[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
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Colin McGinnis, Acting Staff Director
William D. Duhnke, Republican Staff Director
Dean Shahinian, Senior Counsel
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.
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\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\
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\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.
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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\
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\3\ See, e.g., Temple v. Gorman, 201 F. Supp. 2d 1238 (S.D. FL.
2002).
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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.
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\4\ See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
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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\
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\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\
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\6\ Stoneridge Investment Partners, LLC v. Scientific-Atlanta,
Inc., 128 S. Ct. 761, 779 (2008).
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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.
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\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.
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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.
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\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).
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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\
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\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.
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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.
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\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.
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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\
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\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).
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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.
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\8\ The MSRB's transaction reporting rules require dealers to
report transactions in municipal securities within 15 minutes of the
time of trade execution.
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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.
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\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.
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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.
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\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.
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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.
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\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).
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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\
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\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\
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\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.
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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\
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\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.
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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\
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\18\ Source: MSRB transaction data.
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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\
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\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.
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\20\ July 26, 2007, available at http://www.sec.gov/news/press/
2007/2007-148wp.pdf.
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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\
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\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.
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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.
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\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.
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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.
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\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.
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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\
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\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.
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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\
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\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.
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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\
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\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.
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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\
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\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.
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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\
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\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).
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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.
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\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.
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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.
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\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).
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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.
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\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.
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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\
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\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).
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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.
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\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.
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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.
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\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.
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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\
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\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.''
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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\
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\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.
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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\
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\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\
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\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
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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\
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\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.
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\4\ Jerome S. Fons and Frank Partnoy, ``Rated F for Failure,'' New
York Times, March 16, 2009.
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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\
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\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.
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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\
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\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
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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.
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\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.
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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.
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\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.
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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:
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\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\
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\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.
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\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).
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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\
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\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.
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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\
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\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
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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\
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\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.
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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'').
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\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).
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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\
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\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.
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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\
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\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).
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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.
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\19\ Title III, National Securities Markets Improvement Act, Pub.
Law No. 104-290.
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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.
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\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).
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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.
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\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.
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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.
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\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.
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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\
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\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).
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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.
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\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.
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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.
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\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.
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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.
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\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.
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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\
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\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.''
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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:
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\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\
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\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\
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\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'').
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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.
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\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.
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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\
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\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).
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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.
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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.
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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\
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\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.
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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.