--is that sophisticated investors are 
capable of protecting their own interests and do not require the basic 
protections of the regulated market. That myth has been dispelled by 
the current crisis. Not only did ``sophisticated'' institutional 
investors load up on toxic mortgage-backed securities and 
collateralized debt obligations without understanding the risks of 
those investments, but financial institutions themselves either didn't 
understand or chose to ignore the risks they were exposing themselves 
to when they bought toxic assets with borrowed money or funded long-
term obligations with short-term financing. By failing to protect their 
own interests, they damaged not only themselves and their shareholders, 
but also the financial markets and the global economy as a whole. This 
situation simply cannot be allowed to continue. Any proposal to address 
systemic risk must confront this issue head-on in order to be credible.

Other Risk-Related Priorities Should Also Be Addressed
    There are other pressing regulatory issues that, while not 
expressly classified as systemic risk, are directly relevant to any 
discussion of how best to reduce systemic risk. Chairman Frank has 
appropriately raised the issue of executive compensation in this 
context, and CFA supports efforts to reduce compensation incentives 
that promote excessive risk-taking.
    Similarly, improving the reliability of credit ratings while 
simultaneously reducing our reliance on those ratings is a necessary 
component of any comprehensive plan to reduce systemic risk. Ideally, 
some mechanism will be found to reduce the conflicts of interest 
associated with the agencies' issuer-paid compensation model. Whether 
or not that is the case, we believe credit rating agencies must face 
increased accountability for their ratings, the SEC must have increased 
authority to police their ratings activities to ensure that they follow 
appropriate due diligence standards in arriving at and maintaining 
those ratings, and laws and rules that reference the ratings must make 
clear that reliance on ratings alone does not satisfy due diligence 
obligations to ensure the appropriateness of the investment.
    In addition, CFA believes one of the most important lessons that 
have been learned regarding the collapse of our financial system is 
that improved, up-front product-focused regulation will significantly 
reduce systemic risk. For example, if federal regulators had acted more 
quickly to prevent abusive sub-prime mortgage loans from flooding the 
market, it is likely that the current housing and economic crisis would 
not have been triggered. As a result, we have endorsed the concept 
advanced by COP Chair Elizabeth Warren and legislation introduced by 
Senator Richard Durbin and Representative William Delahunt to create an 
independent financial safety commission to ensure that financial 
products meet basic standards of consumer protection. Some opponents of 
this proposal have argued that it would stifle innovation. However, 
given the damage that recent ``innovations'' such as liar's loans and 
Mezzanine CDOs have done to the global economy, this hardly seems like 
a compelling argument. By distinguishing between beneficial and harmful 
innovations, such an approach could in our view play a key role in 
reducing systemic risks.

Congress Needs To Enhance the Quality of Systemic Risk Oversight
    In addition to addressing those issues that currently create a 
significant potential for systemic risk, Congress also needs to enhance 
the quality of systemic risk oversight going forward. Financial 
Services Roundtable Chief Executive and CEO Steve Bartlett summed up 
the problem well in earlier testimony before the Senate Banking 
Committee when he said that the recent crisis had revealed that our 
regulatory system ``does not provide for sufficient coordination and 
cooperation among regulators, and that it does not adequately monitor 
the potential for market failures, high-risk activities, or vulnerable 
interconnections between firms and markets that can create systemic 
risk.''
    In keeping with that diagnosis of the problem, CFA believes the 
goals of systemic risk regulation should be: (1) to ensure that risks 
that could threaten the broader financial system are identified and 
addressed; (2) to reduce the likelihood that a ``systemically 
significant'' institution will fail; (3) to strengthen the ability of 
regulators to take corrective actions before a crisis to prevent 
imminent failure; and (4) to provide for the orderly failure of nonbank 
financial institutions. The latter point deserves emphasis, because 
this appears to be a common misconception: the goal of systemic risk 
regulation is not to protect certain ``systemically significant'' 
institutions from failure, but rather to simultaneously reduce the 
likelihood of such a failure and ensure that, should it occur, there is 
a mechanism in place to allow that to happen with the minimum possible 
disruption to the broader financial markets.
    Although there appears to be near universal agreement about the 
need to improve systemic risk regulation, strong disagreements remain 
over the best way to accomplish that goal. The remainder of this 
testimony will address those key questions regarding such issues as who 
should regulate for systemic risk, who should be regulated, what that 
regulation should consist of, and how it should be funded. CFA has not 
yet reached firm conclusions on all of these issues, including on the 
central question of how systemic risk regulation should be structured. 
Where our position remains unresolved, we will discuss possible 
alternatives and the key issues we believe need to be resolved in order 
to arrive at a conclusion.

Should There Be a Central Systemic Risk Regulator?
    As discussed above, we believe all financial regulators should bear 
a responsibility to monitor for and mitigate potential systemic risks. 
Moreover, we believe a regulatory approach that both closes regulatory 
loopholes and reinvigorates traditional regulation for solvency and 
consumer and investor protection would go a long way toward 
accomplishing that goal. Nonetheless, we agree with those who argue 
that there is a benefit to having some central authority responsible 
and accountable for overseeing these efforts, if only to coordinate 
regulatory efforts related to systemic risk and to ensure that this 
remains a priority once the current crisis is past.
    Perhaps the best reason to have one central authority responsible 
for monitoring systemic risk is that, properly implemented, such an 
approach offers the best assurance that financial institutions will not 
be able to exploit newly created gaps in the regulatory structure. 
Financial institutions have devoted enormous energy and creativity over 
the past several decades to finding, maintaining, and exploiting gaps 
in the regulatory structure. Even if Congress does all that we have 
urged to close the regulatory gaps that now exist, past experience 
suggests that financial institutions will immediately set out to find 
new ways to evade legal restrictions.
    A central systemic risk regulatory authority could and should be 
given responsibility for quickly identifying any such activities and 
assigning them to their appropriate place within the regulatory system. 
Without such a central authority, regulators may miss activity that 
does not explicitly fall within their jurisdiction or disputes may 
arise over which regulator has authority to act. CFA believes 
designating a central authority responsible for systemic risk 
regulation offers the best hope of quickly identifying and addressing 
new risks that emerge that would otherwise be beyond the reach of 
existing regulations.

Who Should It Be?
    Resolving who should regulate seems to be the most vexing problem 
in designing a system for improved systemic risk regulation. Three 
basic proposals have been put forward: (1) assign responsibility for 
systemic risk regulation to the Fed; (2) create a new market stability 
regulator; and (3) expand the President's Working Group on Financial 
Markets (PWG) and give it an explicit mandate to coordinate and oversee 
regulatory efforts to monitor and mitigate systemic threats. Each 
approach has its flaws, and it is far easier to poke holes in the 
various proposals than it is to design a fool-proof system for 
improving risk regulation.
    The Federal Reserve Board--Many people believe the Federal Reserve 
Board (the ``Fed'') is the most logical body to serve as systemic risk 
overseer. Those who favor this approach argue that the Fed has the 
appropriate mission and expertise, an experienced staff, a long 
tradition of independence, and the necessary tools to serve in this 
capacity (e.g., the ability to act as lender of last resort and to 
provide emergency financial assistance during a financial crisis). 
Robert C. Pozen summed up this viewpoint succinctly when he testified 
before the Senate Committee on Homeland Security and Governmental 
Affairs. He said:

        Congress should give this role to the Federal Reserve Board 
        because it has the job of bailing out financial institutions 
        whose failure would threaten the whole financial system . . . 
        If the Federal Reserve Board is going to bail out a broad array 
        of financial institutions, and not just banks, it should have 
        the power to monitor systemic risks so it can help keep 
        institutions from getting to the brink of failure.

    Two other, more pragmatic arguments have been cited in favor of 
giving these responsibilities to the Fed: (1) its ability to obtain 
adequate resources without relying on the congressional budget process 
and (2) the relative speed and ease with which this expansion of 
authority could be accomplished, particularly in comparison with the 
challenges of establishing a new agency for this purpose.
    Others are equally convinced that the Fed is the last agency that 
should be entrusted with responsibility for systemic risk regulation. 
Some cite concerns about conflicts inherent in the governance role bank 
holding companies play in the regional Federal Reserve Banks. 
Particularly when combined with the Board's closed culture and lack of 
public accountability, this conflict is seen as likely to undermine 
public trust in the objectivity of agency decisions about which 
institutions will be bailed out and which will be allowed to fail in a 
crisis. Opponents of the Fed as systemic risk regulator also cite a 
conflict between its role setting monetary policy and its potential 
role as a systemic risk regulator. One concern is that its role in 
setting monetary policy requires freedom from political interference, 
while its role as systemic risk regulator would require full 
transparency and public accountability. Another involves the question 
of how the Fed as systemic risk regulator would deal with the Fed as 
central banker if its monetary policy was contributing to systemic risk 
(as it clearly did in the run-up to the current crisis).
    Others simply point to what they see as the Fed's long history of 
regulatory failure. This includes not only failures directly related to 
the current crisis--its failure to address unsound mortgage lending on 
a timely basis, for example, as well as its failure to prevent banks 
from holding risky assets in off-balance-sheet special purpose entities 
and its cheerleading of the rapid expansion of the shadow banking 
system--but also a perceived past willingness at the Fed to allow banks 
to hide their losses. According to this argument, Congress ultimately 
passed FDICIA in 1991 (requiring regulators to close financial 
institutions before all the capital or equity has been depleted) 
precisely because the Fed had been unwilling to do so absent that 
requirement.
    Should Congress determine to give systemic risk responsibility to 
the Fed, we believe it is essential that you take meaningful steps to 
address what we believe are compelling concerns about this approach. 
Even some who have spoken in favor of the Fed in this capacity have 
acknowledged that it will require significant restructuring. As former 
Federal Reserve Chairman Paul Volcker noted in remarks before the 
Economic Club of New York last April:

        If the Federal Reserve is also . . . to have clear authority to 
        carry effective `umbrella' oversight of the financial system, 
        internal reorganization will be essential. Fostering the safety 
        and stability of the financial system would be a heavy 
        responsibility paralleling that of monetary policy itself. 
        Providing direction and continuity will require clear lines of 
        accountability . . . all backed by a stronger, larger, highly 
        experienced and reasonably compensated professional staff.

    CFA concurs that, if systemic risk regulation is to be housed at 
the Fed, systemic risk regulation must not be relegated to Cinderella 
status within the agency. Rather, it must be given a high priority 
within the organization, and significant additional staff dedicated to 
this task must be hired who have specific risk assessment expertise. 
Serious thought must also be given to (1) how to resolve disputes 
between these two potentially competing functions of setting monetary 
policy and mitigating systemic risks, and (2) how to ensure that 
systemic risk regulation is carried out with the full transparency and 
public accountability that it demands.
    A New Systemic Risk Regulatory Agency--Some have advocated creation 
of an entirely new regulatory agency devoted to systemic risk 
regulation. The idea behind this approach is that it would allow a 
singular focus on issues of systemic risk, both providing clear 
accountability and allowing the hiring of specialized staff devoted to 
this task. Furthermore, such an agency could be structured to avoid the 
significant concerns associated with designating the Fed to perform 
this function, including the conflict between monetary policy and 
systemic risk regulation.
    Although it has its advocates, this approach appears to trigger 
neither the broad support nor the impassioned opposition that the Fed 
proposal engenders. Those who favor this approach, including Brookings 
scholar Robert Litan, tend to do so only if it is part of a more 
radical regulatory restructuring. Adding such an agency to the existing 
regulatory structure would ``add still another cook to the regulatory 
kitchen, one that is already too crowded, and thus aggravate current 
jurisdictional frictions,'' Litan said in recent testimony before the 
Senate Committee on Homeland Security and Governmental Operations. 
Moreover, even its advocates tend to acknowledge that it would be a 
challenge, and possibly an insurmountable challenge, to get such an 
agency up and running in a timely fashion.
    Expanded and Refocused President's Working Group--The other 
approach that enjoys significant support entails giving an expanded 
version of the President's Working Group for Financial Markets clear, 
statutory authority for systemic risk oversight. Its current membership 
would be expanded to include all the major federal financial regulators 
as well as representatives of state securities, insurance, and banking 
officials. By formalizing the PWG's authority through legislation, the 
group would be directly accountable to Congress, allowing for 
meaningful congressional oversight.
    Among the key benefits of this approach: the council would have 
access to extensive information about and expertise in all aspects of 
financial markets. The regulatory bodies with primary day-to-day 
oversight responsibility would have a direct stake in the panel and its 
activities, maximizing the chance that they would be fully cooperative 
with its efforts. For those who believe the Fed must play a significant 
role in systemic risk regulation, this approach offers the benefit of 
extensive Fed involvement as a member of the PWG without the problems 
associated with exclusive Fed oversight of systemic risk.
    This approach, while offering attractive benefits, is not without 
its shortcomings. One is the absence of any single party who is solely 
accountable for regulatory efforts to mitigate systemic risks. Because 
it would have to act primarily through its member bodies, it could 
result in an inconsistent and even conflicting approach among 
regulators. It also raises the risk that systemic risk regulation will 
not be given adequate priority. In dismissing this approach, Litan 
acknowledges that it may be the most politically feasible but he 
maintains: ``A college of regulators clearly violates the Buck Stops 
Here principle, and is a clear recipe for jurisdictional battles and 
after-the-fact finger pointing.''
    Despite the many attractions of this approach, this latter point is 
particularly compelling, in our view. Regulators have a long history of 
jurisdictional disputes. There is no reason to believe those problems 
would simply dissipate under this arrangement. Decisions about who has 
responsibility for newly emerging activities would likely be 
particularly contentious. If Congress were to decide to adopt this 
approach, it would need to set out some clear mechanism for resolving 
any such disputes. Alternatively, it could combine this approach with 
enhanced systemic risk authority for either the Fed or a new agency, as 
the Financial Services Roundtable has suggested, providing that agency 
with the benefit of the panel's broad expertise and improving 
coordination of regulatory efforts in this area.
    FDIC--A major reason federal authorities were forced to improvise 
in managing the events of the past year is that we lack a mechanism for 
the orderly unwinding of nonbank financial institutions that is 
comparable to the authority that the FDIC has for banks. Most systemic 
risk plans seem to contemplate expanding FDIC authority to include 
nonbank financial institutions, although some would house this 
authority within a systemic risk regulator. CFA believes this is an 
essential component of a comprehensive plan for enhanced systemic risk 
regulation. While we have not worked out exactly how this should 
operate, we believe the FDIC, the systemic risk regulator, or the two 
agencies working together must also have authority to intervene when 
failure appears imminent to require corrective actions.
    A Systemic Risk Advisory Panel--One of the key criticisms of making 
the Fed the systemic risk regulator is its dismal regulatory record. 
But if we limited our selections to those regulators with a credible 
record of identifying and addressing potential systemic risks while 
they are still at a manageable stage, we'd be forced to start from 
scratch in designing a new regulatory body. And there is no guarantee 
we would get it right this time.
    A number of academics and others outside the regulatory system were 
far ahead of the regulators in recognizing the risks associated with 
unsound mortgage lending, unreliable ratings on mortgage-backed 
securities and CDOs, the build-up of excessive leverage, the 
questionable risk management practices of investment banks, etc. 
Regardless of what approach Congress chooses to adopt for systemic risk 
oversight, we believe it should also mandate creation of a high-level 
advisory panel on systemic risk. Such a panel could include academics 
and other analysts from a variety of disciplines with a reputation for 
independent thinking and, preferably, a record of identifying 
weaknesses in the financial system. Names such as Nouriel Roubini, 
Frank Partnoy, Joseph Mason, and Joshua Rosner immediately come to mind 
as attractive candidates for such a panel.
    The panel would be charged with conducting an on-going and 
independent assessment of systemic risks to supplement the efforts of 
the regulators. It would report periodically to both Congress and the 
regulatory agencies on its findings. It could be given privileged 
access to information gathered by the regulators to use in making its 
assessment. When appropriate, it might recommend either legislative or 
regulatory changes with a goal of reducing risks to the financial 
system. CFA believes such an approach would greatly enhance the 
accountability of regulators and reduce the risks of group-think and 
complacency. We urge you to include this as a component of your 
regulatory reform plan.

Who Should Be Regulated?
    The debate over who should be regulated for systemic risk basically 
boils down to two main points of view. Those who see systemic risk 
regulation as something that kicks in during or on the brink of a 
crisis, to deal with the potential failure of one or more financial 
institutions, tend to favor a narrower approach focused on a few large 
or otherwise ``systemically important'' institutions. In contrast, 
those who see systemic risk regulation as something that is designed, 
first and foremost, to prevent risks from reaching that degree of 
severity tend to favor a much more expansive approach. Recognizing that 
systemic risk can derive from a variety of different practices, 
proponents of this view argue that all forms of financial activity must 
be subject to systemic risk regulation and that the systemic risk 
regulator must have significant flexibility and authority to determine 
the extent of its reach.
    CFA falls firmly into the latter camp. We are not alone; this 
expansive view of systemic risk jurisdiction has many supporters, at 
least when it comes to the regulator's authority to monitor the markets 
for systemic risk. The Government Accountability Office, for example, 
has said that such efforts ``should cover all activities that pose 
risks or are otherwise important to meeting regulatory goals.'' 
Bartlett of the Financial Services Roundtable summed it up well in his 
testimony when he said that:

        authority to collect information should apply not only to 
        depository institutions, but also to all types of financial 
        services firms, including broker/dealers, insurance companies, 
        hedge funds, private equity firms, industrial loan companies, 
        credit unions, and any other financial services firms that 
        facilitate financial flows (e.g., transactions, savings, 
        investments, credit, and financial protection) in our economy. 
        Also, this authority should not be based upon the size of an 
        institution. It is possible that a number of smaller 
        institutions could be engaged in activities that collectively 
        pose a systemic risk.

The case for giving a systemic risk regulator broad authority to 
monitor the markets for systemic risk is obvious, in our opinion. 
Failure to grant a regulator this broad authority risks allowing risks 
to grow up outside the clear jurisdiction of functional regulators, a 
situation financial institutions have shown themselves to be very 
creative at exploiting.
    While the case for allowing the systemic risk regulator broad 
authority to monitor the financial system as a whole seems obvious, the 
issue of whether to also grant that regulator authority to constrain 
risky conduct wherever they find it is more complex. Those who favor a 
narrower approach argue that the proper focus of any such regulatory 
authority should be limited to those institutions whose failure would 
be likely to create a systemic risk. This view is based on the 
sentiment that, if an institution is too big to fail, it must be 
regulated. While CFA shares the view that those firms that are ``too 
big to fail'' must be regulated, we take that view one step further. As 
we have discussed above, we believe that the best way to reduce 
systemic risk is to ensure that all financial activity is regulated to 
ensure that it is conducted according to basic principles of 
transparency, fair dealing, and accountability.
    Those like Litan who favor a narrower approach focused on 
``systemically important'' institutions defend it against charges that 
it creates unacceptable moral hazard by arguing that it is essentially 
impossible to expand on the moral hazard that has already been created 
by recent federal bailouts simply by formally designating certain 
institutions as systemically significant. We agree that, based on 
recent events and unless the approach to systemic risk is changed, the 
market will assume that large firms will be rescued, just as the market 
rightly assumed for years, despite assurances to the contrary, that the 
government would stand behind the GSEs. Nonetheless, we do not believe 
it follows that the appropriate approach to systemic risk regulation is 
to focus exclusively on these institutions that are most likely to 
receive a bailout. Instead, we believe it is essential to attack risks 
more broadly, before institutions are threatened with failure and, to 
the degree possible, to eliminate the perception that large 
institutions will always be rescued. The latter goal could be addressed 
both by reducing the practices that make institutions systemically 
significant and by creating a mechanism to allow their orderly failure.
    Ultimately, we believe a regulatory approach that relies on 
identifying institutions in advance that are systemically significant 
is simply unworkable. The fallibility of this approach was demonstrated 
conclusively in the wake of the government's determination that Lehman 
Brothers, unlike Bear Stearns, was not too big to fail. As Richard 
Baker, President and CEO of the Managed Funds Association, said in his 
testimony before the House Capital Markets Subcommittee, ``There likely 
are entities that would be deemed systemically relevant . . . whose 
failure would not threaten the broader financial system.'' We also 
agree with NAIC Chief Executive Officer Therese Vaughn, who said in 
testimony at the same hearing, ``In our view, an entity poses systemic 
risk when that entity's activities have the ability to ripple through 
the broader financial system and trigger problems for other 
counterparties, such that extraordinary action is necessary to mitigate 
it.''
    The factors that might make an institution systemically important 
are complex--going well beyond asset size and even degree of leverage 
to include such considerations as nature and degree of 
interconnectivity to other financial institutions, risks of activities 
engaged in, nature of compensation practices, and degree of 
concentration of financial assets and activities, to name just a few. 
Trying to determine in advance where that risk is likely to arise would 
be all but impossible. And trying to maintain an accurate list of 
systemically important institutions going forward, considering the 
complex array of factors that are relevant to that determination, would 
require constant and detailed monitoring of institutions on the 
borderline, would be extremely time-consuming, and ultimately would 
almost certainly allow certain risky institutions and practices to fall 
through the cracks.

How Should They Regulate?
    There are three key issues that must be addressed in determining 
the appropriate procedures for regulating to mitigate systemic risk:

    Should responsibility and authority to regulate for 
        systemic risks kick in only in a crisis, or on the brink of a 
        crisis, or should it be an on-going, day-to-day obligation of 
        financial regulators?

    What regulatory tools should be available to a systemic 
        risk regulator? For example, should a designated systemic risk 
        regulator have authority to take corrective actions, or should 
        it be required (or encouraged) to work through functional 
        regulators?

    If a designated systemic risk regulator has authority to 
        require corrective actions, should it apply generally to all 
        financial institutions, products, and practices or should it be 
        limited to a select population of systemically important 
        institutions?

    When the Treasury Department issued its Blueprint for regulatory 
reform a year ago, it proposed to give the Federal Reserve broad new 
authority to regulate systemic risk but only in a crisis. Despite the 
sweeping scope of its restructuring proposals, Treasury clearly 
envisioned a strictly limited role within systemic risk regulation for 
regulatory interventions exercised primarily through its role as lender 
of last resort. Although there are a few who continue to advocate a 
version of that viewpoint, we believe events since the Blueprint's 
release have conclusively proven the disadvantages of this approach. As 
Volcker stated in his New York Economic Club speech: ``I do not see how 
that responsibility can be turned on only at times of turmoil--in 
effect when the horse has left the barn.'' We share that skepticism, 
convinced like the authors of the COP Report that, ``Systemic risk 
needs to be managed before moments of crisis, by regulators who have 
clear authority and the proper tools.''
    As noted above, most parties appear to agree that a systemic risk 
regulator must have broad authority to survey all areas of financial 
markets and the flexibility to respond to emerging areas of potential 
risk. CFA shares this view, believing it would be both impractical and 
dangerous to require the regulator to go back to Congress each time it 
sought to extend its jurisdiction in response to changing market 
conditions. Others have described a robust set of additional tools that 
regulators should have to minimize systemic risks. As the Group of 30 
noted in its report on regulatory reform: `` . . . a legal regime 
should be established to provide regulators with authority to require 
early warnings, prompt corrective actions, and orderly closings'' of 
certain financial institutions. The specific regulatory powers various 
parties have recommended as part of a comprehensive framework for 
systemic risk regulation include authority to:

    Set capital, liquidity, and other regulatory requirements 
        directly related to risk management;

    Require firms to pay some form of premium, much like the 
        premiums banks pay to support the federal deposit insurance 
        fund, adjusted to reflect the bank's size, leverage, and 
        concentration, as well as the risks associated with its 
        activities;

    Directly supervise at least certain institutions;

    Act as lender of last resort with regard to institutions at 
        risk of failure;

    Act as a receiver or conservator of a failed nondepository 
        organization and to place the organization in liquidation or 
        take action to restore it to a sound and solvent condition;

    Require corrective actions at troubled institutions that 
        are similar to those provided for in FDICIA;

    Make regular reports to Congress; and

    Take enforcement actions, with powers similar to what 
        Federal Reserve currently has over bank holding companies.

Without evaluating each recommendation individually or in detail, CFA 
believes this presents an appropriately comprehensive view of the tools 
necessary for systemic risk regulation.
    Most of those who have commented on this topic would give at least 
some of this responsibility and authority--such as demanding corrective 
actions to reduce risks--directly to a systemic risk regulator. Others 
would require in all but the most extreme circumstances that a systemic 
risk regulator exercise this authority only in cooperation with 
functional regulators. Both approaches have advantages and 
disadvantages. Giving a systemic risk regulator this authority would 
ensure consistent application of standards and establish a clear line 
of accountability for decision-making in this area. But it would also 
demand, perhaps unrealistically, that the regulator have a detailed 
understanding of how those standards would best be implemented in a 
vast variety of firms and situations. Relying on functional regulators 
to act avoids the latter problem but sets up a potential for 
jurisdictional conflicts as well as inconsistent and delayed 
implementation. If Congress decides to adopt the latter approach, it 
will need to make absolutely clear what authority the systemic risk 
regulator has to require its regulatory partners to take appropriate 
action. Without that clarification, disputes over jurisdiction are 
inevitable, and inconsistencies and conflicts are bound to emerge. It 
would also be doubly important under such an approach to ensure that 
gaps in the regulatory framework are closed and that all regulators 
share a responsibility for reducing systemic risk.
    Many of those who would give a systemic risk regulator this direct 
authority to demand corrective actions would limit its application to a 
select population of systemically important institutions. The 
Securities Industry and Financial Markets Association has advocated, 
for example, that the resolution system for nonbank firms apply only to 
``the few organizations whose failure might reasonably be considered to 
pose a threat to the financial system.'' In testimony before the House 
Capital Markets Subcommittee, SIFMA President and CEO T. Timothy Ryan, 
Jr. also suggested that the systemic risk regulator should only 
directly supervise systemically important financial institutions.
    Such an approach requires a systemic risk regulator to identify in 
advance those institutions that pose a systemic risk. Others express 
strong opposition to this approach. As former Congressman Baker of the 
MFA said in his recent House Subcommittee testimony:

        An entity that is perceived by the market to have a government 
        guarantee, whether explicit or implicit, has an unfair 
        competitive advantage over other market participants. We 
        strongly believe that the systemic risk regulator should 
        implement its authority in a way that avoids this possibility 
        and also avoids the moral hazards that can result from a 
        company having an ongoing government guarantee against failure.

    Unfortunately, the recent actions the government was called on to 
take to rescue a series of nonbank financial institutions has already 
created that implied backing. Simply refraining from designating 
certain institutions as systemically significant will not be sufficient 
to dispel that expectation, and it would at least provide the 
opportunity to subject those firms to tougher standards and enhanced 
oversight. As discussed above, however, CFA believes this approach to 
be unworkable.
    That is a key reason why we believe it is absolutely essential to 
provide for corrective action and resolution authority as part of a 
comprehensive plan for enhanced systemic risk regulation. As money 
manager Jonathan Tiemann argued in a recent article entitled ``The Wall 
Street Vortex'':

        Some institutions are so large that their failure would imperil 
        the financial system. As such, they enjoy an implicit 
        guarantee, which could . . . force us to nationalize their 
        losses. But we need for all financial firms that run the risk 
        of failure to be able to do so without causing a widespread 
        financial meltdown. The most interesting part of the debate 
        should be on this point, whether we could break these firms 
        into smaller pieces, limit their activities, or find a way to 
        compartmentalize the risks that their various business units 
        take.

    CFA believes this is an issue that deserves more attention than it 
has garnered to date. One option is to try to maximize the incentives 
of private parties to avoid risks, for example by subjecting financial 
institutions to risk-based capital requirements and premium payments. 
To serve as a significant deterrent to risk, these requirements would 
have to ratchet up dramatically as institutions grew in size, took on 
risky assets, increased their level of leverage, or engaged in other 
activities deemed risky by regulators. It has been suggested, for 
example, that the Fed could have prevented the rapid growth in use of 
over-the-counter credit default swaps by financial institutions if it 
had adopted this approach. It could, for example, have imposed capital 
standards for use of OTC derivatives that were higher than the margin 
requirements associated with trading the same types of derivatives on a 
clearinghouse and designed to reflect the added risks associated with 
trading in the over-the-counter markets. In order to minimize the 
chances that institutions will avoid becoming too big or too inter-
connected to fail, CFA urges you to include such incentives as a 
central component of your systemic risk regulation legislation.

Conclusion
    Decades of Wall Street excess unchecked by reasonable and 
prudential regulation have left our markets vulnerable to systemic 
shock. The United States, and indeed the world, is still reeling from 
the effects of the latest and most severe of a long series of financial 
crises. Only a fundamental change in regulatory approach will turn this 
situation around. While structural changes are a part of that solution, 
they are by no means the most important aspect. Rather, returning to a 
regulatory approach that recognizes both the disastrous consequences of 
allowing markets to self-regulate and the necessity of strong and 
effective governmental controls to rein in excesses is absolutely 
essential to achieving this goal.
                                 ______
                                 

               PREPARED STATEMENT OF DAVID G. TITTSWORTH
            Executive Director and Executive Vice President,
                     Investment Adviser Association
                             March 26, 2009
                           Executive Summary

    Profile of Investment Advisory Profession. There are about 11,000 
SEC-registered investment advisers. These firms collectively provide 
investment management and other advisory services to a wide range of 
clients, including individuals, trusts, and families, as well as 
institutional clients, such as endowments, foundations, charitable 
institutions, state and local governments, pension funds, corporations, 
mutual funds, and hedge funds. There are relatively few large firms in 
the investment advisory profession, but they manage the lion's share of 
total assets. Most investment advisers are small businesses. About 
7,500 employ 10 or fewer employees and 90 percent employ fewer than 50 
people.
    Principles for Regulatory Reform. Restoring the vitality of the 
U.S. economy, renewing investor confidence, and addressing failures of 
and weaknesses in the current regulatory framework are clearly the 
highest priority for this Committee. To that end, the IAA offers the 
following principles for the Committee's consideration:

    First, the IAA supports the efforts of the Congress, the 
        Administration, regulators, and others to address the root 
        causes of the economic crisis, including subprime mortgages, 
        securitization of mortgage-related instruments, and the degree 
        to which leverage contributed to the crisis.

    Second, systemic risk oversight must be strengthened. Such 
        oversight should complement but not replace robust functional 
        regulation of financial institutions. In that vein, Congress 
        must preserve and adequately fund the Securities and Exchange 
        Commission's core missions of protecting investors, maintaining 
        fair and orderly markets, and facilitating capital formation.

    Third, we believe Congress and regulators must address the 
        true regulatory gaps that exist in our current system. Any 
        systemic risk initiatives are destined for failure until and 
        unless these gaps are addressed.

      The IAA continues to support centralized registration and 
        regulation of hedge fund managers by the SEC. Investors, the 
        marketplace, and regulators will benefit from the disclosure, 
        compliance protocols, recordkeeping, exams, and other 
        requirements that accompany SEC registration and regulation of 
        hedge fund managers.

      We also support stronger oversight and transparency of 
        credit default swaps and other complex financial derivatives. 
        The role of these products in the economic crisis has been 
        demonstrated all too clearly. Action must be taken to ensure 
        that these products can no longer be traded outside of a 
        regulatory system that promotes transparency and 
        accountability.

      The IAA supports efforts to provide greater regulatory 
        oversight of credit rating agencies. Congress should address 
        conflicts of interest inherent in the rating agencies' 
        compensation structures and bring greater transparency to the 
        process.

    Congress should consider enhancing investor protection by 
        applying the core principles of the Investment Advisers Act of 
        l940 as integral elements of a regulatory framework for other 
        financial service providers.

    Investment Adviser Issues. In the current debate, two issues have 
been raised that directly implicate the Investment Advisers Act, the 
law governing investment advisory firms.

    Testimony before this Committee has raised the concept of 
        ``harmonizing'' laws and regulations governing brokers and 
        investment advisers, including proposals to replace an 
        investment adviser's fiduciary duty with some other standard. 
        The IAA agrees that market and regulatory developments--
        primarily the migration of brokers toward more traditional 
        advisory services--has created investor confusion about the 
        respective roles and obligations of brokers, advisers, and 
        others who provide investment advice. But we disagree that 
        extending the sale-of-products structure governing brokers 
        would be appropriate for investment advisers providing 
        professional services. Instead, we believe any 
        ``harmonization'' of laws and regulations governing brokers and 
        investment advisers should extend the investor protection 
        benefits of investment adviser fiduciary standards to anyone 
        who offers investment advice. Fiduciary duty requires firms to 
        act in the best interest of their clients and to place client 
        interests ahead of their own. Other standards may require only 
        a commercial duty of fair dealing in arm's-length transactions. 
        Such standards are not commensurate with the trust and 
        confidence placed by investors in their financial services 
        professional. Earlier this week, our organization joined the 
        North American Securities Administrators Association and the 
        Consumer Federation of America in a joint letter to this 
        Committee that underscores the need to apply fiduciary 
        standards to all who provide investment advice.

    The idea of establishing a self-regulatory organization 
        (SRO) for investment advisers has been raised and rejected a 
        number of times over the years. We continue to oppose the 
        creation of an SRO for the advisory profession. The drawbacks 
        to an SRO--including inherent conflicts of interest, questions 
        about transparency, accountability, and oversight, and added 
        costs and bureaucracy--continue to outweigh any alleged 
        benefits. We particularly oppose the idea of FINRA as the SRO 
        for investment advisers, given its governance structure, costs, 
        track record, and advocacy of the broker-dealer model of 
        regulation.

    We believe the SEC has the necessary expertise and 
        experience to govern the activities of the investment advisory 
        profession. However, the adequacy of the SEC's resources to 
        exercise proper oversight of investment advisers is a 
        legitimate question that deserves serious attention by policy 
        makers. Instead of focusing on an SRO as the response to this 
        question, Congress and the SEC should take steps to bolster the 
        SEC's resources:

      There must be full funding for the SEC's regulatory, 
        inspection, and enforcement efforts. We believe Congress should 
        examine alternatives to allow the agency to achieve longer-term 
        and more stable funding, including self-funding mechanisms.

      The SEC should increase the $25 million threshold that 
        separates federally registered and state-registered advisers. 
        An increase in the threshold would reduce the number of SEC-
        registered advisers and permit the SEC to focus on the 
        appropriate universe of advisers on a risk-adjusted basis in 
        its examination program.

      The SEC can and should improve its inspection program for 
        investment advisers. There are a number of steps the SEC can 
        take to better leverage its resources with respect to 
        examinations. For example, the SEC should consider revamping 
        its inspection program to focus more on finding fraud as 
        opposed to technical rules violations. Better technology, 
        enhanced training, and additional data could assist in these 
        efforts as well. We would be pleased to work with the Committee 
        and the SEC to explore additional ways to ensure that 
        investment advisers are subject to appropriate and timely 
        examinations.

Introduction
    The Investment Adviser Association (IAA) \1\ greatly appreciates 
the opportunity to appear before the Committee today to address 
significant issues and developments relating to enhancing investor 
protection and the regulation of securities markets.
---------------------------------------------------------------------------
     \1\ The Investment Adviser Association (IAA) is a not-for-profit 
trade association that exclusively represents the interests of 
federally registered investment advisory firms. Founded in 1937 as the 
Investment Counsel Association of America (ICAA), the IAA's membership 
consists of investment advisory firms that provide investment advice to 
a wide variety of clients, including individuals, trusts, endowments, 
foundations, corporations, pension funds, mutual funds, state and local 
governments, and hedge funds. For more information, please see 
www.investmentadviser.org.
---------------------------------------------------------------------------
    The IAA's members bring important perspectives to the regulatory 
reform discussion both as entities subject to regulation and as 
investors in the securities markets on behalf of their clients. The 
continuing economic crisis, as well as recent events such as the Madoff 
scandal, have focused attention on issues relating to how the financial 
services industry is regulated. These developments have prompted a re-
evaluation of whether current oversight structures should be 
strengthened and modernized. The crisis provides both regulators and 
the industry with an opportunity to enhance investor protection and 
establish more effective regulatory oversight.
    The IAA stands ready to assist the Committee in undertaking the 
critical tasks of restoring the vitality of the U.S. economy, renewing 
investor confidence, and addressing failures of, and weaknesses in, the 
current regulatory framework.

I. Regulatory Reform
    Before discussing our views on matters that specifically relate to 
investment adviser regulation, we wish to emphasize our views regarding 
broader issues of regulatory reform.

    The Congress, Administration, regulators, and other policy 
        makers should focus their collective attention on the root 
        causes of the economic crisis: subprime mortgages, 
        securitization of mortgage-related instruments, and the degree 
        to which leverage contributed to the crisis. These issues 
        clearly represent the highest priority for legislative and 
        regulatory action. Indeed, the issues discussed below relating 
        to potential changes in investment adviser regulation, while 
        important to investor protection, do not address the underlying 
        causes and related regulatory and structural changes that need 
        to be put in place to respond to the economic crisis.

    Systemic risk oversight is long overdue. The present 
        fragmented financial regulatory system does not enable adequate 
        coordination and cooperation among a complex network of market 
        participants and regulators and no one regulatory body is 
        responsible for monitoring and assessing system-wide risk. 
        While systemic risk oversight must be strengthened, such 
        oversight should not replace robust functional regulation of 
        financial institutions.

      As part of the review of financial regulatory systems, 
        restructuring certain government agencies (such as merging the 
        Commodity Futures Trading Commission into the Securities and 
        Exchange Commission) should be considered to ensure more 
        effective regulation, efficiency, and accountability. The SEC 
        is the primary regulator charged with the mission of protecting 
        investors. In reforming the current regulatory structure, 
        Congress must preserve and adequately fund the SEC's core 
        missions of protecting investors, maintaining fair and orderly 
        markets, and facilitating capital formation.

    Congress and regulators should close regulatory gaps and 
        appropriately regulate relatively new services and products 
        that have expanded exponentially over the last decade, 
        significantly impacting the financial system. Any systemic risk 
        initiatives are destined for failure until and unless these 
        gaps are addressed:

      Hedge Funds. The IAA continues to support centralized 
        registration and regulation of hedge fund managers by the SEC. 
        The SEC is the appropriate functional regulator for investment 
        advisers to hedge funds and other unregulated pooled investment 
        vehicles. We do not agree with suggestions by some that hedge 
        funds simply be required to provide information periodically to 
        a systemic risk regulator. Investors and the marketplace will 
        benefit from the disclosure, compliance protocols, 
        recordkeeping, examinations, and other requirements that will 
        accompany SEC registration and regulation of hedge fund 
        managers.

      Derivatives. The IAA supports far stronger oversight and 
        transparency of credit default swaps and other complex 
        financial derivatives. These products played a significant role 
        in the recent market disruptions. Congress should consider ways 
        to regulate securities and economic substitutes for securities 
        in a similar fashion. Current efforts to establish central 
        counterparties to clear credit default swaps, while laudable, 
        are not sufficient, particularly because participation is 
        voluntary.

      Credit Rating Agencies. The IAA supports efforts to 
        provide greater regulatory oversight of credit rating agencies, 
        which have increasingly played an important role in the 
        markets. Congress should address conflicts of interest inherent 
        in the rating agencies' compensation structures and bring 
        greater transparency to the process.

    Congress should consider enhancing investor protection by 
        applying the core principles of the Investment Advisers Act of 
        l940 as integral elements of a regulatory framework for other 
        financial service providers.

      The core principles of the Advisers Act are fiduciary 
        duty, which includes the duty to place the interests of your 
        client above your own interests at all times, coupled with 
        broad antifraud authority and full and fair disclosure 
        obligations overseen by a single direct regulator (SEC). 
        Congress should extend the investor protection benefits of 
        investment adviser fiduciary standards to all entities that 
        offer investment advice.

    In effecting regulatory reform of the financial services industry, 
policy makers should be mindful of three maxims. First, shuffling boxes 
(i.e., creating new regulatory authorities or merging or eliminating 
existing regulators) does not necessarily constitute regulatory reform. 
Effective regulation requires direct and appropriate statutory 
authority, clear and reasonable regulations, and intelligent 
enforcement.
    Second, policy makers should ``do no harm'' in addressing 
regulatory reform. Some financial service providers already are 
appropriately regulated and did not contribute to the current crisis. 
Where such situations exist, policy makers should not attempt to 
reinvent the wheel or create new and additional regulatory 
requirements.
    Third, the changes under consideration by this Congress are 
significant and have the potential to dramatically reshape the 
regulatory landscape for decades. Even in this environment, getting it 
right is much more important than acting in haste.

II. Investment Advisers Act Issues
    In addition to the regulatory reforms under consideration that 
directly pertain to the ongoing financial crisis, two primary issues 
have been raised that relate to the Investment Advisers Act:

    The concept of ``harmonizing'' laws and regulations 
        governing broker-dealers and investment advisers, including a 
        brokerage industry proposal to replace an investment adviser's 
        fiduciary duty with a universal ``fair dealing'' standard.

    Establishment of a self-regulatory organization (SRO) for 
        investment advisers.

    As we discuss in greater detail below, we believe that any 
``harmonization'' of laws and regulations governing broker-dealers and 
investment advisers should extend the investor protection benefits of 
investment adviser fiduciary standards to anyone who offers investment 
advice. In particular, pursuant to fiduciary duty standards, the 
obligation to disclose conflicts of interest should apply to all those 
who provide investment advice. In addition, any ``harmonization'' 
should not result in subjecting investment advisers to inappropriate 
broker-dealer rules, including those of a self-regulatory organization.
    In considering these issues, it is critical to understand the 
investment advisory profession.

A. Profile of the Investment Adviser Profession
    There are about 11,000 SEC-registered investment advisers, 
representing a broad spectrum of firms. There are a few relatively 
large firms that oversee the lion's share of assets under management. 
According to information filed with the SEC, as of April 2008, 82 
investment advisory firms (less than .7 percent) had investment 
management authority with respect to more than half of the $38.67 
trillion in discretionary assets managed by all SEC-registered 
advisers. Some of these larger firms are affiliated with other 
investment advisers, banks, broker-dealers, and insurance companies. 
However, the vast majority of investment advisory firms are small, 
unaffiliated businesses. \2\ According to information filed with the 
SEC, 90 percent of all federally registered investment adviser firms 
have fewer than 50 employees and 68 percent (more than 7,500 firms) 
have ten or fewer employees. \3\ Firms with five or fewer employees 
make up nearly half (49 percent) of all advisers.
---------------------------------------------------------------------------
     \2\ More than 91 percent of SEC-registered advisory firms manage 
less than $1 billion in assets. See IAA/NRS, Evolution/Revolution: A 
Profile of the U.S. Investment Advisory Profession (2008), available on 
our Web site, at 3. Further, approximately 43.7 percent (4,820) of all 
investment advisers are not affiliated with any other financial 
industry entity. Id. at 11.
     \3\ Id. at 8.
---------------------------------------------------------------------------
    Investment advisers manage assets for a wide array of individual 
and institutional investors, including high net worth individuals, 
educational institutions, endowments, foundations, corporations, 
pension plans, mutual funds, hedge funds, private equity funds, bank 
collective trusts, insurance companies, and state and local 
governments. The overwhelming majority of SEC-registered investment 
advisers have discretionary authority to make investment decisions on 
behalf of their clients, consistent with the terms of the advisory 
contract and any client guidelines. Advisory firms employ a variety of 
investment strategies on behalf of their clients. Given the enormous 
diversity and complexity among different types of investment adviser 
firms, it is notable that 67 percent of the more than 11,000 investment 
advisers that were federally registered as of April 2008 were not 
engaged in any business activity other than giving investment advice. 
Only 644 investment advisers (5.8 percent) were dually registered as 
broker-dealers.
    The diverse and small business nature of the investment advisory 
profession benefits the wide range of investors--both individuals and 
institutions--seeking investment advice and should be preserved.

B. ``Harmonization'' of Investment Adviser and Broker-Dealer Laws and 
        Regulations
    Background. Although the concept of ``harmonization'' of broker-
dealer and investment adviser regulation has been advanced recently, 
few details have emerged describing what harmonization actually means. 
\4\ The term surfaced last year in the Treasury Department's 
``Blueprint for a Modernized Financial Regulatory Structure.'' Among 
its ``intermediate-term'' findings, the Blueprint contains a discussion 
of the ``ongoing debate regarding broker-dealer regulation and 
investment adviser regulation,'' and states:
---------------------------------------------------------------------------
     \4\ The IAA has been actively involved in discussions and 
proceedings relating to the potential ``harmonization'' of broker and 
adviser rules for many years. We filed numerous comment letters 
responding to the SEC's rulemakings (first proposed in 1999) relating 
to the circumstances under which the provision of investment advice by 
brokers subjects their activities to the Advisers Act. See, e.g., 
Letter from David G. Tittsworth, Investment Counsel Association of 
America, to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission (Jan. 12, 2000); Letter from David G. Tittsworth, Investment 
Counsel Association of America, to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission (Feb. 7, 2005). In those 
rulemakings, the IAA supported applying a consistent, functional 
regulatory approach so that the same rules apply to the same 
activities. We also supported functional regulation with respect to 
other market participants. See, e.g., Letter from David G. Tittsworth, 
Investment Counsel Association of America,, to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, re: Exemption for 
Thrifts Under the Investment Advisers Act (Dec. 27, 2001).

        Treasury notes the rapid and continued convergence of the 
        services provided by broker-dealers and investment advisers and 
        the resulting regulatory confusion due to a statutory regime 
        reflecting the brokerage and investment advisory businesses of 
        decades ago. An objective of this report is to identify 
        regulatory coverage gaps and inefficiencies. This is one 
        situation in which the U.S. regulatory system has failed to 
        adjust to market developments, leading to investor confusion. 
        Accordingly, Treasury recommends statutory changes to harmonize 
        the regulation and oversight of broker-dealers and investment 
        advisers offering similar services to retail investors. \5\
---------------------------------------------------------------------------
     \5\ The Department of the Treasury Blueprint for a Modernized 
Financial Regulatory Structure (Mar. 2008), at 125-126.

Despite suggesting statutory harmonization, the Treasury Blueprint did 
not include any specific recommendations about what this might entail.
    The Blueprint followed on the heels of a report commissioned by the 
SEC that examined marketing practices and financial products and 
services provided to individual investors by broker-dealers and 
investment advisers and evaluated investor understanding of the 
differences between investment adviser and broker-dealer products, 
services, duties, and obligations. \6\ The so-called RAND report found 
that ``trends in the financial service market since the early 1990s 
have blurred the boundaries'' between broker-dealers and investment 
advisers and that ``the typical retail investor finds it difficult to 
understand the nature of the business from which he or she receives 
investment advisory or brokerage services.'' The RAND report did not 
set forth any specific policy recommendations relating to its findings.
---------------------------------------------------------------------------
     \6\ Investor and Industry Perspectives on Investment Advisers and 
Broker-Dealers, LRN-RAND Center for Corporate Ethics, Law, and 
Governance (pre-publication copy Dec. 2007).
---------------------------------------------------------------------------
    Fiduciary Duty. Consistent with our long-standing support for a 
functional approach, we believe that brokers, advisers and others 
should be held to the same high standards depending not on the statute 
under which they are registered, but upon the role they are playing. If 
the service being offered bears the core characteristics of investment 
advisory services from the investor's perspective, it should be subject 
to the same high standards and duties. That high standard is fiduciary 
duty.
    Investment advisers are subject to a strict fiduciary duty. This 
duty has been upheld by the U.S. Supreme Court \7\ and espoused by the 
SEC for over half a century. \8\ Fiduciary duty is the highest standard 
of care recognized under the law and serves as a bedrock principle of 
investor protection. This duty is one of the primary distinctions 
between investment advisers and others in the financial services 
industry. As a fiduciary, ``an investment adviser must at all times act 
in its clients' best interests, and its conduct will be measured 
against a higher standard of conduct than that used for mere commercial 
transactions.'' \9\ Fiduciary duty is not susceptible to strict 
definition or formulaic application but rather is dependent upon facts 
and circumstances. However, certain core principles of an adviser's 
fiduciary duty have been well-established, as reflected in our 
organization's Standards of Practice. \10\
---------------------------------------------------------------------------
     \7\ SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963).
     \8\ See, e.g., In re: Arleen W. Hughes, Exchange Act Release No. 
4048 (Feb. 18, 1948).
     \9\ Lemke & Lins, Regulation of Investment Advisers, at 2:33 
(2008).
     \10\ The first article of the IAA Standards of Practice, entitled 
``Fiduciary Duty and Professional Responsibility,'' provides as 
follows: ``An investment adviser stands in a special relationship of 
trust and confidence with, and therefore is a fiduciary to, its 
clients. As a fiduciary, an investment adviser has an affirmative duty 
of care, loyalty, honesty, and good faith to act in the best interests 
of its clients.'' The Standards describe some of the parameters of 
fiduciary duty, available at: http://www.investmentadviser.org/eweb/
dynamicpage.aspx?webcode=StandardsPractice.
---------------------------------------------------------------------------
    There has been some dissent from the view that the highest standard 
should be applied to all those who give investment advice. At a recent 
hearing before the Senate Banking Committee, the Securities Industry 
and Financial Markets Association (SIFMA), in echoing calls for 
``harmonization'' of investment adviser and broker-dealer regulation, 
concluded that a different legal standard should be applied: \11\
---------------------------------------------------------------------------
     \11\ Testimony of T. Timothy Ryan, Jr., President and Chief 
Executive Officer, Securities Industry and Financial Markets 
Association, Before the U.S. Senate Committee on Banking, Housing and 
Urban Affairs, Hearing on ``Enhancing Investor Protection and the 
Regulation of the Securities Markets'' (Mar. 10, 2009) (``March 10 
Banking Committee Hearing'').

        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.

    We urge the Committee to consider ways to extend an investment 
adviser's fiduciary duty to other financial services professionals who 
offer investment advice--not to eliminate it or water it down with some 
new ``fair dealing'' standard. Investors deserve nothing less than the 
fiduciary duty owed to them under the Investment Advisers Act. Our 
views on this important subject are shared by others. Earlier this 
week, the IAA joined the North American Securities Administrators 
Association and the Consumer Federation of America in a joint letter to 
this Committee that supports the extension of an investment adviser's 
fiduciary standard to others that provide advisory services:

        Surely we can all agree that, in the current climate, there 
        must be no weakening of investor protections. We therefore urge 
        you to resist the call to water down the standards applicable 
        to advisory activities and instead to extend application of the 
        fiduciary duty to all those engaged in advisory services.

    A number of witnesses made similar statements at the Committee's 
first hearing on this subject. \12\
---------------------------------------------------------------------------
     \12\ See Testimony of Paul Schott Stevens, Investment Company 
Institute, at p. 13; Testimony of Damon A. Silvers, AFL-CIO, at p. 8; 
Testimony of Mercer E. Bullard, Fund Democracy, at p. 38; March 10, 
Banking Committee Hearing.
---------------------------------------------------------------------------
    Other Harmonization Issues. Other than extending fiduciary duty to 
other financial services providers, the Committee should scrutinize 
carefully any further specific ``harmonization'' proposals. We believe 
that the basic structure of the Investment Advisers Act--including an 
overarching fiduciary duty, broad antifraud provisions, and single 
regulator--provides an appropriate structure best designed to promote 
investor protection. The duties of a fiduciary are significantly 
different from those involved in commercial transactions, including 
brokers that sell financial products.
    Many of the differences in the regulations governing brokers and 
advisers appropriately reflect the different business models and 
services of brokers and advisers. Those calling for harmonization do 
not appear to recognize these differences. For example, at a recent 
hearing before the Senate Banking Committee, FINRA testimony regarding 
harmonization focused on products and transactions, rather than 
professional fiduciary services. \13\ Broker-dealer rules have derived 
from the historic role of brokers executing transactions and selling 
financial products to consumers (thus, the brokerage industry is 
commonly referred to as the ``sell side''). Investment adviser rules 
have derived from the historic role of advisers in providing investment 
advisory services to clients, including managing client portfolios 
(thus, the advisory profession is commonly referred to as the ``buy 
side'').
---------------------------------------------------------------------------
     \13\ Testimony of Stephen Luparello, Interim Chief Executive 
Officer, FINRA, before the Senate Committee on Banking, Housing, and 
Urban Affairs, at p. 6-7 (Jan. 27, 2009) (``Luparello Testimony'') (the 
solution is ``greater regulatory harmonization--creating a regulatory 
system that gives retail investors the same protections and rights no 
matter what product they buy,'' including that for every 
``transaction,'' there be consistent: (1) licensing requirements; (2) 
advertising requirements; (3) ``appropriateness'' standards for 
products, and (4) full disclosure for the ``products being sold.'') 
(emphasis added).
---------------------------------------------------------------------------
    Traditionally, brokers have been compensated by commissions derived 
from sales of securities, and any related financial advice provided was 
nondiscretionary (i.e., requiring customer consent). In contrast, 
advisers traditionally have been compensated by fees (typically based 
on assets under management) and have provided discretionary advice to 
clients. In a typical contract for discretionary investment management 
services, the client grants the adviser authority to decide which 
securities to purchase or sell on its behalf. The client also typically 
grants the adviser authority to select brokers as appropriate to 
execute trades for the client's account. The investment adviser is then 
responsible for determining the overall investment strategy for the 
client or the portion of client assets it is retained to manage, 
consistent with its fiduciary duty to make decisions in the best 
interest of the client and with any written investment guidelines 
established by the client. Brokers typically have custody of customer 
funds and securities, whereas most investment advisers use the services 
of independent third-party custodians to hold client assets.
    We agree that, in some situations, the lines between traditional 
brokerage and investment advisory services have been blurred in recent 
years, primarily as a result of the migration of brokers toward more 
traditional advisory services. Accordingly, in adopting business models 
that include investment advisory services, brokers should be subject to 
the fiduciary advice regulatory structure of the Advisers Act, rather 
than attempting to subject advisers to the inapt product-sales approach 
of the Exchange Act.
    We also agree with the RAND report that the migration of brokers 
toward more traditional advisory services--in combination with their 
use of misleading titles (e.g., financial advisor and financial 
consultant) and a lack of meaningful enforcement of current rules 
governing the broker-dealer exemption from the Advisers Act--has 
created investor confusion about the respective roles and obligations 
of brokers, advisers, and others who provide investment advice. It 
would be a perverse result, however, if this confusion leads to a 
diminution in the duties of financial professionals to their clients. 
Instead, all financial services firms and their personnel should be 
required to provide clear information at the inception of the 
relationship about the services they provide, the fees they charge, and 
any conflicts of interest. Registered investment advisers already are 
required to provide such information to their clients at or before the 
time they enter into the advisory relationship.
    Investor Education. Strengthening investor protection by imposing 
the highest standards is only a part of the solution. Educated and 
informed investors will not only reduce confusion regarding types of 
service providers but can also serve as an effective guard against 
fraudsters seeking to take advantage of their clients. At a minimum, we 
believe the SEC and FINRA, as well as financial services firms, should 
do more to assist investors in understanding and assessing differences 
between various investment services professionals. In 2006, we 
participated with the North American Securities Administrators 
Association (NASAA), Consumer Federation of America (CFA), and others 
in publishing a brochure that is designed to help educate investors 
about the differences between investment advisers, brokers, and 
financial planners, the legal duties and standards applicable to each, 
and questions that investors should ask in seeking an investment 
services professional. Entitled, ``Cutting Through the Confusion: Where 
to Turn for Help with Your Investments,'' the brochure is an example of 
the type of investor education that is necessary to assist individuals 
who seek investment assistance. \14\
---------------------------------------------------------------------------
     \14\ Cutting Through the Confusion: Where To Turn for Help with 
Your Investments, published by the Coalition for Investor Education 
(IAA, CFA, NASAA, Financial Planning Association, and CFA Institute), 
available at: http://www.investmentadviser.org/eweb/
dynamicpage.aspx?webcode=Confused.
---------------------------------------------------------------------------
C. Self-Regulatory Organizations and the Advisory Profession
    Background. The idea of establishing a self-regulatory organization 
(SRO) for investment advisers is not new; it has been raised and 
rejected a number of times over the years. For example, in 1989, \15\ 
the SEC transmitted a legislative proposal to Congress to provide for 
the establishment of one or more self-regulatory organizations for 
registered investment advisers. \16\ The impetus for the 1989 proposal 
was the growth of registered investment advisers--and corresponding 
increases in the number of advisory clients and assets under 
management--and the lack of adequate SEC resources to conduct effective 
oversight of the profession. \17\ In responding to the proposed 
legislation, our organization supported the goal of more effective 
oversight of the advisory profession, but strongly opposed the 
establishment of a self-regulatory organization for investment 
advisers. As is the case today, we commented that the problem is not 
one of structure, but rather how to better fund inspections, and noted 
that the same increased fees that would fund self-regulations would 
fund needed enhancements to the SEC's inspection program. \18\
---------------------------------------------------------------------------
     \15\ Questions relating to the establishment of a self-regulatory 
organization for the investment advisory profession were raised well 
before 1989. For example, on June 11, 1962, our organization responded 
to a series of questions from Milton H. Cohen, Director of the SEC's 
Special Study of the Securities Markets, which included a question as 
to whether we would consider it desirable in the public interest for 
our organization to ``obtain official status as an industry self-
governing body.''
     \16\ See Letter from David S. Ruder, Chairman, U.S. Securities and 
Exchange Commission to The Honorable Dan Quayle, President of the U.S. 
Senate. (June 19, 1989).
     \17\ In 1980, there were 5,600 SEC-registered investment advisers. 
By 1990, the number had grown to more than 17,000. When the Investment 
Advisers Supervision Coordination Act was enacted in 1996 (Title III of 
the National Securities Markets Improvement Act), the number of SEC-
registered investment advisers was more than 22,500.
     \18\ Letter from Charles E. Haldeman, Jr., President, Investment 
Counsel Association of America, Inc., to Senators Christopher J. Dodd 
and John Heinz (Sept. 22, 1989).
---------------------------------------------------------------------------
    The 1989 SRO proposal was not pursued. However, a few years later, 
Congress took action to strengthen oversight of the investment advisory 
profession. The Investment Advisers Supervision Coordination Act was 
enacted in 1996. \19\ The Coordination Act was the most significant 
revision of the Investment Advisers Act since 1940. The law allocated 
responsibility for investment advisers between the SEC and the states, 
with the SEC regulating larger advisers and the states regulating 
smaller advisers.
---------------------------------------------------------------------------
     \19\ Title III, National Securities Markets Improvement Act, Pub. 
Law No. 104-290.
---------------------------------------------------------------------------
    The IAA strongly supported enactment of the Coordination Act, which 
prohibits an investment adviser from registering with the SEC unless it 
has more than $25 million in assets under management (AUM) \20\ or is 
an adviser to a registered investment company or fits within another 
exemption. The Coordination Act's allocation of regulatory 
responsibility between the SEC and the states enhances investor 
protection, provides for more efficient use of limited regulatory 
resources, and reduces burdensome, inconsistent, and unnecessary 
regulatory costs.
---------------------------------------------------------------------------
     \20\ The $25 million threshold was intended to provide a bright 
line test for allocating regulatory responsibility of advisers between 
the SEC and the states, representing a rough cut between advisers that 
generally do business in interstate commerce and those that generally 
have more localized practices. The report accompanying the Senate-
passed bill notes that the Commission ``may also use its exemptive 
authority under the bill to raise the $25 million threshold higher as 
it deems appropriate in keeping with the purposes of the Investment 
Advisers Act.'' S. Rpt. 104-293, p. 5 (June 26, 1996).
---------------------------------------------------------------------------
    The 2008 Treasury Blueprint also raised the SRO issue by 
recommending that Congress should subject investment advisers to a 
``self-regulatory regime similar to that of broker-dealers.'' The 
Blueprint asserted that ``self-regulation of the investment advisory 
industry should enhance investor protection and be more cost-effective 
than direct SEC regulation.'' \21\ This recommendation presumably was 
prompted by FINRA--the only commenter on the Blueprint to recommend an 
SRO for advisers. \22\ More recently, FINRA has cited the Madoff 
scandal as further justification for its longstanding desire to extend 
its jurisdiction to investment advisers. \23\ This argument is 
misplaced.
---------------------------------------------------------------------------
     \21\ The Department of the Treasury Blueprint for a Modernized 
Financial Regulatory Structure (Mar. 2008) at 125-126.
     \22\ Letter from Mary L. Schapiro, CEO, FINRA, to the Department 
of the Treasury re: Review by the Treasury Department of the Regulatory 
Structure Associated with Financial Institutions (Dec. 19, 2007), at 5.
     \23\ Luparello Testimony, supra note 13 at p. 5.
---------------------------------------------------------------------------
    The Madoff Scandal. We share the outrage of the Committee and all 
investors about the Madoff scandal. The Madoff case has raised 
justifiable concerns about the ability of regulators to uncover and 
prevent fraudulent activities. Such fraudulent activities cast a shadow 
over legitimate enterprises and thus underscore our continued support 
for effective regulatory, inspection, and enforcement activities to 
ensure investor confidence and protection.
    We believe the Madoff scandal represents a failure of enforcement, 
not of investment adviser regulation. Bernard Madoff operated his Ponzi 
scheme for decades through Bernard Madoff Investment Securities LLC, a 
brokerage firm. He only became subject to investment adviser regulation 
in September 2006 when his firm dually registered with the SEC as an 
investment adviser. \24\ Neither before nor after September 2006 were 
his investment advisory activities ever operated though a subsidiary or 
any other legal entity separate from his brokerage firm.
---------------------------------------------------------------------------
     \24\ Until September 2006, Madoff was registered only as a broker-
dealer. Because his firm received no separate fees for his advisory 
services, Madoff apparently availed himself of the broad exemption 
under the Advisers Act for broker-dealers whose advisory services are 
``solely incidental'' to their brokerage activities and who do not 
charge ``special compensation'' for advice. However, on January 31, 
2006, full compliance with the new SEC ``Broker-Dealer Rule'' was 
required. Among other things, the new Rule (vacated by court decision 
on March 30, 2007) clarified that discretionary management of clients' 
accounts--as provided by Madoff--could not be considered ``solely 
incidental'' to brokerage activities. Accordingly, Madoff could no 
longer claim an exemption from the Advisers Act on this basis and, 
reportedly at the direction of the SEC, registered as an investment 
adviser. Even after Madoff dually-registered in September 2006, his 
investment advisory function was not operated though a separate entity.
---------------------------------------------------------------------------
    According to information that has been made available thus far, 
both the SEC and FINRA conducted numerous inspections of the Madoff 
firm over a period of many years. This fact alone negates any argument 
that the failure to uncover Madoff's fraudulent activities was the 
result of insufficient resources or lack of oversight since both the 
SEC and FINRA (and its predecessor organization NASD) had clear 
authority to inspect all aspects of the Madoff enterprise and used 
their resources to inspect the firm on numerous occasions. 
Unfortunately, these examinations failed to uncover the fraudulent 
activities of the firm.
    Despite FINRA's claims to the contrary, FINRA had ample authority 
to examine all aspects of the Madoff firm. Professor John C. Coffee, 
Jr., a witness at the Committee's January 27 hearing and a widely 
acknowledged authority on securities law, specifically addressed 
whether FINRA had jurisdiction to examine all accounts of the Madoff 
firm and definitively concluded that FINRA/NASD had clear and 
unequivocal authority to do so. \25\
---------------------------------------------------------------------------
     \25\ Testimony of Professor John C. Coffee, Jr., Adolf A. Berle 
Professor of Law, Columbia University Law School, before the Senate 
Committee on Banking, Housing and Urban Affairs (Jan. 27, 2009).
---------------------------------------------------------------------------
    We thus find it troublesome that FINRA is using the Madoff scandal 
as an example of why investment advisers should be subjected to its 
jurisdiction as a self-regulatory organization. \26\ Rather than using 
Madoff as a pretext to expand its jurisdiction, we urge FINRA to 
instead take steps--similar to those the SEC is taking--to seriously 
examine why its inspections of Madoff failed to uncover the Ponzi 
scheme and how it can avoid such failures in the future.
---------------------------------------------------------------------------
     \26\ Instead, the Madoff scandal ``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.'' Testimony of 
Mercer Bullard, President and Founder of Fund Democracy, Inc. and 
Associate Professor of Law at University of Mississippi School of Law, 
March 10 Banking Committee Hearing.
---------------------------------------------------------------------------
    The ``solution'' to Madoff--solely a broker-dealer for most of its 
existence--is not to create a new regulatory structure for advisers, 
but to enhance the SEC's tools to prevent and detect fraud. For 
example, sharing of information between FINRA and the SEC--especially 
with regard to dually registered broker-dealers like Madoff--should be 
formalized. Further, in recent testimony SEC staff noted that it is 
considering ways to ``strengthen the custody and audit requirements for 
regulated firms.'' We recently submitted a letter to SEC Chairman 
Schapiro that sets forth a number of recommendations for the Commission 
to consider in issuing an expected proposed rulemaking addressing self-
custody issues. \27\ The SEC's Office of Inspector General is 
conducting an investigation relating to the agency's handling of the 
Madoff case (including issuing a request for proposal to review the 
SEC's inspection program) \28\ and the results of that investigation 
may provide additional recommendations the agency should consider to 
detect similar frauds in the future.
---------------------------------------------------------------------------
     \27\ Letter from Karen L. Barr, General Counsel, Investment 
Adviser Association to The Hon. Mary L. Schapiro, Chairman, SEC (Mar. 
6, 2009) (``IAA Letter''). The letter is available on our web site 
under ``Publications/News'' and ``Comments & Statements.''
     \28\ See SEC's Request for Quotation for Examination Inspection 
Review (Feb. 12, 2009), available at: https://www.fbo.gov/download/300/
300792fafb8a21b909f4b5e1b9d4c0f4/Amend_3_SECHQ1-09-Q-
0125_Examination_Inspection_Review.pdf.
---------------------------------------------------------------------------
    The SEC Is the Appropriate Direct Regulator of Investment Advisers. 
The IAA strongly supports robust and appropriate oversight and 
regulation of the investment advisory profession. We believe the SEC 
has the necessary expertise and experience to govern the activities of 
the investment advisory profession. Given the great diversity among 
advisory firms--including a relatively small number of large firms and 
thousands of small businesses--this expertise and experience is 
critical in regulating and overseeing the profession.
    The SEC has been an effective regulator with a strong enforcement 
arm in the areas of disclosure and fiduciary duty, the bedrock 
principles underlying investment adviser regulation. While the current 
system of regulation and oversight of investment advisers can and 
should be improved, adding a new and additional layer of bureaucracy 
and cost on the profession via an SRO will not significantly enhance 
investor protection.
    We therefore continue to oppose the creation of an SRO for the 
advisory profession. Ultimately, the drawbacks to an SRO continue to 
outweigh any alleged benefits. These drawbacks include inherent 
conflicts of interest based on industry funding and influence, 
questions regarding transparency, accountability and oversight, due 
process issues in disciplinary proceedings, and added cost and 
bureaucracy.
    While self-regulation may appeal to those who wish to shift 
taxpayer-funded regulation costs to industry, we also note that 
appropriate government oversight is required in any SRO structure and 
thus requires expanded dedication of government resources. Further, 
most investment advisory firms are small businesses with limited 
resources. The costs of any SRO are borne by the regulated entities and 
will obviously impact all investment advisers, including thousands of 
small advisory firms. Ultimately, those costs may be passed on to 
investors. It would be more cost effective to use the industry's funds 
that would be spent on an SRO to bolster the SEC's oversight efforts, 
for example through a self-funding structure as discussed below.
    Further, the reasons that persuaded Congress to authorize the 
creation of an SRO for broker-dealers in 1939--including the high level 
of interconnectivity between broker-dealers as well as highly technical 
issues related to settlement, execution, and reconciliation involving 
broker-dealer transactions--simply do not exist in the investment 
advisory profession.
    Finally, the diversity of the investment adviser industry makes a 
rules-based SRO model unworkable. There is not sufficient commonality 
among the various types of adviser business models--traditional asset 
management firms, financial planners, wealth managers, advisers that 
are part of global financial institutions, small advisers with a 
limited number of high net worth clients, advisers that sell products, 
asset allocators, hedge fund managers, mutual fund managers, pension 
consultants, and others--to achieve fair and flexible self-regulation. 
Command-and-control requirements that seek to impose a one-size-fits-
all solution for various legal and regulatory issues do not lend 
themselves to this widely divergent community of advisers. We thus 
believe that continued oversight of the advisory profession by the SEC 
under the current structure of the Advisers Act--and its reliance on 
disclosure and broad antifraud authority rather than specific and rigid 
regulatory requirements--is both appropriate and effective.
    FINRA as Adviser SRO. Putting aside the merits of the SRO model as 
such, we strongly believe that FINRA would be an inappropriate SRO for 
investment advisers. As noted above, FINRA has been pursuing a role in 
supervising investment advisers for some time. We have serious concerns 
about FINRA, its governance structure, costs imposed on its members, 
\29\ areas of expertise, and track record.
---------------------------------------------------------------------------
     \29\ For example, FINRA collected more than $680 million in 
members fees alone in 2007. It charges a variety of other fees as well. 
See data from FINRA 2007 Annual Financial Report, available at http://
www.finra.org/web/groups/corporate/@corp/@about/@ar/documents/
corporate/p038602.pdf ; see also By-Laws of FINRA, Inc., available at: 
http://finra.complinet.com/en/display/
display_viewall.html?rbid=2403&element_id=4598&record_id=5998.
---------------------------------------------------------------------------
    Perhaps most important, FINRA has demonstrated an agenda favoring 
the extension of its broker-dealer rules and requirements to investment 
advisers. As a result of this bias, we are extremely concerned that 
establishing FINRA as the SRO for investment advisers would result in a 
complete overhaul of investor protections set forth in the Investment 
Advisers Act, including fiduciary duty, requirements to disclose 
conflicts of interest, and restrictions on principal trading. \30\
---------------------------------------------------------------------------
     \30\ In written testimony before this Committee, FINRA 
specifically referenced its belief that broker-dealer rules should be 
extended to the investment advisory profession: ``The absence of FINRA-
type oversight of the investment adviser industry leaves their 
customers without an important layer of protection inherent in a 
vigorous examination and enforcement program and the imposition of 
specific rules and requirements. It simply makes no sense to deprive 
investment adviser customers of the same level of oversight that 
broker-dealer customers receive.'' Luparello Testimony, supra note 13 
at p. 5. FINRA's recent testimony echoes arguments made by NASD in 
written comments submitted to the SEC in 2005 relating to the broker-
dealer exclusion under the Investment Advisers Act. See Letter of Mary 
L. Schapiro and Elisse B. Walter, NASD to Annette Nazareth and Meyer 
Eisenberg, SEC (Apr. 4, 2005): ``[A] careful analysis of the relative 
regulatory standards shows that the substantive protections afforded 
broker-dealer customers are equivalent to, and in many cases exceed, 
those afforded to adviser customers.''
---------------------------------------------------------------------------
    Given its clear preference for broker-dealer rules, we believe it 
would be inappropriate and counterproductive to establish FINRA as the 
SRO for investment advisers. Any regulator for investment advisers 
should, at a minimum, acknowledge and reflect the practices, culture, 
regulation, and oversight of the advisory profession. In light of its 
explicit statements favoring the broker-dealer regulatory model, FINRA 
clearly cannot serve in this capacity. Establishing FINRA as the SRO 
for investment advisers would eviscerate the ``self'' in self-
regulation. Instead, it would lead to an extension of the broker-dealer 
regulatory model to the advisory profession.
    In any case, it is far too premature to consider the possibility of 
an SRO for investment advisers. Instead, as discussed below, there are 
several other steps that should be taken to bolster the resources of 
the SEC, which is in a much better position to regulate and oversee the 
advisory profession consistent with its mission of investor protection.
    The SEC's Resources Should Be Bolstered. The adequacy of the SEC's 
resources to appropriately oversee and examine investment advisers is a 
legitimate and compelling concern that deserves serious consideration 
and action by policy makers. We believe there are steps--other than the 
establishment of an adviser SRO--that should be taken to address the 
SEC's resources and to ensure a robust and appropriate oversight 
program of the investment advisory profession.
    First, as long supported by the IAA, there must be full funding for 
the SEC's regulatory and enforcement efforts. While we applaud the 
Administration's recommended budget increase for the SEC, more 
resources are still needed. We believe Congress should examine 
alternatives to allow the agency to achieve longer-term and more stable 
funding. SEC Commissioner Luis Aguilar, for example, has spoken in 
favor of a self-funding mechanism for the SEC, stating that self-
funding ``would greatly enhance the SEC's ability to advance its 
mission.'' \31\ As he noted in a recent speech:
---------------------------------------------------------------------------
     \31\ ``Empowering the Markets Watchdog To Effect Real Results'' by 
Commissioner Luis A. Aguilar, SEC, at North American Securities 
Administrators Association's Winter Enforcement Conference (Jan. 10, 
2009). He also noted in that speech that ``the return on investment in 
the SEC is extremely high.''

        Being self-funded is not a novel idea. In addition to the 
        Federal Deposit Insurance Corporation, other regulators that 
        are independently funded include the Office of Thrift 
        Supervision, Office of the Comptroller of the Currency, and the 
        Federal Reserve, to name a few. There is no logical reason to 
        treat the SEC differently, and many reasons to similarly 
        empower the Commission. \32\
---------------------------------------------------------------------------
     \32\ Reinvigorating the Enforcement Program to Restore Investor 
Confidence, Speech by SEC Commissioner Luis A. Aguilar before the 
District of Columbia Bar (Mar. 18, 2009).

    Congress should consider providing the SEC with the ability to 
budget and self-fund its operations. In this challenging environment, 
the SEC should be able to set long-term budgets, be able to react to 
changing markets and new products and services, and be able to adjust 
its staffing as appropriate. \33\
---------------------------------------------------------------------------
     \33\ See Testimony of Lynn Turner, March 10 Banking Committee 
Hearing, at p.16 (``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'').
---------------------------------------------------------------------------
    Second, we recommend that the SEC increase the $25 million 
threshold that separates federally registered and state-registered 
advisers. An increase in the $25 million level would reduce the number 
of SEC-registered advisers (such advisers would be subject to 
regulation and oversight of state securities regulators). \34\ The 
allocation of responsibility between the states and the SEC set forth 
in the Coordination Act has worked well, and the Act explicitly 
contemplated that the threshold would be regularly re-evaluated and 
adjusted. \35\ Although the SEC has authority to do so, in more than 12 
years since enactment of the law, the SEC has never, to our knowledge, 
initiated any formal review or proceeding to determine whether the 
threshold should be increased. In considering such action, the SEC 
obviously needs to coordinate closely with the North American 
Securities Administrators Association (NASAA) to ensure that state 
securities regulators are comfortable with any increased AUM level.
---------------------------------------------------------------------------
     \34\ To illustrate the effect of such a change, as of April 2008, 
there were more than 3,700 SEC-registered advisers that reported assets 
under management (AUM) between $25-100 million.
     \35\ See S. Rpt. 104-209, supra note 20.
---------------------------------------------------------------------------
    Third, we believe the SEC can and should improve its inspection 
program for investment advisers. We recognize that the number of 
investment advisers has outgrown the SEC's ability to conduct frequent 
examinations of the adviser population. In addition to the funding and 
threshold recommendations discussed above, there are steps the SEC can 
take to make more effective use of its resources with respect to 
examinations. For example, the SEC should consider revamping its 
inspection program to focus more on finding fraud and misappropriation 
of client funds as opposed to technical rules violations. In this vein, 
the SEC's inspection office has recently begun a series of focused 
examinations related to custody-related issues. SEC staff testified 
recently that it is considering a number of potential changes and 
improvements to its oversight program, including the ``examination 
frequencies for investment advisers.'' \36\
---------------------------------------------------------------------------
     \36\ Testimony of Andrew J. Donohue, Lori Richards, Erik Sirri, 
Linda Chatman Thomsen, Andrew Vollmer, U.S. Securities and Exchange 
Commission, before the House Committee on Financial Services, 
Subcommittee on Capital Markets, Insurance and Government-Sponsored 
Enterprises, Concerning Investor Protection and Securities Fraud (Feb. 
4, 2009).
---------------------------------------------------------------------------
    These and other measures should be fully explored to implement 
meaningful reforms designed to effectuate an inspection program that 
focuses on activities that harm investors and pose the greatest risks. 
Chairman Schapiro recently testified that the Commission plans to ``use 
additional technology funding to improve our ability to identify 
emerging risks to investors.'' She noted that the SEC needs better 
mechanisms to gather, link, and analyze data ``to determine which firms 
or practices deserve a closer look.'' \37\ In our recent letter to 
Chairman Schapiro on self-custody issues, \38\ we recommended enhanced 
disclosures by investment advisers regarding custody arrangements, 
indicating, among other things, that the SEC could use this more 
specific data in its risk assessment process. In that letter, we also 
recommended that the SEC consider joint examinations of dually 
registered firms. Steps such as enhanced training, better technology, 
and more specific, focused data could assist the SEC in better 
leveraging its inspection resources.
---------------------------------------------------------------------------
     \37\ Testimony of March L. Schapiro, before the Subcommittee on 
Financial Services and General Government, House Committee on 
Appropriations, (Mar. 11, 2009).
     \38\ See IAA Letter, supra note. 27.
---------------------------------------------------------------------------
    We would be pleased to work with the Committee and the SEC to 
explore additional ways to ensure that all investment advisers are 
subject to appropriate and timely inspections.
    The IAA appreciates the opportunity to discuss our views on 
regulatory reform and specific issues that have been raised with 
respect to the Investment Advisers Act. We look forward to working with 
the Committee in the coming weeks and months in efforts to enhance and 
improve the effective and appropriate regulation of the financial 
services industry, to restore the vitality of the U.S. economy, and to 
renew investor confidence in our markets.

                  PREPARED STATEMENT OF RITA M. BOLGER
          Senior Vice President and Associate General Counsel,
              Global Regulatory Affairs, Standard & Poor's
                             March 26, 2009

    Mr. Chairman, Mr. Ranking Member, Members of the Committee, good 
morning. My name is Rita Bolger. I head the Global Regulatory Affairs 
department at Standard & Poor's and I am pleased to appear before you 
today. These are unprecedented times and we at S&P appreciate the 
opportunity to work with Congress to address them. My testimony today 
covers four broad topics:

    The current regulatory regime for credit rating agencies, 
        including S&P Ratings Services, our nationally recognized 
        statistical ratings organization (``NRSRO'');

    The SEC's exercise of its oversight authority under the 
        current regime, including our implementation of recommendations 
        made by the SEC following its recent examination;

    Initiatives we have undertaken to help restore market 
        confidence; and

    Our views on potential changes to the current legislative 
        and/or regulatory structure.

    Before turning to these topics, I want to state at the outset that 
we at S&P appreciate the seriousness of the current dislocation in the 
capital markets and the challenges it poses for the American and global 
economies. For many decades, S&P has effectively served the global 
capital markets with high quality, independent, and transparent credit 
ratings. Today, there are approximately nine million current and 
historical ratings available on our Web sites and we have ratings 
outstanding on approximately $30 trillion worth of debt. S&P has a long 
tradition of--and a strong cultural commitment to--integrity and 
professionalism. We recognize, however, that a number of our recent 
ratings in the structured finance area have not performed in line with 
our historical standards. We have reflected on these events and have 
made, and are continuing to make, a number of changes to enhance our 
processes.
    Restoring confidence in both ratings and the markets more broadly 
is critical. Workable solutions will involve both government action and 
private initiative. Toward that end, we have worked closely with 
lawmakers on potential measures and will continue to do so. We believe 
any legislative or regulatory action should reflect a systemic view and 
address all aspects of the capital markets that have contributed to the 
type of dislocation we have recently seen. Bringing together 
representatives from different areas of the capital markets, as the 
Committee has done in its two hearings on systemic risk, is in our view 
a productive way to work towards that goal.
    As discussed later in my testimony, we have done a lot of thinking 
about the regulatory framework for rating agencies. Appropriate 
regulation can provide comfort to investors that the information 
available to them--including ratings--has integrity, and we support 
measures towards that end. Having said that, we would be concerned 
about legislation or regulation that purported to mandate particular 
analytical approaches, as analytical independence is the hallmark of 
ratings quality and, in our view, an essential factor in market 
confidence. As addressed later on, we also believe internationally 
consistent regulation is critical given the increasingly global nature 
of the capital markets.

The Current NRSRO Regulatory Regime
    Recent calls for regulation of credit rating agencies have arisen 
in large part out of the poor performance of structured finance 
securities issued between the middle of 2005 and the middle of 2007, 
the years in which ``subprime'' lending reached its peak. It is true 
that, generally speaking, our ratings on these structured finance 
instruments have performed worse than we anticipated. Consistent with 
our commitment to constant improvement, we have taken a long, hard look 
at the situation and implemented a number of measures in response.
    From a regulatory perspective, however, it is important to point 
out that the world in which virtually all of these structured finance 
ratings were issued is not the world we find ourselves in today. As the 
Committee is aware, the Credit Rating Agency Reform Act of 2006 
(``CRARA''), passed in September of 2006, is the first comprehensive 
regulatory scheme for ratings agencies that choose to register as 
NRSROs. This regulatory regime was the product of several years of 
consideration and, in our view, reflects a judicious balance between 
oversight and analytical independence. The SEC's implementing rules 
took effect on June 26, 2007.
    Today, NRSROs such as S&P are subject to a robust regulatory 
regime. That regime starts with the CRARA, the first comprehensive law 
focused on rating agencies. The regime has two primary goals:

    Promoting competition in the rating agency industry, 
        thereby furthering ratings quality; and

    Providing for regulatory oversight to promote integrity in 
        the ratings process.

    We believe both goals have been significantly advanced in the short 
time since the CRARA became effective in the second half of 2007. On 
competition, the number of NRSROs has grown to ten, double what it was 
at the time the CRARA was enacted. Moreover, the SEC now requires 
NRSROs to disclose detailed performance data about their ratings, which 
facilitates comparisons and promotes competition. Going forward, we 
expect competition among NRSROs to continue to grow under the CRARA.
    The current regime also includes a vigorous set of rules. As noted, 
the first set of SEC rules under the CRARA became effective in June 
2007. Those rules addressed a number of topics, including the resources 
deployed by an NRSRO, potential conflicts of interest, the misuse of 
nonpublic information, and potentially abusive and unfair practices. 
Under these rules, certain practices are prohibited outright, such as 
issuing ratings for entities that provided the NRSRO with ten percent 
or more of its net revenue in the most recent fiscal year. Other 
practices must be disclosed and managed, including receiving 
compensation for ratings analysis (from either issuers or subscribers) 
and the provision of nonratings services to issuers. The rules also 
include extensive record-keeping requirements and require public 
disclosure of financial information, including revenues received from 
large issuers.
    The SEC has continued its rule-making under the CRARA since 2007. 
Among other things, the SEC adopted additional rules earlier this year 
that:

    Require enhanced disclosure of ratings performance data;

    Require enhanced disclosures related to the rating 
        methodologies employed by NRSROs;

    Require disclosure when ratings deviate from the output 
        suggested by models used in the rating process;

    Prohibit an NRSRO from rating an issuer or security if the 
        NRSRO provided recommendations to the issuer; and

    Prohibit an NRSRO from rating an issue or issuer if it 
        receives gifts of more than de minimus value.

    We have in place practices and procedures to comply with those 
rules that are in effect and are actively working to implement 
additional measures, as needed. We believe that, on the whole, the 
SEC's rules will further enhance the integrity of the ratings process 
and overall ratings quality to the benefit of the markets.

The SEC's Exercise of Its Oversight Authority Under the Current NRSRO 
        Regime
    Under the current framework, the SEC also has broad oversight and 
enforcement powers. Not only does the SEC have extensive examination 
and inspection authority, but it can also take disciplinary action 
against NRSROs--including censure, fines, or even revocation of their 
registration in certain circumstances--if it deems such action to be in 
the interest of investors. This provides a level of accountability that 
did not exist prior to the adoption of the CRARA.
    Since the effective date of the CRARA, the SEC has been exercising 
its oversight authority over S&P. In the second half of 2007, the SEC 
began an examination of our practices and procedures, with a focus on 
our ratings of structured finance securities. The exam, which lasted 
several months, involved dozens of meetings and interviews and the 
production of a significant volume of documents.
    The exam coincided with an exam by the SEC of two other NRSROs and 
resulted in a number of recommendations. These recommendations related 
to the following areas, among others:

    Staffing and resource levels dedicated to ratings analysis, 
        including surveillance of existing ratings;

    Documentation of policies and procedures used to determine 
        ratings on RMBS and CDOs;

    Potential conflicts of interest arising from the ``issuer 
        pays'' model;

    Securities ownership by NRSRO employees; and

    Internal auditing of ratings practices and procedures.

    At S&P, we have been active in implementing the SEC's 
recommendations:

    With respect to staffing and resource levels, S&P has 
        reorganized the new issue and surveillance groups in its U.S. 
        Structured Finance department, and, more broadly, has developed 
        tools for resource planning and for strengthening the quality 
        of analytical resources;

    It has long been S&P's practice and policy to disclose its 
        ratings processes and methodologies, including its processes 
        and methodologies for U.S. RMBS and CDOs. Nonetheless, 
        consistent with the SEC's recommendation, S&P has initiated a 
        review of its disclosures in those areas, including a review of 
        its criteria administration process, a redesign of its Web 
        site, among other things, to facilitate the publication of 
        criteria, and a review and revision of its policies and 
        procedures concerning the disclosure of ratings process and 
        criteria changes;

    S&P is in the process of implementing new policies that 
        will further insulate its analysts from commercial aspects of 
        our business. In addition to our long-standing prohibition of 
        analyst involvement in negotiating fees or commercial 
        arrangements, analysts will not participate in the process of 
        recording fees on forms, will not have responsibility for 
        retaining engagement letters, and will not participate in 
        business discussions about market share statistics or other 
        financial information such as deal pipelines and financial 
        performance. Commercial activities will be conducted outside of 
        the analytical function by nonanalytical business management 
        staff and a centralized group who will handle fee negotiations 
        and contract discussions. In addition, consistent with current 
        practice, no personnel engaged in commercial activities will be 
        permitted to vote in a rating committee.

    S&P is also enhancing its existing personnel policies and 
        procedures, including realigning performance goals for 
        compensation and compensation pools for analytical staff to 
        further diminish any potential commercial influences on 
        analytical processes.

    These are just some of the many steps that S&P has taken and is 
continuing to develop in response to the SEC's recommendations. The SEC 
has remained in regular communication with us regarding our progress 
and we have provided the SEC with copies of adopted policies and 
procedures related to its recommendations. The SEC has also continued 
to follow up on our progress on the remaining recommendations, 
including, for example, two telephonic updates in the last 10 days.

S&P's Initiatives To Enhance the Ratings Process and Promote Confidence
    The restoration of investor confidence is critical to both the 
financial markets and global economy. We believe both appropriate 
government action and meaningful private initiatives are essential to 
accomplishing that goal. Therefore, it is imperative that all market 
participants take stock of what has happened and take whatever steps 
they can to promote market confidence.
    At S&P, we have been actively applying lessons from the current 
crisis to adopt a number of constructive measures. In 2008, we 
announced a series of initiatives aimed at promoting four broad 
objectives: (i) ensuring the integrity of the ratings process; (ii) 
enhancing analytical quality; (iii) providing greater transparency to 
the market; and (iv) more effectively educating the marketplace about 
ratings. To date, we have made significant implementation progress. For 
example, we have:

    Established an Office of the Ombudsman. The Ombudsman will 
        address concerns related to potential conflicts of interest and 
        analytical and governance processes that are raised by issuers, 
        investors, employees and other market participants across S&P's 
        businesses. The Ombudsman has oversight over the handling of 
        all issues, with authority to escalate all unresolved matters, 
        as necessary, to the CEO of McGraw-Hill and the Audit Committee 
        of the Board of Directors;

    Implemented ``look back'' reviews to ensure the integrity 
        of ratings, whenever an analyst leaves to work for an issuer;

    Instituted a rotation system for analysts;

    Established an enterprise wide independent Risk Assessment 
        Oversight Committee. The committee will assess all risks that 
        could impact the integrity and quality of the ratings process. 
        This committee will also assess the feasibility of rating new 
        types of securities;

    Increased our analyst training programs;

    Invested significantly in our compliance function;

    Created a separate Model Validation Group to independently 
        analyze and validate all models, developed by S&P or provided 
        by issuers, used in the ratings process;

    Implemented procedures to collect more information about 
        the processes used by issuers and originators to assess the 
        accuracy and integrity of their data and their fraud detection 
        measures so that we can better understand their data quality 
        capabilities;

    With respect to increased transparency, we have published a 
        series of articles addressing certain ``what if'' scenarios; 
        and

    With respect to investor education, we have published a 
        ``Guide to Credit Ratings Essentials'' that provides important 
        information about ratings and their role in the markets.

    As these measures demonstrate, we believe in being proactive when 
it comes to taking steps to restore market confidence. S&P has always 
sought to study events and use the lessons learned to improve. That 
tradition has been a hallmark of our success over the years and you can 
expect the same commitment from us going forward.

Potential Regulatory Measures
    We also believe legislation and/or regulation can play an important 
role in restoring investor confidence both in ratings and the markets 
as a whole. Appropriate regulation can provide a level of comfort to 
investors that policies are being disclosed and enforced and that there 
is consistency and integrity in the ratings process.
    As noted earlier, we believe any regulatory approach should include 
``end-to-end'' solutions. That is, legislation and/or regulation should 
cover all aspects of the capital markets that, taken together, 
contribute in a systemic way to their functioning, and we believe that 
international consistency, leading to increased transparency is a 
formula that should be workable for all market participants. With 
respect to ratings, we believe an appropriate combination of 
legislation and rule-making should cover not just rating agencies, but 
also those entities that can play a role in promoting the quality of 
ratings and their appropriate use. For example, an important factor in 
ratings quality is the reliability of information available to be 
analyzed. That information is not generated by rating agencies, but by 
others--i.e., corporations, mortgage originators, underwriters, and 
others. Still other entities, such as professional audit firms in the 
corporate world and third-party due diligence firms in certain 
structured finance securities, are responsible for reviewing that 
information and verifying it. In our view, these entities and the roles 
they perform should be a part of any regulatory approach.
    To that end, earlier this month, we published an article entitled 
``Toward a Global Regulatory Framework for Credit Ratings'' that lays 
out how a regulatory framework for ratings agencies that takes account 
of their place in the broader markets might work. In it, we highlight 
those features we think would promote sound, global rating agency 
oversight. They include:

    Registration. One feature of a globally workable regulatory 
        regime would be to have rating agencies register in the 
        jurisdiction of their principal place of business and only 
        allow registration of those that have in place standards to 
        promote ratings integrity. From its home jurisdiction, a rating 
        agency could be recognized to do business in other 
        jurisdictions pursuant to a notice filing with the local 
        regulator. This ``passport'' would allow for a streamlined and 
        consistent regulatory approach across all the jurisdictions in 
        which the credit rating agency conducts business. Regulators 
        could consider limiting regulation to agencies whose ratings 
        are used in local laws or regulations.

    Performance Measurement. Another feature would be to 
        require registered rating agencies to publicly issue 
        performance measurement statistics over the short, medium, and 
        long term, and across asset classes and geographies.

    Disclosure of Rating Methodologies. Registered credit 
        rating agencies could also be required to make robust 
        disclosures regarding the analytical bases of their ratings 
        opinions, the type of information used to arrive at ratings, 
        and their internal standards for promoting consistency and for 
        monitoring and updating ratings. With greater transparency of 
        credit rating agency methodologies, investors would be in a 
        better position to assess the opinions.

    Control Over Nonpublic Information and Disclosure of 
        Underlying Data. By having access to nonpublic information, 
        rating agencies are in a position to provide more informed 
        analysis, thus potentially enhancing the quality of the ratings 
        they provide. Accordingly, any regulatory regime for credit 
        rating agencies should ensure that agencies have policies and 
        procedures requiring their employees to treat nonpublic 
        information confidentially.

    Organizational Transparency. Registered credit rating 
        agencies should be required to disclose detailed information 
        about their organization's structure, including their 
        resources, their independence from any particular issuer, their 
        ability to train and retain employees, and the independence of 
        commercial from analytical functions. Rating agencies should 
        provide pertinent information about their financial resources 
        to regulators on a confidential basis. This disclosure will 
        allow regulators to assess the viability of agencies.

    Development of Code of Ethics. Rating agencies should 
        develop and disclose to the public a detailed code of ethics, 
        including a description of how that code will be enforced and 
        how it relates to broader principles such as existing industry 
        or regulatory standards. An independent officer or ombudsman 
        should be established to communicate with the public regarding 
        concerns that might arise about the code's enforcement.

    Elimination of Potential Conflicts of Interest. A 
        regulatory regime must include robust standards for analyst and 
        employee independence and the procedures for mitigating 
        potential conflicts of interest in the ratings process. 
        Regulation should require disclosure of such conflicts and 
        prohibit analysts from performing commercial activities and 
        providing consulting or advisory services to entities they 
        rate. In this regard, regulation should require disclosure of 
        the guidelines for analyst and issuer interaction. Regulation 
        should prohibit analysts from being compensated based on the 
        fees paid by the entities they directly rate.

    Prohibitions on Anticompetitive Activity. A regulatory 
        regime should prohibit unfair, abusive, or coercive activity.

    Transparency of Models. A regulatory regime should require 
        policies and procedures on the use and transparency of models, 
        assumptions, and how agencies check their effectiveness, 
        including through the use of third parties.

    Accessibility. A regulatory regime should require a 
        mechanism for ratings users to raise questions about 
        methodologies and should require registered credit rating 
        agencies to have in place personnel to answer these questions.

    Effective Oversight. A regulatory regime should provide for 
        effective oversight of registered agencies' compliance with 
        their policies and procedures through robust, periodic 
        inspections. Such oversight must avoid interfering in the 
        analytical process and methodologies, and refrain from second-
        guessing rating opinions. External interference in ratings 
        analytics undermines investor confidence in the independence of 
        the rating opinion and heightens moral hazard risk in 
        influencing a rating outcome.

    Analytical Independence. Regulators must preserve the 
        analytical independence of rating agencies' opinions, 
        analytical processes, and methodologies. This independence is 
        critical to restoring confidence in credit ratings and 
        fostering innovation in financial services.

    Accountability. A regulatory regime should hold registered 
        rating agencies accountable for established breaches of the 
        regulations without undermining analytical independence. 
        Sanctions may include penalties proportionate to the nature and 
        seriousness of any breach, suspending or removing an agency's 
        registration, and disallowing the continued use of that 
        agency's ratings for regulatory purposes.

    International Consistency. Regulatory regimes globally must 
        be consistent in applying standards. Regulators should 
        coordinate in exercising oversight of rating agencies subject 
        to regulation beyond their own borders. This will avoid 
        inconsistent rules and inconsistent handling of infractions 
        that would create uncertainty for analysts and users of 
        ratings. Regulators should commit to sharing information 
        subject to confidentiality undertakings.

    Meaning of Ratings. Rating agencies should clearly explain 
        the meaning of their credit ratings and what elements they do 
        not address: for example, suitability of investments for any 
        particular investor.

    Differentiate New and Complex Ratings. A regulatory regime 
        could require that new and complex ratings, including 
        structured finance products, be differentiated in some manner 
        to put investors on notice that potential volatility or the 
        types of underlying assets/data for rating structured products 
        may be distinguishable from factors affecting corporate and 
        municipal ratings.

    Each of these areas can play a meaningful role in restoring market 
confidence, but I want to highlight again two particularly important 
points here. The first is analytical independence. At its core, a 
rating is an analytical determination. It results from a group of 
experienced professionals analyzing a set of facts and forming a 
judgment as to what might happen in the future. For the markets to have 
confidence in those ratings, they must be made independently. That 
means, of course, that they must be free of undue commercial 
considerations--and we are fully committed to that principle--but it 
also means that they must truly reflect the substantive views of the 
analysts making them, not the dictates of a regulator or other external 
authority.
    The second is the need for international consistency. Ratings are 
issued and used globally. This reflects one of their many benefits--
their ability to provide a common language for analyzing risk. However, 
it also underscores the importance of a consistent approach to the 
regulation of ratings around the world. A rating produced under one set 
of regulations may not mean the same thing or address the same risks as 
one produced under another if those regulations are not compatible. 
Inconsistent ratings regulation could actually promote uncertainty in 
the markets, at a time when it can be least afforded.
    Some have also asked whether ratings should be used in regulations 
and investment guidelines. S&P has never advocated for inclusion of its 
ratings in any regulation or guideline. However, we do believe that if 
legislators and regulators choose to incorporate ratings in their rules 
as benchmarks to measure creditworthiness, then the use of additional 
benchmarks may also be warranted. For example, there may be additional 
appropriate benchmarks for market participants to choose from--whether 
in regulations, investment guidelines, or private agreements--that 
would protect against ``credit cliffs'' (i.e., situations in which a 
deterioration in credit quality can occur quickly and without 
forewarning.) In short, because ratings speak to creditworthiness, and 
not other factors that may matter to investors, they have been designed 
to and should continue to be used only for the important but limited 
purposes for which they are intended and supplemented with other 
benchmarks, as appropriate.
    Lastly, some have called for the prohibition of the ``issuer pays'' 
business model that S&P and most other NRSROs use. We believe that 
would be a mistake. The ``issuer pays'' model allows for a number of 
benefits to the market, particularly with respect to transparency, that 
are not available under other approaches. The question as we see it 
however is not whether one model is ``good'' while others are not, but 
whether potential conflicts of interest--which can exist in any 
business model--are appropriately managed so that the rating process 
employed has integrity. Critics sometimes ignore that any business 
model under which one entity is paid by another for a service poses the 
potential for a conflict of interest. The key question is whether the 
rating agency is capable of producing, and does produce, independent 
and robust analysis. Thus, the focus of any legislation or regulation 
should be on taking steps to protect the integrity of the ratings 
process from all potential conflicts of interest. Many of the steps 
outlined above and the measures we have undertaken are aimed at 
precisely that goal.
Conclusion
    I thank you for the opportunity to participate in this hearing. Let 
me also assure you again of our commitment to analytical excellence and 
our desire to continue to work with Congress and governments, 
legislatures and policymakers worldwide as they explore the recent 
troubling developments and strive to develop solutions to restore 
stability in the global capital markets. I would be happy to answer any 
questions you may have.



















                                 ______
                                 

                   PREPARED STATEMENT OF DANIEL CURRY
                               President,
                               DBRS, Inc.
                             March 26, 2009

Introduction
    The recent turmoil in the financial markets has shone a spotlight 
on the way in which various market participants are regulated and the 
effect of that regulation on investor protection. DBRS is pleased to 
have the opportunity to address these important issues as they relate 
to one segment of the financial markets, credit rating agencies. In 
particular, I would like to discuss four broad areas relating to credit 
rating agency regulation and investor protection:

  1.  The importance of competition in the credit rating agency 
        industry to the safety and soundness of the capital markets;

  2.  The need for uniform rating agency regulation;

  3.  The need for regulatory stability; and

  4.  The need for regulatory recognition of the global nature of 
        credit ratings.

    In order to put this discussion in context, I would like to begin 
with an overview of our company.
Overview of DBRS
    DBRS is a Toronto-based credit rating agency established in 1976 
and still privately owned by its founders. With a U.S. affiliate 
located in New York and Chicago, DBRS analyzes and rates a wide variety 
of issuers and instruments, including financial institutions, insurance 
companies, corporate issuers, issuers of government and municipal 
securities and various structured transactions. The firm currently 
maintains ratings on more than 43,000 securities in approximately 35 
countries around the globe. Since its inception, DBRS has been widely 
recognized as a provider of timely, in-depth and impartial credit 
analysis. DBRS operates on an ``issuer-pay'' model, which means that 
our ratings are available to the public free of charge.
    DBRS is committed to ensuring the objectivity and integrity of its 
ratings and the transparency of its operations. To this end, the firm 
has adopted a wide range of internal controls designed to eliminate 
conflicts of interest wherever possible, and to disclose and manage 
those conflicts that cannot be eliminated. DBRS also has adopted a 
Business Code of Conduct in accordance with the Code of Conduct 
Fundamentals for Credit Rating Agencies developed by the International 
Organization of Securities Commissions (IOSCO). In addition to 
displaying its credit ratings, DBRS' public Web site also discloses the 
firm's ratings policies and methodologies as well as extensive 
information about how its ratings have performed over time. As a result 
of a recent SEC rule, DBRS will soon be making additional information 
about its ratings history available in a user-friendly, searchable 
format that will allow investors to compare DBRS' ratings to those of 
its competitors.
    In 2003, DBRS was designated by the staff of the SEC as a full-
service nationally recognized statistical rating organization (NRSRO)--
the first non-U.S. based rating agency to attain that designation. Four 
years later, DBRS became registered as an NRSRO under the regulatory 
regime adopted pursuant to the Credit Rating Agency Reform Act of 2006 
(Rating Agency Act). In addition to its NRSRO registration, DBRS has 
achieved broad recognition by regulators globally, including 
recognition as an External Credit Assessment Institution (ECAI) in the 
U.S., Canada, Switzerland, and the European Union.
    With that background, I would like to turn my attention to what 
DBRS sees as an overarching principle that should inform all efforts at 
regulatory reform, namely, the development of a competitive market for 
credit ratings.
The Importance of Competition in the Credit Rating Industry
    It is no secret that the credit rating industry in the United 
States is dominated by three players: Standard and Poor's, Moody's, and 
Fitch Ratings. This situation developed over the course of many years, 
and was no doubt perpetuated by a regulatory system that gave special 
treatment to NRSRO credit ratings, yet made the process of becoming an 
NRSRO opaque and hard to navigate. This concentrated structure 
benefitted neither issuers nor investors, as it left the large NRSROs 
with tremendous pricing power and provided limited diversity of rating 
opinions to the market.
    Although great strides were made in opening the industry to the 
possibility of competition when Congress passed the Rating Agency Act 
in 2006, the actual competitive landscape has been very slow to change. 
DBRS submits that the continued dominance of the largest rating 
agencies contributed to the recent turmoil in the structured finance 
market, when changes in the assumptions underlying their rating models 
led to rapid and dramatic ratings downgrades over a very short period 
of time. Concentrating ratings opinions in so few hands had a profound, 
destabilizing effect on the markets.
    As the markets now struggle to regain their footing, more work 
needs to be done to open the credit rating industry to competition. 
Unfortunately, although the government can be a catalyst for change in 
this area, the opposite seems to be occurring.
    Recognizing that the securitization markets have ceased to function 
and that such markets are crucial in providing diversified sources of 
liquidity to corporations and consumers, the Federal Reserve has 
created the Term Asset-Backed Securities Loan Facility, or ``TALF.'' 
The Fed has announced that in order to be eligible for this program, an 
asset-backed security must receive a AAA-rating from a ``major'' NRSRO, 
which it defines as Standard and Poor's, Moody's and Fitch. No 
explanation has been given for the creation of this new sub-category of 
registered credit rating agency. The result of this approach is that 
DBRS--with over 30 years of experience as a rating agency and more than 
six, as an NRSRO--has been deemed unqualified to rate TALF-eligible 
securities, even though several issuers have asked it to do so. DBRS is 
consulting with the Fed about this issue and understands that the 
discriminatory policy is being reviewed. But while this review takes 
place, DBRS remains unable to participate in this important recovery 
effort.
    The harmful effects of limiting rating agency competition under the 
TALF are profound, because for the foreseeable future, the TALF is 
likely to be the entire securitization market in the United States. 
Moreover, it is probable that the securitization market that emerges 
from this crisis will be different from the market that existed in the 
past. Therefore, by excluding all but the three largest rating agencies 
from the TALF, the government may be further entrenching the historic 
oligopoly for years to come. This not only will impede competition 
among existing NRSROs, but also will discourage the formation of new 
ones.
    The long-term efficiency of the capital markets requires that 
NRSROs be allowed to compete on the quality of their work, not their 
size or their legacy. DBRS urges Congress to take whatever steps are 
necessary to make the promise of competition created by the Rating 
Agency Act a reality.

The Need for Uniform Regulation
    Because fostering competition among rating agencies was one of the 
primary goals of the Rating Agency Act, the statute contemplates a 
single regulatory regime applicable to all NRSROS: big firms and small 
firms; those operating on an issuer-pay model and those operating on a 
subscriber-pay model; \1\ and those who use quantitative methods, 
qualitative methods or both to determine their credit ratings. DBRS 
endorses this commitment to neutrality and believes it fosters a 
diversity of credit rating opinions that benefits the markets.
---------------------------------------------------------------------------
     \1\ In an ``issuer-pay'' model, an NRSRO's credit ratings are paid 
for by the obligor being rated or by the issuer, underwriter or sponsor 
of the securities being rated. Issuer-paid credit ratings generally are 
made available to the public free of charge. By contrast, in a 
``subscriber-pay'' model, the NRSRO's credit ratings are paid for and 
are available only to parties who subscribe to the NRSRO's services.
---------------------------------------------------------------------------
    Unfortunately, cracks have begun to appear in this foundation. One 
of the most disturbing of these is that unequal regulatory burdens have 
begun to be imposed on issuer-pay and subscriber-pay NRSROs. In order 
to provide users of credit ratings, investors and other market 
participants with the raw data they need to compare how NRSROs 
initially rated an obligor or security and how they adjusted those 
ratings over time, the SEC recently adopted a rule requiring issuer-pay 
NRSROs to publish ratings history information, on a delayed basis in a 
user-friendly format, on their public Web sites. The SEC did not impose 
a similar requirement on subscriber-pay NRSROs, because they protested 
that any public disclosure of their ratings, even with a substantial 
time delay, would be antithetical to their business model. The 
Commission now proposes to perpetuate this disparate treatment by 
adding another disclosure requirement for issuer-pay NRSROs only.
    There has been much debate in the past few years about the relative 
quality and reliability of ratings determined under the issuer-pay and 
subscriber-pay business models. Questions also have been raised as to 
whether the conflicts of interest faced by rating agencies who are paid 
by issuers are more pronounced than the conflicts faced by rating 
agencies who are paid by subscribers, who may also have a stake in how 
an issuer or instrument is rated.
    This debate cannot be resolved so long as investors and other 
market participants are unable to verify the ratings accuracy claims 
made by subscriber-based ratings providers. Anecdotal discussions by 
subscriber-pay NRSROs of ``where they got it right'' are no substitute 
for an objective, independent analysis of the universe of their 
ratings. Although DBRS appreciates the need to protect the commercial 
value of subscriber-pay NRSROs' real-time ratings, DBRS believes that 
absolving such NRSROs from all transparency obligations is not in the 
best interests of investors or the capital markets.
    DBRS also has concerns that as more and more obligations are 
imposed on NRSROs under the Rating Agency Act, the regulatory regime 
will become skewed in favor of large rating agencies. While the 
incremental cost of each new rule might seem modest when viewed in 
isolation, taken as a whole, the costs of complying with the current 
regulatory regime are substantial. DBRS understands that balancing the 
need for robust regulation against the need for affordable regulation 
is a delicate exercise. But DBRS urges this Committee to be mindful of 
the fact that at some point, more regulation harms investors by driving 
reputable and credible rating agencies from the market.

The Need for Regulatory Stability
    The freezing of credit and the ensuing turmoil in the global 
financial markets has sent shock waves through investors, market 
intermediaries, policy makers and regulators. A critical examination of 
whether the current regulation of credit rating agencies contributed to 
this crisis is a necessary and healthy exercise. However, any 
alteration of the existing regulatory approach must be reasoned and 
likely to improve the safety and soundness of the capital markets. 
Change for the sake of change will only make things worse.
    The regulatory regime established under the Rating Agency Act was 
implemented in September 2007, when the first group of NRSROs became 
registered. This regime focuses not on the substance of credit ratings, 
but rather on the integrity and objectivity of ratings and on the 
transparency of the NRSROs' operations. It does this by requiring 
NRSROs to implement extensive internal controls on their conflicts of 
interest, their use of material nonpublic information and their 
business practices; and by requiring such firms to publicly disclose 
the procedures and methodologies they use in determining credit 
ratings, along with performance measurement statistics regarding those 
ratings. NRSROs are also obligated to keep an extensive array of 
records, which enable the SEC staff to examine registered firms' 
operations in order to ensure compliance with the Rating Agency Act and 
related rules.
    In response to the subprime crisis, the SEC has recently taken 
steps to fortify the regulation of NRSROs. These steps include new 
restrictions on conflicts of interest, new recordkeeping requirements 
and enhanced disclosure requirements regarding ratings procedures, 
methodologies and default and transition data. An additional set of SEC 
rule proposals is pending. These latest proposals include a mechanism 
to discourage ratings shopping with regard to ratings for structured 
finance products by facilitating the issuance of unsolicited ratings 
for such products.
    DBRS endorses the fundamental characteristics of the current 
approach to regulating NRSROs and believes that this approach is 
reasonably designed to protect the safety and soundness of the 
financial markets. Since this system is barely eighteen months old and 
since the enhancements to this system have yet to take effect, DBRS 
also believes that it would be unwise to significantly overhaul or 
abandon the current regulatory regime at this time.
    No superior alternative to the current approach has been 
identified. Moreover, the costs of complying with the current 
requirements have been very high, and smaller NRSROs might be driven 
from the market if they are required to start over under a new 
compliance regime less than 2 years after they paid to establish the 
first one.
    DBRS further submits that the regulation of credit rating agencies 
is most effective when the regulator understands the credit rating 
industry. For this reason, DBRS sees no benefit in transferring NRSRO 
jurisdiction from the SEC, which has overseen NRSROs for 34 years, to a 
regulator who has no experience in this area. Interposing a self-
regulatory body between NRSROs and the SEC would be the worst idea of 
all, since it would lead to duplicative regulation by a costly private 
bureaucracy that may or may not know anything about the industry. A far 
better approach would be to make sure that the SEC has the resources it 
needs to effectively examine NRSROs and to take any enforcement actions 
that may be warranted under the existing laws and rules.

Recognition of the Global Nature of Credit Ratings
    Given recent events, there can be no question that the financial 
markets are interdependent and global in nature. One of the core 
benefits of credit ratings is they are globally comparable. That is, 
they are designed to help investors understand risk across borders. 
Because the ratings activities of NRSROs are not confined to the United 
States, it is important that U.S. policy makers and regulators endeavor 
to harmonize NRSRO regulation with the regulatory regimes of other 
major markets, to the extent this can be done without compromising 
safety and soundness.
    In this regard, DBRS notes that while the Rating Agency Act and the 
SEC's rules thereunder are not identical to international standards 
such as the IOSCO Code of Conduct Fundamentals for Credit Rating 
Agencies, the U.S. law and rules address the same basic principles as 
the IOSCO Code and they do so in a way that allows NRSROs to comply 
comfortably with both.
    Ensuring that credit rating agency regulation continues to be as 
globally consistent as possible will encourage competition in this 
market among firms of varying size and business models. This, in turn, 
will help to ensure ratings stability and accuracy and will increase 
the availability of information to investors for their decision-making. 
Conversely, a balkanized system of regulation will increase costs and 
drive smaller rating agencies from the market. The result will be the 
continuation of the rating agency oligopoly with all the attendant 
risks to the market that the Rating Agency Act was designed to 
eliminate.
    I appreciate having the opportunity to present DBRS' views here 
today and I look forward to answering any questions you may have.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ
                     FROM MARY L. SCHAPIRO

Q.1. Business Development Companies (BDCs), which are regulated 
under the Investment Company Act, support more than 10,000 jobs 
in my home State of New Jersey through their extension of 
credit and investments in more than 20 small and middle-market 
companies. I understand that the BDC industry has largely 
ceased to extend credit due to certain Investment Company Act 
rules that, in the current market environment, may be having 
unintended consequences.
    Does the Commission intend to address this problem, and if 
so, could the Committee expect to receive a report on the 
Commission's actions?

A.1. Over the past year, the greatest challenges to BDCs have 
resulted from market conditions rather than regulatory 
restrictions. The dearth of available credit, with the general 
decline in the value of financial assets, has severely limited 
the ability of BDCs to raise new capital to invest in small and 
middle-market companies. During the year ending on March 31, 
2009, the net asset value (``NAV'') of the four largest BDCs 
declined an average of 32.5 percent. Declines in the market 
value of the shares of these BDCs were more severe, and shares 
of all four BDCs trade at significant discounts to NAV. The two 
largest BDCs are in default under their loan agreements, and 
their auditors have raised going concern issues. As detailed 
below, the staff generally believes that the regulatory 
requirements for BDCs are operating as intended. The staff also 
generally believes that improvements in the availability of 
credit and in the market values of assets held by BDCs are far 
more likely to enable BDCs to raise additional capital, and 
extend credit to small and middle-market companies, than 
regulatory relief.

The Relevant Regulatory Requirement for BDCs Under the Investment 
        Company Act of 1940 (``Act'')

    BDCs are a type of closed-end investment company regulated 
under the Act. The Act's capital structure requirements limit 
the ability of a BDC to raise additional capital by issuing 
preferred stock or incurring debt. Specifically, the Act 
prohibits a BDC from issuing or selling preferred stock or 
incurring debt (or declaring cash dividends on its common stock 
or repurchasing its common stock), unless immediately 
thereafter the BDC has asset coverage of its preferred stock 
plus debt securities of at least 200 percent. These 
requirements are more permissive than the Act's requirements 
for other closed-end investment companies whose debt securities 
must have asset coverage of at least 300 percent. In addition, 
a BDC may issue multiple classes of debt securities, but other 
closed-end investment companies may issue only one class of 
debt security.
    The Act's asset coverage requirement for BDCs exists for 
the protection of both investors in common stock on one hand 
and investors in debt securities or preferred stock on the 
other hand. As the percentage of a BDC's capital from preferred 
stock or debt increases, the risk to the common stockholders 
also increases. At the same time, the risk also increases that 
the BDC will lack the resources to pay promised interest or 
dividends or the principal or liquidation preference to the 
holders of the debt securities or preferred shares. In this 
regard, Section 1(b) of the Act states that the national 
interest is adversely affected ``when investment companies by 
excessive borrowing and the issuance of excessive amounts of 
senior securities [i.e., preferred stock or debt securities] 
increase unduly the speculative character of their junior 
securities [i.e., common stock]'' or ``fail to protect the 
preferences and privileges of the holders of their outstanding 
securities.'' Section 1(b) also states that the Act is to be 
interpreted ``to mitigate and, so far as is feasible, to 
eliminate the conditions enumerated in this section which 
adversely affect the national public interest and the interest 
of investors.''

The Regulatory Requirement Generally Is Operating as Intended

    The Act does not prohibit a BDC from investing all of its 
available capital in portfolio companies. If a BDC fully 
invests its capital, a subsequent decline in the value of those 
investments that cause asset coverage to dip below 200 percent 
does not constitute a violation of the Act. (However, as 
explained above, the Act would prohibit the BDC from taking on 
additional leverage, declaring cash dividends on its common 
stock or repurchasing its common stock unless its asset 
coverage equals at least 200 percent at that time.)
    The Act's asset coverage requirement does not limit the 
ability of BDCs to raise capital by issuing additional common 
stock. In the past, some of the largest BDCs periodically 
issued shares priced at a premium to NAV. This additional 
equity capital, in turn, increased the BDCs' borrowing 
capacity. Under the Act, a BDC may issue additional shares 
priced at a discount to NAV, provided that the BDC's board 
makes certain findings and shareholders approve the offering. A 
number of BDCs have obtained board and shareholder 
authorization for such offerings. In fact, Prospect Capital 
Corporation, one of the ten largest BDCs, recently raised over 
$60 million in a public offering of its common stock priced 
below NAV.
    To the extent that BDCs have been interested in exploring 
relief from the Act's asset coverage requirement, the staff has 
given this issue serious and careful consideration in numerous 
meetings with BDC representatives, their accounting firms and 
their lawyers. The staff continues to engage in a dialogue with 
BDCs and their representatives about regulatory relief. In 
general, the staff believes that the Act's restriction on 
further leverage and payment of cash dividends on common shares 
or repurchase of common shares when asset coverage is less than 
200 percent are generally working as intended. Nevertheless, 
the staff has provided no-action relief from the asset coverage 
requirement to the largest BDC so that it, and other BDCs in 
similar circumstances, could make cash dividend payments to the 
extent necessary to take advantage of IRS relief made available 
to certain closed-end investment companies earlier this year. 
The staff also agreed to permit BDCs to use the shelf 
registration process for sales of shares priced below NAV. 
Prospect Capital Corporation used a shelf registration for its 
recent sale of shares priced below NAV.
    We hope that this analysis constitutes the report 
contemplated by this question, but if Senator Menendez or the 
Committee requires additional information or updates, the staff 
would be pleased to provide it.

Q.2. Does the Commission need any additional authority to 
address these problems, or are there legislative solutions that 
are necessary to make certain that credit continues to be made 
available to small and middle-market companies?

A.2. The staff does not believe that additional authority would 
enhance the ability of BDCs to attract additional capital to 
invest in small and middle-market companies. If Congress were 
explicitly to authorize the Commission to suspend or eliminate 
all of the Act's capital structure requirements applicable to 
BDCs, the staff doubts that lenders would be more willing to 
extend credit to BDCs or the capital markets more willing to 
purchase shares issued by BDCs.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                       FROM RICHARD BAKER

Q.1. Does the concept of the sophisticated investor, which sets 
certain income and asset-size limitations on investors in hedge 
funds, need to be revisited? If so, how should it be revisited?

A.1. The Managed Funds Association (MFA) strongly supports 
limiting investments in hedge funds to sophisticated investors. 
Rule 501 of Regulation D under the Securities Act of 1933 
defines the term ``accredited investor'' as including:

    (5) Any natural person whose individual net worth, 
        or joint net worth with that person's spouse, at the 
        time of his purchase exceeds $1,000,000;

    (6) Any natural person who had an individual income 
        in excess of $200,000 in each of the two most recent 
        years or joint income with that person's spouse in 
        excess of $300,000 in each of those years and has a 
        reasonable expectation of reaching the same income 
        level in the current year . . .

    The Commission adopted these standards in 1982. In May 
2003, the SEC held a public roundtable meeting to discuss the 
hedge fund industry. In connection with that roundtable, MFA 
submitted its ``White Paper on Increasing Financial Eligibility 
Standards for Investors in Hedge Funds.'' \1\ In the White 
Paper, MFA proposed that the Commission could increase the 
dollar thresholds for the accredited investor definition to 
address concerns that, because of inflation, the thresholds no 
longer adequately ensured the sophistication of accredited 
investors. In 2007, the Securities and Exchange Commission 
proposed modifying the accredited investor definition to 
account for the effects of inflation on the thresholds. \2\ In 
its comment letter to the proposed rule change, MFA supported 
increasing these thresholds to account for the effects of 
inflation. \3\ MFA continues to support increasing the 
accredited investor threshold to ensure that hedge fund 
investors are sophisticated investors who are capable of 
understanding the risks associated with an investment in a 
hedge fund and who have the financial wherewithal to withstand 
the potential losses from an investment. MFA also supports 
adjusting, as appropriate, the accredited investor threshold to 
account for inflation on a going forward basis, to ensure that 
the threshold appropriately limits investing in hedge funds to 
sophisticated investors.
---------------------------------------------------------------------------
     \1\ Available at: http://www.sec.gov/spotlight/hedgefunds/hedge-
mfa2.htm#wpaper2.
     \2\ Securities Act Release No. 8828 (August 3, 2007); 72 FR 45116 
(August 10, 2007). The Commission has not adopted this proposal.
     \3\ Letter from John G. Gaine, President, MFA, October 19, 2007, 
available at: http://www.managedfunds.org/downloads/
MFA%20Regulation%20D%20Comment%20Letter.pdf.
---------------------------------------------------------------------------
    The SEC has noted on several occasions that the objective 
income test in Regulation D strikes an appropriate balance 
between limiting private offerings to sophisticated investors 
only and promoting capital formation for companies. Prior to 
the SEC's adoption of Rule 242 under the Securities Act of 
1933, which was replaced by the adoption of Regulation D under 
the Securities Act, issuers relying on the private offering 
exemption had to make a subjective determination of the 
sophistication of the investors to whom they offered or sold 
securities. The requirement to make this subjective 
determination, however, ``created uncertainty about whether the 
exemption was available and thus posed problems for issuers, 
primarily small issuers, about potential rescission liability 
should the exemption turn out to be unavailable.'' \4\ To 
address this concern, the SEC incorporated the objective 
standard for accredited investors in Regulation D. In its 2007 
proposed rulemaking to amend the accredited investor standards, 
the Commission again recognized the appropriateness of 
objective thresholds,
---------------------------------------------------------------------------
     \4\ Securities Act Release No. 8041 (December 19, 2001); 66 FR 
66841 (December 27, 2001).

        Before 1982, our rules generally required an issuer 
        seeking to rely on section 4(2) to make a subjective 
        determination that each offeree had sufficient 
        knowledge and experience in financial and business 
        matters to enable that offeree to evaluate the merits 
        of the prospective investment or that such offeree was 
        able to bear the economic risk of the investment. In 
        part because of a degree of uncertainty as to the 
        availability of the section 4(2) exemption, the 
        Commission adopted Regulation D under the Securities 
        Act in 1982 to establish nonexclusive ``safe harbor'' 
        criteria for the section 4(2) private offering 
        exemption. \5\
---------------------------------------------------------------------------
     \5\ Securities Act Release No. 8766 (December 27, 2006); 72 FR 
403-404 (January 4, 2007) (footnote omitted).

    We recognize that asset and income tests do not necessarily 
guarantee the level of sophistication of investors, but we 
agree with the SEC that such tests do achieve an appropriate 
balance between investor protection and market certainty. 
Bright line, easy to understand thresholds promotes certainty, 
which is important to market participants and also promotes 
efficient and effective oversight by regulators. Investors who 
meet significant income or asset thresholds are more likely to 
have greater investment experience and sophistication, and 
therefore are better able to protect their interests than are 
retail investors. At the very least, these thresholds help 
ensure that investors who do not personally have such 
experience and sophistication have the means to engage 
fiduciaries who do have such experience to assist them in 
making investment decisions. Further, investors who meet such 
tests are likely to have the financial wherewithal to withstand 
losses that may arise from their investment decisions. As such, 
we believe that limiting hedge funds to investors who meet 
significant income or asset thresholds is an effective, if not 
perfect, means to ensure that only sophisticated investors 
invest in hedge funds.
    In 1996, Congress amended the Investment Company Act of 
1940 to, among other things, introduce an additional, 
heightened sophisticated investor standard, the ``qualified 
purchaser'' \6\ standard, which is applicable to investors in 
certain kinds of hedge funds (so-called ``3(c)(7) hedge 
funds''). In practice, investors in 3(c)(7) hedge funds must 
meet both the accredited investor and qualified purchaser 
thresholds. Like the accredited investor test, the qualified 
purchaser test sets out an objective standard ($5,000,000 in 
investments for an individual). We believe that the qualified 
purchaser standard has worked well since its inception; 
however, Congress may want to consider whether it is 
appropriate to adjust the standard to account for inflation. If 
Congress does decide to make an adjustment to the qualified 
purchaser standard, it is important for the new standard to be 
objective, transparent and easy to understand.
---------------------------------------------------------------------------
     \6\ The term qualified purchaser is defined in section 2(a)(51) of 
the Investment Company Act of 1940 to mean:
    (A)(i) any natural person (including any person who holds a joint, 
community property, or other similar shared ownership interest in an 
issuer that is excepted under section 80a-3 (c)(7) of this title with 
that person's qualified purchaser spouse) who owns not less than 
$5,000,000 in investments, as defined by the Commission;
    (ii) any company that owns not less than $5,000,000 in investments 
and that is owned directly or indirectly by or for 2 or more natural 
persons who are related as siblings or spouse (including former 
spouses), or direct lineal descendants by birth or adoption, spouses of 
such persons, the estates of such persons, or foundations, charitable 
organizations, or trusts established by or for the benefit of such 
persons;
    (iii) any trust that is not covered by clause (ii) and that was not 
formed for the specific purpose of acquiring the securities offered, as 
to which the trustee or other person authorized to make decisions with 
respect to the trust, and each settlor or other person who has 
contributed assets to the trust, is a person described in clause (i), 
(ii), or (iv); or
    (iv) any person, acting for its own account or the accounts of 
other qualified purchasers, who in the aggregate owns and invests on a 
discretionary basis, not less than $25,000,000 in investments.
    (B) The Commission may adopt such rules and regulations applicable 
to the persons and trusts specified in clauses (i) through (iv) of 
subparagraph (A) as it determines are necessary or appropriate in the 
public interest or for the protection of investors.
    (C) The term ``qualified purchaser'' does not include a company 
that, but for the exceptions provided for in paragraph (1) or (7) of 
section 80a-3 (c) of this title, would be an investment company 
(hereafter in this paragraph referred to as an ``excepted investment 
company''), unless all beneficial owners of its outstanding securities 
(other than short-term paper), determined in accordance with section 
80a-3 (c)(1)(A) of this title, that acquired such securities on or 
before April 30, 1996 (hereafter in this paragraph referred to as 
``pre-amendment beneficial owners''), and all pre-amendment beneficial 
owners of the outstanding securities (other than short-term paper) of 
any excepted investment company that, directly or indirectly, owns any 
outstanding securities of such excepted investment company, have 
consented to its treatment as a qualified purchaser. Unanimous consent 
of all trustees, directors, or general partners of a company or trust 
referred to in clause (ii) or (iii) of subparagraph (A) shall 
constitute consent for purposes of this subparagraph.

Q.2. What level of standardization of disclosures might help 
investors in hedge funds? What is the balance between 
disclosure for the protection of investors and the protection 
---------------------------------------------------------------------------
of hedge funds' intellectual property?

A.2. MFA and its members strongly support hedge funds providing 
an appropriate level of disclosure to investors and potential 
investors in hedge funds, to allow those investors to make 
informed investment decisions. Hedge funds do disclose a 
significant amount of information to investors because of 
regulatory requirements and the requirements of investors. \7\ 
We believe that the appropriate balance between disclosure to 
investors and protection of intellectual property is best 
determined between sophisticated hedge fund investors and hedge 
fund managers. Investors who believe that they do not have 
sufficient information about a hedge fund should not make an 
investment in that fund. The balance between disclosure to 
investors and protection of intellectual property is, of 
course, set in the context of the anti-fraud provisions of the 
federal securities laws.
---------------------------------------------------------------------------
     \7\ To assist investors in their diligence process, MFA has 
published a model due diligence questionnaire, which illustrates the 
types of information commonly requested by investors prior to 
investing. MFA's model DDQ is available at: http://
www.managedfunds.org/downloads/Due%20Dilligence%20Questionnaire.pdf.
---------------------------------------------------------------------------
    We believe that because the class of investors who can 
invest in hedge funds is limited to sophisticated investors 
only, those investors are able to request and receive any 
information they believe to be relevant to their investment 
decisions. Further, we believe that sophisticated investors are 
better able than regulators to determine what information they 
need and how they want that information to be presented. Any 
investor who fails to receive the information that it believes 
is material to an investment decision can choose not to make an 
investment. Because sophisticated investors are best able to 
determine what information they need, and they have the ability 
to request and receive that information (or not make an 
investment if they do not), we believe that it is neither 
necessary nor advisable to require standardized disclosures by 
hedge funds.
    While hedge funds provide a significant amount of 
information to investors, we do not believe that detailed 
public disclosure about hedge funds should be required. Public 
disclosure of such information could be misleading, as it would 
likely be incomplete data that would be viewed by the public 
outside of the proper context. Public investors may be inclined 
to take action based on this data without fully understanding 
the information, which could lead to adverse consequences for 
those public investors, for investors in the relevant hedge 
funds, and for the stability of the financial system as a 
whole. Public disclosure of proprietary information also harms 
the ability of market participants to establish and exit from 
investment positions in an economically viable manner. We 
believe that investors in hedge funds can receive the 
information they need to make informed investment decisions 
(and regulators can receive information reported on a 
confidential basis to allow them to fulfill their investor 
protection, oversight, monitoring and other regulatory 
functions) without the adverse consequences that would result 
from public disclosure of the intellectual property of hedge 
funds.

Q.3. Is it reasonable that regulators could review detailed 
information such as trading positions of hedge funds overall to 
see where there might be concentrations, or is this level of 
analysis too difficult? If so, why?

A.3. MFA supports the notion of a central systemic risk 
regulator (SRR) and believes that such a regulator should be 
responsible for oversight over the key elements of the entire 
financial system, across all relevant structures, classes of 
institutions and products of all financial system participants. 
\8\ Factors a SRR should consider in determining whether an 
entity is systemically important should include the amount of 
assets of an entity, the concentration of its activities, and 
an entity's interconnectivity to other market participants.
---------------------------------------------------------------------------
     \8\ See Testimony of the Honorable Richard H. Baker, President and 
Chief Executive Officer, Managed Funds Association, before the 
Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 
26, 2009; and Testimony of the Honorable Richard H. Baker, President 
and Chief Executive Officer, Managed Funds Association, before the 
Subcommittee on Capital Markets, Insurance, and Government Sponsored 
Enterprises, Committee on Financial Services, U.S. House of 
Representatives, March 5, 2009.
---------------------------------------------------------------------------
    While we 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; we believe that most hedge funds are not 
systemically significant entities and, thus, hedge funds, as a 
class, should not be singled out for greater scrutiny. A SRR 
should have the authority to request and receive, on a 
confidential basis, from those entities that it determines to 
be of systemic relevance, including any hedge funds, 
information that the regulator determines necessary or 
advisable to enable it to adequately assess potential risks to 
the financial system. We don't mind reporting information 
within reason if systemically relevant, provided that the SRR 
provides assurance of confidentiality.
    In this respect, we also believe a SRR should not equate 
systemically relevant entities with entities that are too big, 
or too interconnected, to fail. An entity that is perceived by 
the market to have a government guarantee, whether explicit or 
implicit, has an unfair competitive advantage over other market 
participants. We strongly believe that the systemic risk 
regulator should implement its authority in a way that avoids 
this possibility and also avoids the moral hazards that can 
result from a company having an ongoing government guarantee 
against its failure.
    With respect to whether a regulator could assess an 
entity's trade concentrations through reviewing trade 
positions, we provide the following example for comparison:
    The Commodity Futures Trading Commission currently performs 
analysis of the trading positions of market participants, 
including hedge funds, as part of its market surveillance 
program. For example, the CFTC operates a large-trader 
reporting system (LTRS) through which it collects daily market 
data and position information from clearing members, futures 
commissions merchants, and foreign brokers. \9\ In this way, 
the CFTC conducts real-time surveillance of market 
participants.
---------------------------------------------------------------------------
     \9\ Section 4g of the Commodity Exchange Act (CEA); 17 CFR Parts 
15, 16, 17, 18, 19, and 21.
---------------------------------------------------------------------------
    We understand that the CFTC reviews the position 
information daily and will contact a market participant that 
exceeds an accountability level or position limit to conduct an 
inquiry (note: an accountability level is a soft limit and 
exceeding it is not per se illegal, whereas a position limit is 
a hard limit). If a market participant exceeds an 
accountability level, the CFTC will inquire into the market 
participant's positions, strategy or other rationale for 
exceeding the accountability level. If the CFTC is not 
satisfied with its finding, it may require the market 
participant to decrease its position. All of this is done 
quietly and privately to avoid alarming or putting other market 
participants on notice and creating a market impact.
    The CFTC provides the public with aggregated data of 
reported positions via its weekly Commitments of Traders 
reports. The Commodity Exchange Act protects market 
participants by prohibiting the CFTC from disclosing any 
person's positions, transactions, or trade secrets (except in 
limited circumstances). \10\
---------------------------------------------------------------------------
     \10\ Section 8 of the CEA.
---------------------------------------------------------------------------
    As provided in the above example, it is possible for 
regulators to review detailed information to assess position 
concentrations. Similar to the CFTC's market surveillance 
program, we believe it would be more meaningful for a SRR to 
review trading positions across all market participants that it 
deems systemically significant, rather than single out specific 
types of market participants, such as hedge funds. While we 
believe it is useful for the public to receive aggregated 
position information for specific markets (i.e., commodities), 
we strongly believe information reported to a systemic risk 
regulator by market participants should be kept confidential 
for the reasons discussed in our written testimony.
    A SRR is also likely to need sufficient authority and 
flexibility to adapt to changing conditions and take a forward-
looking view toward risk regulation. Attempting to pre-
determine what information a regulator would need would not 
provide sufficient flexibility and likely would be ineffective 
as a tool to address potential future risks. As a starting 
point, however, a SRR may consider collecting aggregated trade 
data from counterparties, such as banks, broker-dealers and 
exchanges. MFA and its members are actively engaged in an 
effort to identify the types of information and data that would 
be relevant to a SRR. While we don't have recommendations yet, 
we are committed to being constructive participants in the 
regulatory reform discussions and working with policy makers to 
develop smart regulation.
    A systemic risk regulator's challenge will be to understand 
the interplay and use of various financial instruments across 
classes of institutions to assess the soundness of the 
financial system. For this reason, we believe it is important 
that a systemic risk regulator's mandate should be focused on 
the protection of the financial system and that other 
regulatory entities should continue to focus on investor 
protection and market integrity.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                       FROM JAMES CHANOS

Q.1. You summarized the failures we have seen during this 
downturn in the financial markets. From your perspective, what 
led to such a disintegration of market discipline?

A.1. While all market participants bear some degree of 
responsibility for where we are today in the global equity, 
credit and asset-backed markets, the root cause of the severe 
difficulties we face can be found in the massive debt and the 
large volume of unsound loans made and secured beyond any 
reasonable level by heavily regulated organizations. This 
created a massive credit bubble that could but only burst. 
Market discipline was lost as businesses sought ever-increasing 
returns in a highly competitive market, and rating agencies 
made the implausible seem highly possible which in turn created 
higher returns which fed the bubble in prices for assets. 
Transparency of value and pricing was lost which also played a 
role in the disintegration of market discipline.

Q.2. If market discipline needs to be coupled with regulatory 
oversight, as you state in your testimony, what is the industry 
doing to improve market discipline--as the government is 
working to improve the regulatory structure?

A.2. The recommendations for hedge fund best practices of the 
President's Working Group Asset Managers' Committee and the 
Institutional Investors' Committee represent an important step 
by industry participants to raise the bar on disclosure, 
transparency and valuation. These best practices in many areas 
such as valuation exceed the norms of other market participants 
engaged in similar activities.

Q.3. Does the concept of the sophisticated investor, which sets 
certain income and asset-sized limitations on investors in 
hedge funds, need to be revisited? Is so, how should it be 
revisited?

A.3. That is a complex question which also opens up a 
discussion of funds of funds registered under the Investment 
Company Act that invest only in hedge funds. Since they are 
registered, they are open to retail investors without any 
minimum financial qualifications. CPIC did not oppose the SEC 
proposal to revise 3(c)(1) eligibility levels for individuals. 
For a full discussion please see our comment letter to the SEC 
dated March 9, 2007, a copy of which is attached.

Q.4. What level of standardization of disclosures might help 
investors in hedge funds? What is the balance between 
disclosure for the protection of investors and the protection 
of hedge funds' intellectual property?

A.4. Better transparency, particularly for investors, is a good 
thing. Having recently served on one of the President's Working 
Group's Committees to develop best practices for asset managers 
and institutional investors, there are enhanced disclosures 
that could be adopted or, if necessary, codified. For example, 
managers should disclose more data regarding how their funds 
derive income and losses from FAS 157 Level 1, 2, and 3 assets. 
A fund's annual financial statement should be audited by an 
independent audit firm subject to PCAOB oversight. 
Additionally, provisions could be adopted to assure that 
potential investors are provided with specified disclosures 
relating to the fund and its management before any investment 
is accepted. This information should include any disciplinary 
history and pending or concluded litigation or enforcement 
actions, fees and expense structure, the use of commissions to 
pay broker-dealers for research (``soft dollars''), the fund's 
methodology for valuation of assets and liabilities, any side-
letters and side-arrangements, conflicts of interest and 
material financial arrangements with interested parties 
(including investment managers, custodians, portfolio brokers 
and placement agents), and policies as to investment and trade 
allocations. Required disclosures to regulators and 
counterparties could also include information regarding 
counterparty risk, lender risk and systemic risk. Finally, 
Congress also should require safeguards that I have advocated 
for many years--simple, common-sense protections relating to 
custody of fund assets and periodic audits.
    As for disclosure of a fund's positions, particularly short 
positions, it is not problematic to disclose positions on a 
confidential basis to the prudential or systemic risk 
regulator. Such information could also be aggregated on a 
confidential basis and used by the regulators. Public 
disclosure, however, even on a delayed basis, would jeopardize 
proprietary information/intellectual property and drastically 
undercut liquidity in the market along with the financial 
detective role played by short sellers. Short sellers also 
would be exposed to retaliation and trading could move to less 
transparent markets.

Q.5. Is the ideal regulator someone from the industry, who 
understands how it works? If so, who is willing to perform this 
public service at this point in our country's economic turmoil?

A.5. It is imperative that regulatory staff, from examiners to 
enforcement, have more experience and training in the day-to-
day operations of the markets they are overseeing. Staff should 
either be--or be trained by--people who have sat on trading 
desks, who have run hedge funds or who have run investment 
firms. While the pool of potential trainers may not be large, 
there may be some seasoned, possibly retired, Wall Street 
professionals who could serve the nation by teaching the well-
schooled and well-meaning staff what to look for now and what 
to look for in the future in order to safeguard investments and 
the financial system.

Q.6. Is it reasonable that regulators could review detailed 
information such as trading positions of hedge funds overall to 
see where there might be concentrations, or is this level of 
analysis too difficult? If so, why?

A.6. It is possible, dependent on the criteria used to select 
the funds or trading strategies to be targeted. And all market 
participants with similar investments, from commercial and 
investment banks to mutual funds, should be subject to the same 
level of scrutiny.









































         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                      FROM RITA M. BOLGER

Q.1. What recourse do investors have today to take action if 
they are frustrated about what they see as a lack of diligence 
on your part in reviewing information that is used in 
determining your ratings?

A.1. Investors have ample opportunity to influence the rules 
under which NRSROs like S&P operate as regulated entities under 
the Credit Rating Agency Reform Act of 2006. That Act provides 
the Securities and Exchange Commission--acting on behalf of 
investors--with authority to require NRSROs to adhere to their 
established procedures and methodologies for assigning credit 
ratings, and otherwise to comply with a comprehensive set of 
SEC rules, including new rules that became effective just this 
month. Moreover, as part of this comprehensive regulatory 
regime, the Commission has powerful tools at its disposal, 
including the ability to subject NRSROs to rigorous 
examinations and to impose fines and other sanctions, including 
revocation of our status as an approved NRSRO.
    It is also worth noting that numerous private law suits 
that relate to our ratings have been filed on behalf of 
investors against S&P. In numerous cases currently pending 
across the nation, investors are asserting legal claims against 
S&P under Section 10(b) of the Securities Exchange Act of 1934; 
Sections 11, 12 and 15 of the Securities Act of 1933; the ERISA 
laws; and common law principles sounding in negligence, 
negligent misrepresentation, breach of fiduciary duty, fraud, 
breach of contract and aiding and abetting the alleged 
misconduct of others. Additionally, legal claims have been made 
by the State of Connecticut for alleged breach of that State's 
consumer protection statute. Investors have also filed 
complaints with Attorneys General of various states who have 
considered and in some cases commenced investigations relating 
to alleged misconduct by S&P.
    On the specific issue of the quality of information that is 
used to determine ratings, S&P has recently taken steps to 
address data quality issues with respect to U.S. RMBS by 
strengthening our criteria to take account of the due diligence 
procedures employed by RMBS issuers and their agents, and other 
criteria enhancements relating to the originators and sellers 
of securitized loans. These steps were taken following 
discussions with both investors and issuers. However, S&P does 
not, and cannot, practically audit the information we receive 
from corporations, governmental entities, structured finance 
issuers and others in our credit rating process. The market has 
not traditionally looked to S&P to assume this role and it 
would simply not be feasible for us to do so, given the extent 
of debt issued in this country and around the world.
                                ------                                


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                       FROM DANIEL CURRY

Q.1. What recourse do investors have today to take action if 
they are frustrated about what they see as a lack of diligence 
on your part in reviewing information that is used in 
determining your ratings?

A.1. The answer to this question depends the reason for the 
investors' frustration and the nature of the perceived lack of 
diligence.
    Frustration that derives from a misapprehension about the 
nature of credit ratings or the role of credit rating agencies 
is best addressed by educating investors. Credit ratings are 
opinions that assess an issuer's ability and willingness to 
make timely payments on outstanding obligations (whether 
principal, interest, dividend or distributions) with respect to 
the terms of an obligation. Ratings for structured finance 
vehicles reflect an opinion on the ability of the pooled assets 
to fund repayment to investors according to each security's 
priority of payments. Credit ratings are not buy, sell or hold 
recommendations, and they do not address the market price or 
trading liquidity risk of a security.
    Credit rating agencies base their ratings opinions on 
quantitative and qualitative analyses of information the rating 
agencies receive from issuers, obligors or arrangers. Although 
rating agencies believe the information they use is accurate 
and reliable, the agencies do not audit or verify that 
information. In other words, credit rating agencies are not 
auditors.
    DBRS makes a concerted effort to educate investors about 
the nature of credit ratings and the limitations on using 
ratings to make investment decisions. In this regard, DBRS 
posts a plain-English discussion of this topic under the Rating 
Policies section of its public Web site [www.dbrs.com]. DBRS 
also clearly discloses the fact that it does not verify or 
audit the information it relies on in formulating its credit 
ratings. In addition, DBRS publishes its Information Review 
Policy, which describes the measures the firm has adopted to 
ensure that the information it uses in assigning a rating is of 
sufficient quality to support a credible rating.
    The primary recourse for an investor who is frustrated by 
the nature of credit ratings or the function of credit rating 
agencies is to avoid overrelying on credit ratings in making 
investment decisions. Admittedly, this is easier to do in the 
corporate market, where investors have access to ample 
information on which to base their investment decisions, than 
it is in the structured finance market, where such public 
information can be hard to come by. For this reason, DBRS has 
urged the Securities and Exchange Commission (SEC) to take 
steps, such as amending Regulation AB, to require issuers and 
arrangers to provide investors with more information about the 
structure or underlying assets of securitized products.
    Competition among rating agencies provides another avenue 
of recourse for an investor frustrated with a particular 
agency's behavior. There are currently ten registered 
Nationally Recognized Statistical Rating Organizations 
(NRSROs), each of whom is required to make information about 
its ratings policies and performance available to the public. 
DBRS strongly believes that maintaining a transparent and 
competitive credit ratings market allows investors to assess 
the sufficiency of rating agencies' respective procedures and 
to select the agencies they feel produce the highest quality 
credit ratings.
    Another avenue of recourse involves the SEC. Investors 
whose frustration derives from a belief that a rating agency is 
not following its stated policies regarding the review of 
information can lodge a complaint about the rating agency with 
the SEC. Although the Credit Rating Agency Reform Act of 2006 
does not provide a private right of action, it does empower the 
SEC to take action against an NRSRO that issues credit ratings 
in material contravention of the NRSRO's published procedures.
    Finally, if a rating agency's conduct involves fraud, 
recklessness or the violation of certain securities laws and 
rules, a frustrated investor has recourse to the courts.
    We hope that this information assists you in your 
examination of investor protection and the regulation of the 
securities markets. DBRS would be pleased to answer any 
additional questions you may have in this area.
