[House Hearing, 114 Congress]
[From the U.S. Government Publishing Office]
LEGISLATIVE PROPOSALS TO
ENHANCE CAPITAL FORMATION,
TRANSPARENCY, AND
REGULATORY ACCOUNTABILITY
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON CAPITAL MARKETS AND
GOVERNMENT SPONSORED ENTERPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED FOURTEENTH CONGRESS
SECOND SESSION
__________
MAY 17, 2016
__________
Printed for the use of the Committee on Financial Services
Serial No. 114-88
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HOUSE COMMITTEE ON FINANCIAL SERVICES
JEB HENSARLING, Texas, Chairman
PATRICK T. McHENRY, North Carolina, MAXINE WATERS, California, Ranking
Vice Chairman Member
PETER T. KING, New York CAROLYN B. MALONEY, New York
EDWARD R. ROYCE, California NYDIA M. VELAZQUEZ, New York
FRANK D. LUCAS, Oklahoma BRAD SHERMAN, California
SCOTT GARRETT, New Jersey GREGORY W. MEEKS, New York
RANDY NEUGEBAUER, Texas MICHAEL E. CAPUANO, Massachusetts
STEVAN PEARCE, New Mexico RUBEN HINOJOSA, Texas
BILL POSEY, Florida WM. LACY CLAY, Missouri
MICHAEL G. FITZPATRICK, STEPHEN F. LYNCH, Massachusetts
Pennsylvania DAVID SCOTT, Georgia
LYNN A. WESTMORELAND, Georgia AL GREEN, Texas
BLAINE LUETKEMEYER, Missouri EMANUEL CLEAVER, Missouri
BILL HUIZENGA, Michigan GWEN MOORE, Wisconsin
SEAN P. DUFFY, Wisconsin KEITH ELLISON, Minnesota
ROBERT HURT, Virginia ED PERLMUTTER, Colorado
STEVE STIVERS, Ohio JAMES A. HIMES, Connecticut
STEPHEN LEE FINCHER, Tennessee JOHN C. CARNEY, Jr., Delaware
MARLIN A. STUTZMAN, Indiana TERRI A. SEWELL, Alabama
MICK MULVANEY, South Carolina BILL FOSTER, Illinois
RANDY HULTGREN, Illinois DANIEL T. KILDEE, Michigan
DENNIS A. ROSS, Florida PATRICK MURPHY, Florida
ROBERT PITTENGER, North Carolina JOHN K. DELANEY, Maryland
ANN WAGNER, Missouri KYRSTEN SINEMA, Arizona
ANDY BARR, Kentucky JOYCE BEATTY, Ohio
KEITH J. ROTHFUS, Pennsylvania DENNY HECK, Washington
LUKE MESSER, Indiana JUAN VARGAS, California
DAVID SCHWEIKERT, Arizona
FRANK GUINTA, New Hampshire
SCOTT TIPTON, Colorado
ROGER WILLIAMS, Texas
BRUCE POLIQUIN, Maine
MIA LOVE, Utah
FRENCH HILL, Arkansas
TOM EMMER, Minnesota
Shannon McGahn, Staff Director
James H. Clinger, Chief Counsel
Subcommittee on Capital Markets and Government Sponsored Enterprises
SCOTT GARRETT, New Jersey, Chairman
ROBERT HURT, Virginia, Vice CAROLYN B. MALONEY, New York,
Chairman Ranking Member
PETER T. KING, New York BRAD SHERMAN, California
EDWARD R. ROYCE, California RUBEN HINOJOSA, Texas
RANDY NEUGEBAUER, Texas STEPHEN F. LYNCH, Massachusetts
PATRICK T. McHENRY, North Carolina ED PERLMUTTER, Colorado
BILL HUIZENGA, Michigan DAVID SCOTT, Georgia
SEAN P. DUFFY, Wisconsin JAMES A. HIMES, Connecticut
STEVE STIVERS, Ohio KEITH ELLISON, Minnesota
STEPHEN LEE FINCHER, Tennessee BILL FOSTER, Illinois
RANDY HULTGREN, Illinois GREGORY W. MEEKS, New York
DENNIS A. ROSS, Florida JOHN C. CARNEY, Jr., Delaware
ANN WAGNER, Missouri TERRI A. SEWELL, Alabama
LUKE MESSER, Indiana PATRICK MURPHY, Florida
DAVID SCHWEIKERT, Arizona
BRUCE POLIQUIN, Maine
FRENCH HILL, Arkansas
C O N T E N T S
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Page
Hearing held on:
May 17, 2016................................................. 1
Appendix:
May 17, 2016................................................. 47
WITNESSES
Tuesday, May 17, 2016
Bartl, Timothy J., Chief Executive Officer, Center on Executive
Compensation................................................... 6
Cherry-Seto, Joshua, Chief Financial Officer, Blue Wolf Capital
Partners, LLC, on behalf of the Association for Corporate
Growth......................................................... 12
Gallagher, Hon. Daniel M., President, Patomak Global Partners,
LLC............................................................ 5
Quaadman, Thomas, Senior Vice President, Center for Capital
Markets Competitiveness, U.S. Chamber of Commerce.............. 10
Taub, Jennifer, Professor of Law, Vermont Law School............. 8
APPENDIX
Prepared statements:
Bartl, Timothy J............................................. 48
Cherry-Seto, Joshua.......................................... 66
Gallagher, Hon. Daniel M..................................... 71
Quaadman, Thomas............................................. 92
Taub, Jennifer............................................... 107
Additional Material Submitted for the Record
Garrett, Hon. Scott:
Written statement of the Society of Corporate Secretaries &
Governance Professionals and the National Investor
Relations Institute........................................ 121
Insert from Ambassador James K. Glassman, Washington, DC..... 129
Insert from Thomas Quaadman.................................. 131
Duffy, Hon. Sean:
Written statement of the Biotechnology Innovation
Organization............................................... 132
Written statement of John Hayes, Chairman, President, and
Chief Executive Officer, Ball Corporation; and Chair,
Business Roundtable Committee on Corporate Governance...... 133
Written statement of Nasdaq.................................. 138
Maloney, Hon. Carolyn:
Written statement of Americans for Financial Reform.......... 139
Written statement of the Council of Institutional Investors.. 144
Written statement of the Florida State Board of
Administration ................................ 160
Written statement of Glass, Lewis & Co....................... 176
Written statement of Institutional Shareholder Services, Inc. 191
LEGISLATIVE PROPOSALS TO
ENHANCE CAPITAL FORMATION,
TRANSPARENCY, AND
REGULATORY ACCOUNTABILITY
----------
Tuesday, May 17, 2016
U.S. House of Representatives,
Subcommittee on Capital Markets and
Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to notice, at 2:57 p.m., in
room 2128, Rayburn House Office Building, Hon. Scott Garrett
[chairman of the subcommittee] presiding.
Members present: Representatives Garrett, Hurt, Royce,
Neugebauer, Huizenga, Duffy, Fincher, Hultgren, Wagner,
Schweikert, Poliquin, Hill; Maloney, Sherman, Lynch,
Perlmutter, Scott, Himes, Foster, Carney, and Murphy.
Ex officio present: Representative Hensarling.
Also present: Representative Barr.
Chairman Garrett. The Subcommittee on Capital Markets and
Government Sponsored Enterprises will now come to order.
Today's hearing is entitled, ``Legislative Proposals to Enhance
Capital Formation, Transparency, and Regulatory
Accountability.''
Without objection, the Chair is authorized to declare a
recess--hopefully we won't need another one for votes--of the
subcommittee at any time. I thank the panel for their patience.
I now recognize myself for 2 minutes for an opening
statement.
Today, the subcommittee meets to examine three important
pieces of draft legislation that continue to work over the last
5 years to modernize our nation's securities laws and promote
transparency and competition in our capital markets. And
basically to bring real reform and accountability to the SEC's
rulemaking process.
A recent poll indicates that about two-thirds of Americans
believe our country is headed in the wrong direction. And a
declining number of people believe that their children will be
better off financially than they have been.
So despite the big promises that have come with granting
vast and, in some cases, unlimited authority to the Federal
bureaucracy in D.C., most Americans aren't buying the argument
that a bigger Washington leads to a bigger paycheck at home or
even any paycheck at all.
Fortunately, our subcommittee has, for 5 years now, tried
an alternative approach which seeks to do what? To empower
entrepreneurs and investors and small businesses, but not the
bureaucrats. This approach has led to some successes, most
notably the JOBS Act of 2012.
But maybe more important than that, it has led Congress and
the regulators to think in a different way than they have
historically. So today we continue our important work with
three pieces of legislation. First, we will consider the SEC
Regulatory Accountability Act.
It would require the SEC to determine that the benefits of
any regulations they are considering actually outweigh its
cost. Even President Obama, through Executive Order 2011, in
2011, has recognized the importance of economic analysis in
rulemaking. And this legislation would codify much of what the
President's executive order did for the SEC.
Secondly, we add the Investment Advisers Modernization Act,
with Mr. Hurt sponsoring it. This is a long overdue piece of
legislation that would allow private capital to continue to
play a critical role in our economy which reduces many of the
unnecessary bureaucratic requirements that have led the effect
of starving middle market businesses of the capital they need.
Thirdly and finally, Mr. Duffy has put forward a Proxy
Advisory Firm Reform Act of 2016, which would, for the first
time in memory, provide some much needed sunlight to the way in
which proxy adviser firms develop and distribute their advice.
So this subcommittee has led the charge in Congress for
reform of the proxy adviser industry. And this draft
legislation is the next step.
So with that being said, I want to thank all of the
sponsors here for their hard work on all these bills. And I
look forward to our witnesses today.
And with that, I yield to the gentlelady from New York for
5 minutes.
Mrs. Maloney. Thank you. And I thank the chairman for
holding this important hearing and for all of our panelists to
being here today. We are considering three bills, all of which
deal with different issues.
First, Mr. Duffy and Mr. Carney have a bill that would
establish a regulatory regime for proxy advisers. Proxy
advisers provide recommendations to institutional investors on
how to vote on Board of Director elections and shareholder
resolutions.
Big institutional investors are shareholders of thousands
of public companies and they simply don't have the time to
carefully review every single 100-page proxy statement in
detail. Especially because most public companies hold their
shareholder meetings in the same 3-month period.
So institutional investors rely on proxy advisers for vote
recommendations, which are often tailored to the investor's
particular corporate governance preference. This is healthy.
Proxy advisers do have the time to carefully read all of the
statements and proposals because they have professionals who
simply read these statements all day, every day. However, this
means that proxy advisers can be very influential in the
outcomes of shareholder votes.
Although the evidence on the influence of proxy advisers is
mixed, it is probably fair to say that the current regulatory
regime for proxy advisers is not ideal. Two advisory firms
account for 97 percent of the market, ISS and Glass Lewis.
But for some reason, they are regulated differently. ISS is
a registered investment adviser, while Glass Lewis is not.
Surely, this is not an ideal setup, so I am absolutely open to
the idea of a better and more consistent regulatory regime for
proxy advisers. But there are several things in this bill that
concern me.
I don't see why companies should have a statutory right to
receive and comment on a proxy adviser's draft recommendations
before they are sent to investors. Proxy advisors aren't
Federal agencies and a notice and comment period for private
companies that are providing a valuable service is, in my
opinion, is not appropriate at all. I don't recall where this
regulation is on any other private company.
I am also concerned about giving companies the right to sue
proxy advisers just because they didn't get a meaningful chance
to comment on draft recommendations. But I am willing to hear
other perspectives on this issue because it is an important one
that Congress has not examined for a long time.
The second bill is intended to modernize the Investment
Advisers Act for advisers to private equity firms and funds.
This bill makes a series of targeted changes to the Advisers
Act which are intended to make it more compatible with the
private equity business model. I think there is probably space
to better tailor the Advisory Act to private equity advisers.
But I am concerned about making sweeping changes to core
aspects of a regulatory regime that has been quite successful.
We need to think very carefully before we make changes to the
books and records rule, the custody rule or the advertising
rule. These are core aspects of the Advisers Act and they
shouldn't be discarded lightly.
Finally, Chairman Garrett has an SEC cost benefit bill.
This is similar to a bill that this committee has considered
before. But I am interested to hear if any of the witnesses can
offer any fresh perspective on this issue.
I would like to thank our panelists for appearing before us
today. And I would like to insert a few statements into the
record. These are statements from the Council of Institutional
Investors, the Florida State Board of Administration, ISS, and
Glass Lewis. And I hope that I will be able to place these
statements into the record.
Chairman Garrett. Without objection, it is so ordered.
Mrs. Maloney. Thank you.
I yield back.
Chairman Garrett. The gentlelady yields back.
We now go to the Vice Chair of the subcommittee, Mr. Hurt,
for 1\1/2\ minutes.
Mr. Hurt. Thank you, Mr. Chairman. Thank you for holding
this hearing today. I think every member of this committee can
agree that with millions of Americans out of work, our top
focus in Congress should be enacting policies to help spur job
creation throughout our country.
As I travel across my district, Virginia's 5th District, I
continue to hear hardworking Americans express concern about
the current state of our economy and the economic uncertainty
facing their children and their grandchildren.
Today we will discuss several legislative efforts that, if
enacted, will encourage economic growth and job creation by
reducing unnecessary regulatory burdens. In Virginia's 5th
District, thousands of jobs would not exist without the
investment from private equity. These critical investments
allow our small businesses to innovate, expand their operations
and create the jobs that our communities desperately need.
Over the past three Congresses, there has been a growing
concern about the burden that Dodd-Frank unnecessarily places
on advisers to private equity while at the same time exempting
advisers to similar investment funds. Over recent years, many
of us have worked together in a bipartisan way to eliminate the
registration requirements mandated by Dodd-Frank.
Today, however, among the legislation we are considering is
a discussion draft titled, The Investment Advisers
Modernization Act. This bill would not change the registration
requirement that Dodd-Frank mandated, but rather would update
the Investment Advisers Act of 1940, a 76-year-old law, to
reflect the current business model of private equity. This bill
would go a long way toward facilitating capital formation while
maintaining our commitment to investor protection. I believe
that it is incumbent upon Congress to look for common sense
solutions to problems caused by regulatory structure.
And I believe that this legislation is a pragmatic approach
to addressing some of the concerns with the Investment Advisers
Act. I look forward to the testimony of our witnesses.
And I yield back the balance of my time. Thank you, Mr.
Chairman.
Chairman Garrett. I thank you, the sponsor.
I now turn to the other sponsor. Mr. Duffy is recognized
for the remaining 1\1/2\ minutes.
Mr. Duffy. Thank you, Mr. Chairman. And thank you for
holding today's hearing and giving me an opportunity to briefly
discuss my bill to foster a greater accountability,
transparency, responsiveness, and competition in the proxy
advisory firm industry.
Increasingly, institutional investors rely on the analysis
and recommendations of proxy adviser firms on key issues facing
shareholders and public companies. As the share of
institutional investor ownership has grown from roughly 46
percent in 1987 to over 75 percent today, the volume of proxy
votes, which investors are responsible for casting, has grown
into the billions.
Just two proxy advisory firms control 97 percent of the
market. And the writings, analysis reports, and voting
recommendations affect fundamental corporate transactions like
mergers and acquisitions, the approval of corporate directors,
and shareholder proposals.
I have heard from many companies about their frustration
with the methodologies used by proxy advisory firms, the
inaccuracies and inconsistencies in the information they share
with their clients and, most importantly, the concern for
conflicts of interest. These are very powerful firms that have
a huge influence in regard to corporate governance.
In 2013, Mr. Chairman, you held a hearing and have been
involved in this issue on the subcommittee. And had respected
witnesses recommend more oversight of the proxy advisory firm
industry, which my bill now provides. So I look forward to the
witnesses' testimony on this issue and the other bills.
With that, Mr. Chairman, I yield back.
Chairman Garrett. Thank you. The gentleman yields back.
We now welcome the panel. Some of you have been here before
many times. Others are new here. You will be given 5 minutes
for your oral testimony. And without objection, your entire
written statement will be made a part of the record.
I now recognize from Mr. Daniel Gallagher. He is the
president of Patomak Global Partners, and a former Commissioner
with the of the SEC. You are recognized for 5 minutes and
welcome to the panel.
STATEMENT OF THE HONORABLE DANIEL M. GALLAGHER, PRESIDENT,
PATOMAK GLOBAL PARTNERS, LLC
Mr. Gallagher. Good afternoon and thank you, Chairman
Garrett, Ranking Member Maloney, and members of the
subcommittee for inviting me to testify today. My name is Dan
Gallagher, and I am president of Patomak Global Partners.
From 2011 through 2015, I served as an SEC Commissioner.
And from 2006 until 2010, I served on the Commission staff in
various capacities, ultimately as Deputy Director of the
Division of Trading and Markets. I am testifying today in my
own capacity.
Let me begin by expressing my appreciation for the work
this committee has done over the last 5\1/2\ years on
legislation to rationalize and remove regulatory obstacles
standing in the way of small businesses, as well as your
initiatives to enhance investor choice.
During my time as a commissioner, this committee regularly
challenged the commission to satisfy its statutory mission to
facilitate capital formation, whether through the legislative
process or through constructive and insightful hearings and
roundtables. In an era of unbridled misguided regulation, this
was truly a breath of fresh air. And I deeply appreciated the
opportunity to have worked with many of you on both sides of
the aisle on these important issues.
Mr. Chairman, having spent 4 years as a commissioner
focusing on Dodd-Frank Act rulemakings, it is particularly
refreshing to testify today on three bills which I believe will
help the SEC get back to the basic blocking and tackling
responsibilities of securities regulation that advance the
agency's core mission.
First, Congressman Duffy's bill will bring much needed
transparency, oversight and accountability to the proxy
advisory industry. Due in large part to the unintended
consequences of the SEC's own rules, proxy advisory firms now
play an outsized role in the shareholder voting process, often
to the detriment of public companies, investors, and the
American system of corporate governance.
Representative Duffy's legislation would help resolve many
issues, which apparently remain unresolved despite recent SEC
staff guidance, through a comprehensive registration and
examination regime for proxy advisory firms.
I applaud Representative Duffy for taking an incremental
legislative approach that is similar in many important ways to
the framework for the Credit Rating Agency Reform Act, which
enjoyed bipartisan support and passed the Senate by unanimous
consent.
Second, Chairman Garrett's SEC Regulatory Accountability
Act would promote and improve economic analysis at the SEC and
make the agency even more accountable to the investing public.
While the SEC has dramatically improved the economic analysis
supporting its rules, there remains room for improvement.
In particular, I believe that in certain mandated
rulemakings, the SEC's lawyers have played an outsized role in
interpreting congressional intent thereby setting the ground
rules by which the economists are expected to operate.
The CEO pay ratio rulemaking is the best example of this.
Finding benefits when Congress described none may help get a
rule done. But it ensures that the economic analysis is not
done right. This trend needs to stop before it becomes the
loophole that devours the SEC's 2012 commitment to proper
economic analysis. Ultimately, Chairman Garrett's bill will
help ensure that economic analysis conducted by economists is
firmly entrenched in every rulemaking the SEC conducts under
the Federal securities laws.
Last, but certainly not least, Vice Chairman Hurt's
Investors Advisers Modernization Act would preserve the
registration regime for private fund advisers, while at the
same time removing or modernizing some of the more unnecessary
and overly burdensome requirements in the Advisers Act that
serve only to drive up the costs for funds and investors and
hinder the efficient allocation of capital that helps
businesses and jobs grow.
Since the passage of Dodd-Frank, the SEC has devoted a
significant amount of its limited resources towards overseeing
and examining advisers to private funds, who primarily serve
sophisticated investors, such as pension funds and endowments.
During this non-recovery recovery, to borrow Chairman
Hensarling's words, and given that there are over 11,000 SEC
registered investment advisers and just hundreds of SEC
staffers to examine them, the SEC should be focusing its
attention less on funds serving sophisticated investors who are
better able to fend for themselves and more on making U.S.
capital markets more efficient and competitive, promoting small
business capital formation and protecting mom and pop
investors. Vice Chairman Hurt's sensible legislation will help
the SEC do just that.
Thank you again for the opportunity to testify today.
[The prepared statement of Mr. Gallagher can be found on
page 71 of the appendix.]
Chairman Garrett. Thank you very much.
Next, from the Center on Executive Compensation, Mr.
Timothy Bartl. Welcome. You are recognized for 5 minutes.
STATEMENT OF TIMOTHY J. BARTL, CHIEF EXECUTIVE OFFICER, CENTER
ON EXECUTIVE COMPENSATION
Mr. Bartl. Thanks, Mr. Chairman, Vice Chairman Hurt, and
Ranking Member Maloney. I appreciate the opportunity to
testify. My name is Tim Bartl and on behalf of the Center on
Executive Compensation, I am pleased to share our experience
with proxy advisory firms and to testify in favor of the Proxy
Advisory Firm Reform Act.
As I think you know, the center is a research and advocacy
organization. We represent over 125 companies and the senior
human resource officers of those companies across a broad
spectrum. And we have daily interaction with those companies
and, therefore, have firsthand knowledge of their experience
with proxy advisory firms.
You know, at the end of the day, companies seek accurate
and fair assessment of their pay programs. And when you look at
the fact that, as Congresswoman Maloney indicated, proxy
advisory firms do perform a necessary function in the proxy
advisory and the proxy voting regime.
But unfortunately the timeframe and the lack of oversight
leads to a check the box mentality that is really a poor fit
for pay programs which are individualized, complex and lengthy.
And, you know, when you look at the influence the proxy
advisory firms hold over the regime, I think it is important
that we take a look at that as we look at Congressman Duffy's
bill.
As of May 13, companies holding say on pay votes this year
who received a negative ISS recommendation, experienced a 31
percent reduction compared to the previous year for a mean
support of somewhere around 61 percent. Those receiving a
positive recommendation had an average result of 93 percent.
A 2014 center survey found that 74 percent of respondents
indicated that they had changed or adopted a compensation plan,
policy or practice in the previous 3 years primarily to meet a
proxy advisory firm policy.
And research that we cite in our testimony by Professor
Larcker, McCall and Ormazabal, suggested that the adoption in
advance of a proxy advisory firm policy actually had a negative
impact on shareholder value.
Both the Congresswoman Maloney and Mr. Chairman, you
mentioned the impact of conflicts of interest, as did
Congressman Duffy. And because proxy advisory firms are
accorded significant deference in light of their independent
status, the conflicts are a big deal and need to be addressed.
ISS, the largest and most influential firm, consults with
investor clients regarding shareholder proposals that the
investors sponsor while at the same time, making
recommendations on those same proposals to other investor
clients. This leads to the perception that ISS may favor such
proposals in making recommendations.
ISS also continues to make recommendations and provide
analysis of proxy issues to be put to a shareholder vote on the
research side of the operation, while providing consulting
services to corporations whose policies and shareholder
proposals they evaluate. And that is on the consulting side.
The aggressive marketing from the consulting side has left
impressions on several occasions that it is privy to the
information or the decisions on the research side.
And as an example, back in 2013 there was a company that
was contacted by an ISS consulting representative after the
company received a negative ISS recommendation that had a low
say on pay vote, around 68 percent.
In an email to the company, the representative said that
she would provide the company with a better understanding of
the reasons for ISS' negative vote recommendation and what to
expect in terms of additional scrutiny from ISS' research side
in the next year.
After a call was set up, during the call, the
representative indicated that the information provided by the
consulting side was not available elsewhere and that the
success of companies that had engaged with the consulting side
were over 90 percent because of its knowledge of the research
side.
At the SEC roundtable, even Gary Retelny, ISS' president,
indicated that he was disappointed with the approach the
representative had taken. But it indicates the leverage.
In addition to operational conflicts, there are also
ownership conflicts. We have talked in this committee before
about this, in the subcommittee. Glass Lewis is owned by the
$170 billion Ontario Teachers' Pension Plan Board, which
engages in public and private equity investments in which Glass
Lewis makes recommendations.
And in addition to that, there are issues around errors and
inaccuracies. And a 2014 center survey I cited earlier
indicated that a final report had one or more errors.
Mr. Chairman, as I conclude, we believe that a more formal
and appropriate regulatory regime, such as that included in the
Proxy Advisory Firm Reform Act would help address the conflicts
of interest. And we have seen before that where there has been
specific oversight of the regime and of the issues, it has had
an impact on the conduct of proxy advisory firms.
And I would be happy to talk more about that during the
question and answer period. But we believe that the structure
is definitely worth considering and a worthwhile initiative.
Thank you for the opportunity to testify, and I look forward to
your questions.
[The prepared statement of Mr. Bartl can be found on page
48 of the appendix.]
Chairman Garrett. Thank you.
Next up, from the Vermont Law School, Professor Taub.
Welcome. You are recognized for 5 minutes.
STATEMENT OF JENNIFER TAUB, PROFESSOR OF LAW, VERMONT LAW
SCHOOL
Ms. Taub. Chairman Garrett, Ranking Member Maloney, and
distinguished members of this subcommittee, thank you for this
opportunity to testify today. My name is Jennifer Taub. I am a
professor at Vermont Law School, where I teach business law
classes, including corporations and securities regulation.
Before joining academia, I was an associate general counsel
at Fidelity Investments. I offer my testimony today solely as
an academic and not on behalf of any other association.
In this brief opening statement, I will highlight the
concerns that I have with each bill. For a more comprehensive
exposition, I would refer you to my written testimony.
First, the Investment Advisers Modernization Act allows
private funds to retreat into the shadows once again. The word
private is somewhat misleading these days. Consider that one-
quarter of the equity in private equity funds comes from public
pension retirement funds. And please recall that private funds,
including hedge funds, can now be marketed through general
solicitations to the public.
It is odd. Just when private equity funds are in the
sunlight, thanks to Dodd-Frank, and many have been exposed in
SEC examinations as in violation of the law, including for
misallocating expenses, you are now proposing that they be able
to hide their tracks.
Instead of encouraging a culture of compliance, this bill
would provide a loophole for investment advisor record keeping
requirements. Subjecting communications to confidentiality
agreements, or keeping them in house, would allow advisers to
destroy critical investment records.
This bill would also exempt all private equity fund
advisers and many hedge fund advisers from submitting a
completed Form PF. This information that would be withheld is
important to monitor for systemic risk and to protect
investors.
This bill would block the SEC from broadly banning
materially misleading statements in private fund sales
literature, including concerning fund performance. This is
backwards. The SEC should be encouraged to, not discouraged
from, making rules against fraud.
With Rule 506(c), pursuant to the JOBS Act, private funds
can now be advertised through general solicitations to the
public. Public offerings were supposed to come with
commensurate broad protections against fraud.
This bill would also weaken the SEC's ability to stop false
advertising by advisers generally, including to certain retail
investors. And it would shockingly eliminate the annual
independent audit of certain fund advisers to ensure they
actually have the assets and securities they claim to hold.
This should be called the Madoff loophole.
Next, the SEC Regulatory Accountability Act would limit the
agency's ability to protect the investing public. Prior to
issuing most regulations, the SEC would have to engage in a new
cost-benefit process. Yet the SEC already conducts economic
analysis and the securities laws already require the
consideration of the promotion of efficiency, competition and
capital formation. The SEC is already subject to the Paperwork
Reduction Act, the Regulatory Flexibility Act, the
Congressional Review Act, and the APA.
The existing requirements set out several speed bumps.
These proposed requirements are tire shredders designed to
bring progress to a crashing halt. Notably, this bill would
require the SEC to consider endless alternative approaches and
only select the one that maximizes net benefits. How could this
be measured with any precision? It can't.
As Harvard Professor John Coates notes, it is not possible
to specify and quantify all benefits and all costs in a single
uniform bottom line metric representing the net welfare effects
of a proposed rule. The results are not precise, but instead
what he calls guesstimations. What this bill mostly creates is
opportunities for litigation and legal fees to be generated.
Finally, the Proxy Advisory Reform Act represents
fraternalistic over reaching that is unnecessary and could
entrench existing firms. These firms are business success
stories. They help institutional investors cast votes on
important corporate governance matters at the portfolio
companies they own.
The SEC already has the authority to examine and discipline
any institutional investors who mindlessly follow advice
without considering their fiduciary duty to underlying
investors. And the SEC has authority under the Exchange Act and
the Advisers Act to address conflicts of interest.
Thank you for this opportunity to speak. I look forward to
your questions.
[The prepared statement of Ms. Taub can be found on page
107 of the appendix.]
Chairman Garrett. Thank you.
From the U.S. Chamber of Commerce, Mr. Quaadman, welcome
back to the panel. You are recognized for 5 minutes.
STATEMENT OF THOMAS QUAADMAN, SENIOR VICE PRESIDENT, CENTER FOR
CAPITAL MARKETS COMPETITIVENESS, U.S. CHAMBER OF COMMERCE
Mr. Quaadman. Thank you very much, Mr. Chairman, Ranking
Member Maloney, and members of the subcommittee. Thank you for
the opportunity to testify today. The SEC's domain are the
public capital markets and its mission is to promote investor
protection, competition and capital formation.
By many metrics, the SEC is missing the mark. For 19 out of
the last 20 years, we have seen a constant decline in the
number of public companies in the United States to the point
that we have fewer than half of the public companies today than
we did in 1996.
The bills that are before us today are for smart regulation
to have appropriate oversight for the benefit of investors and
the businesses that they invest in. The SEC Regulatory
Accountability Act is based upon the Executive Orders issued by
President Reagan, President Clinton, and President Obama. It
enshrines those Executive Orders into the SEC rulemaking
process.
This bill also has some very innovative means to make
rulemaking even more successful. As an example, the post-
implementation economic analysis allows for the use of precise
economic data 2 years after the rule writing to look at exactly
what the costs are, what the benefits are, if the rule is
working, and, if not, what changes need to be made to the rule.
Additionally, the mandatory look back to reassess major
rules allows the SEC to separate the wheat from the chaff. That
is, for those rules that are obsolete, to take them off the
books. Those rules that need to be tweaked should be tweaked.
And for those issues that are looming, have the SEC actually
write rules before they become a problem.
So in short, this bill is designed to impose rigor and
discipline in the rule writing process for the benefit of both
investors and businesses.
The Proxy Advisory Firm Reform Act of 2016 that has been
introduced by both Duffy and Congressman Carney is an important
step forward. Proxy advisory firms are necessary because we
have institutional investors who can invest in thousands of
companies. As has been noted, we have two firms that cover 97
percent of the market share, and they have become de facto
corporate governance regulators.
However, proxy advisory firms are also beset by many
problems. One firm has 180 analysts looking at tens of
thousands of companies globally and making recommendations in
250,000 shareholder proposals and director elections. Proxy
advisory firms have been beset by conflicts of interest and
lack of process and transparency in how they develop their vote
recommendations and voting policies. There are questions about
their error rates, as well as lack of input.
Some institutional investors use proxy advisory reports as
data points in their independent judgment of how they execute
their votes in shareholder proposals. Other investors, however,
outsource their corporate governance voting responsibilities in
total. For those investors, that becomes a difficulty in
determining how they can meet their fiduciary obligation to the
people who invest in those funds.
The 2014 SEC guidance, which was only issued as a result of
the 2013 hearing of this subcommittee, is a step in the right
direction. But this bill provides more oversight. This bill
would have proxy advisory firms create transparent processes
for the development of voting recommendations and policies. It
would allow for further disclosure and management of conflicts
of interest. And it would have the proxy advisory firms
demonstrate to the SEC that they have the resources needed to
meet their due diligence.
Furthermore, to give one example, proxy advisory firms make
recommendations on shareholder proposals when a proponent is a
client. That is no different than the problems 10, 12 years ago
with the conflicts of interest of financial analysts.
Finally, the Investment Advisor Modernization Act by
Congressman Hurt is an important step forward. The Dodd-Frank
Act requires the SEC to build transparency around private
equity firms. However, there has been a regulatory mismatch.
The SEC is imposing public company tools on private equity
partnerships. That is like using a meat cleaver when we should
be using a scalpel. The bill would allow the SEC to tailor
regulations.
So in conclusion, Mr. Chairman, we would have liked to have
seen the SEC move forward on these issues on their own.
However, we believe that, at a minimum, congressional pressure
is needed to make the SEC move forward. But if the SEC is not
willing to move forward, we look forward to working with you,
the co-sponsors and members of this subcommittee, to have these
bills become law. Thank you.
[The prepared statement of Mr. Quaadman can be found on
page 92 of the appendix.]
Chairman Garrett. All right, thank you.
And last, but not least, from Blue Wolf Capital Partners,
Mr. Cherry-Seto. You are recognized for 5 minutes.
STATEMENT OF JOSHUA CHERRY-SETO, CHIEF FINANCIAL OFFICER, BLUE
WOLF CAPITAL PARTNERS, LLC, ON BEHALF OF THE ASSOCIATION FOR
CORPORATE GROWTH
Mr. Cherry-Seto. Chairman Garrett, Ranking Member Maloney,
and members of the subcommittee, thank you for this opportunity
to testify today on important legislation that, if passed,
provides a modernized regulatory framework that is efficient
and meaningful allowing private equity advisers to continue to
focus on growing companies, providing important returns to our
investors, most importantly, working families counting on a
secure pension when they retire while helping to create jobs
now and in the future.
On a personal note, good jobs are something that I care
deeply about. As I began my career as a union organizer with
SEIU and the ability of private equity firms to be strategic
partners and investors in creating and sustaining good jobs is
what brought me to work in this industry.
My name is Joshua Cherry-Seto. And I am the chief financial
officer of Blue Wolf Capital Partners. Blue Wolf provides
investment and strategic support to good, small to mid-size
companies, often not served well by public markets because of
challenges they face.
We take seriously our fiduciary responsibility to our
investors, as stewards of their capital and managers of our
portfolio companies. We invest responsibly and believe strongly
in a culture of compliance and transparency.
I am also honored to be testifying on behalf of the
Association for Corporate Growth, a global trade association
created to drive middle market growth on Main Street, focused
on companies with revenues between $10 million and $1 billion.
The Association directly serves 90,000 M&A professionals within
the middle market. Including more than 1,000 private equity
firms like ours, which invest in local communities and help
create jobs throughout Main Street America.
Let me briefly share an example. Healthcare Laundry System
is a leading provider of hospital-grade laundry service to the
Chicago area, spanning more than 550 healthcare providers,
including more than 40 hospitals and employing more than 500
people.
Despite the firm's compelling market position, it had
challenges precluding it from raising capital from the public
markets. Blue Wolf, by working in partnership with management,
government, the employees and the multiple unions representing
them, we were able to provide capital and strategic support to
create a stronger business with more quality and stable jobs.
Having addressed these challenges, Healthcare Laundry
System was later sold to a public company, providing long-term
stability to the company and its employees. I am here today to
support the Modernization Act that would modernize the 1940 Act
so that the law better reflects the vast market and
technological and structural changes that have taken place over
the past 76 years.
Due to the 1940 Act's ambiguity in today's world, firms
like ours spend many hours and significant dollars trying to
comply with ill-fitting rules for our industry that don't
further the intent to protect investors, including on advisers
and lawyers trying to interpret regulations not specifically
written with our industry in mind.
An example of the bill's common sense approach is the
advertising rule, an outdated provision from 1961, designed for
public retail marketing. Private equity advisers advertise
exclusively to qualified sophisticated investors and already
have a robust private placement disclosure process, which
should continue to be regulated and reviewed. However, the 1940
Act did not contemplate, and could not foresee, how to regulate
technology advances such as websites.
Unlike the retail market, private equity websites are not
aimed at investors but are instead are used to more efficiently
connect with companies and management teams looking for an
investment partner. It is important to note that basic anti-
fraud provisions of the Federal securities laws would remain in
effect for all private fund advisers. Just imagine if you were
asked to operate under the House rules of 1940, restricting
communications to your constituents to the regular mail.
We recognize and value transparency, accountability to
regulators, operating in the open, but most importantly today,
we seek to update the regulatory framework to increase our
focus on growing companies on Main Street across the country.
For Blue Wolf, that means from Madawaska, Maine, to Suwanee,
Florida, to Chicago, Illinois, to Santa Barbara, California,
creating good, sustainable, American jobs.
Thank you for this time this afternoon, and I look forward
to answering your questions.
[The prepared statement of Mr. Cherry-Seto can be found on
page 66 of the appendix.]
Chairman Garrett. Thank you. The gentleman yields back. And
I thank all the members of the panel.
At this point we will turn to questions, and I will
recognize myself for 5 minutes. I guess I will start with Mr.
Gallagher. So you heard my opening comment talking about our
legislation dealing with the cost-benefit analysis and what
could be the benefit of having such an analysis. What does it
do?
It gives the opportunity or the requirement to an agency,
which is what the President basically has already asked
agencies across the spectrum to do and what the SEC has already
said they would do.
And all we are doing is now trying to do what? Codify that
and say going forward you always have to do it, to look at
every angle, if you will, every permutation, see what can be
the benefits and the consequences of a rule. And that is all
well and good, but there is another angle to this I want you
get into if you can, joint rulemaking.
So we have seen some joint rule making for the various
agencies in the past. Most notably is in the area of the
Volcker Rule. And when that is done, you have various agencies
doing it. When that was done, SEC looked at analysis. Other
agencies look at it and some don't.
Talk about if this legislation were to pass, or had been
passed, what would be an effect on joint rulemaking? Could the
agency get out of it or what happens?
Mr. Gallagher. Well, thank you for the question, Mr.
Chairman. In practical effect, the legislation, as you point
out, because it would make years of guidance and disparate
regulatory and legislative requirements binding in the U.S.
Code, I think it would cause the SEC, in the context, let us
use the Volcker Rule, since you mentioned it, to actually not
be able to lawyer the situation in a way that I cautioned in my
opening comments.
And so, as you might recall in the Volcker Rule, the
Volcker Rule was promulgated even by the Securities and
Exchange Commission under the Bank Holding Company Act, not the
Securities and Exchange Act of 1934.
Chairman Garrett. Okay.
Mr. Gallagher. So the various disparate legislative
requirements, you know, in the Exchange Act, the APA,
everything else, didn't apply because the lawyers determined
that pursuant to the Dodd-Frank mandate on the Volcker Rule
that it was legal and permissible for the agency to promulgate
the rule--
Chairman Garrett. So I guess I want to be clear, and I will
go to Mr. Quaadman, if you want to jump in here. If we have
this law now and you go into a joint rulemaking territory, and
the SEC has to do it--I will throw it at Mr. Quaadman.
Would you say that the SEC has the--they would do the joint
rulemaking, but would they have the--they would do the
analysis. Would they have the ability basically to stop the
joint rule from going forward then?
Mr. Quaadman. No. So in fact, we have a situation right now
with the Incentive Comp Rules, which are being released, where
you have five agencies that have not done any sort of analysis
and the SEC has.
I think also, to Commissioner Gallagher's point with the
Volcker Rule, no agency did an economic analysis with the
Volcker Rule. So what we have now are markets where we have
liquidity stresses, which should have been picked up in the
economic analysis of that rulemaking.
Chairman Garrett. Did you have a last point on that?
Mr. Gallagher. Yes, I think, so basically this stand-alone
statutory requirement would not allow the commission to seek
rulemaking authority other than the Federal securities laws.
And so where the Bank Holding Company Act did not require cost-
benefit analysis, an economic analysis, this standalone would
force them to do it, even in the context of Volcker.
And just one little small point, too--
Chairman Garrett. Yes, sir.
Mr. Gallagher. --just so this committee knows to keep an
eye on this. The commission still needs to promulgate a rule to
make the Volcker Rule enforceable under the Federal securities
laws under the Exchange Act.
Chairman Garrett. Yes.
Mr. Gallagher. Now, that would change the baseline of the
economic analysis when they conduct that rulemaking because the
Volcker Rule exists today. If they had done that back in 2013,
it would not have existed, so the baseline for the economic
analysis would have been much different than what you are going
to get whenever this rulemaking happens.
Chairman Garrett. Right. And I only have a minute left to
hit 10 more questions. So one question is, so oftentimes the
charges that we are trying to do is undo regulations or undo
rules or peel things back. If you do a cost benefit analysis,
is that really the case?
Or really what you are doing--I will throw it to Mr.
Quaadman again. Is that really what you are doing or you are
trying to get the most efficient, cost-effective approach and
if helping both the industry and investors, or what have you,
but also the agency itself to most perform effectively?
Mr. Quaadman. Yes. No. And I think what your bill does, it
does in two ways, right? One is not only during the rulemaking
process do you actually get a sense of what the potential costs
and benefits are, and then figuring out the right way to get at
the objective of the rule. But then when you take a look at it
2 years post-implementation, you are actually looking at real
numbers that will allow you to get to the point of if the rule
is working or how you need to change it.
Chairman Garrett. Okay. I have a whole bunch of questions
on proxy advisers and I am not going to go over my time. Maybe
we will circle back.
With due deference to the other Members here, I now yield 5
minutes to the gentlelady from New York.
Mrs. Maloney. Okay. Thank you.
Professor Taub, I would like to ask you about the private
equity bill. You noted in your testimony the bill amends the
books and records rule, which requires investment advisers to
keep key records of transactions they execute for their clients
as well as investment decisions.
The bill would provide a broad exemption to the books and
records rule. And I am concerned about how that could affect
the SEC's ability to examine investment advisers and ensure
that they are complying with the law. Can you discuss a little
bit more why the books and records rule is important, and
whether the bill's exemptions to the rule are too broad?
Ms. Taub. Thank you. That is a really great question. So
the recordkeeping requirements are basic business records, as
you have noted. And it includes things like investment advice
given. And it includes the way that it would interfere with the
SEC's ability to do examinations is that if these
communications between employees--they could be communicating
by email or they could be communicating in writing concerning
transactions that could now be destroyed, for example.
Or even external communications, as long as they were
subject to confidentiality agreement, there would be no record
of those. And in the first examinations of, for example,
private equity funds that began in 2012 resulted, by mid-2014,
there were about 150 of the firms examined and over half of
them there were either legal problems or problems with
controls.
And the SEC found mostly problems with expense allocation
and also problems with fee disclosure. And all of that, to be
able to discover whether there has been one story told to the
investor and a different story communicated in-house, you
actually need those records. And this would permit those
records to be destroyed.
Mrs. Maloney. Okay. You also stated in your testimony that
the private equity bill's exemption to the custody rule should
be called a ``Madoff loophole.'' Could you elaborate more? How
would this exemption have helped Bernie Madoff?
Ms. Taub. The reason why I called that the Madoff loophole
is because I was recently rereading the Diana Henriques
wonderful book called, ``Wizard of Lies'' about Bernie Madoff.
And one of the things that folks failed to check is actually
see if the assets and securities he claimed to have were truly
there.
And in this bill, there are exemptions from what is now
required by the SEC, which is an annual surprise audit. So you
have an independent audit firm, doesn't tell you they are
coming in. They are supposed to come in and see if you actually
have your clients' money. And in securities it seems like a
very sensible thing.
And the carve-out in this legislation--the reason why I am
calling it the Bernie Madoff--the carve out is if you only run
money, you manage money and assets for family members, and
there is a whole long list. And one is for investors you have a
relationship with.
And if you think about Bernie Madoff and other folks, there
is this affinity fraud. The definition of who you have a
relationship with. These are all built on relationships. It is
far too broad.
And moreover, I don't see why anyone would object to--why
any honest investment adviser would not want to assure their
investors that their money is actually there. So it is an
invitation. It is basically tying the SEC's hands, and it is an
invitation for fraud to flourish in the shadows.
Mrs. Maloney. Thank you.
Mr. Quaadman, I would like to ask you about proxy advisers.
And I understand that there is still disagreement in the
academic literature about the influence of these advisers. Some
studies find them very influential while more recent studies
find that their influence is limited, and even declining.
Some of the biggest asset managers tell me that they use
proxy advisers primarily for their centralized data management
on all of the shareholder meetings and to help them actually
cast the thousands of votes that they have to cast every year
and not as much for their vote recommendations.
So I would like to ask you, first, how do you respond to
the studies that show that proxy advisers aren't very
influential anymore? And secondly, if proxy advisers' vote
recommendations are less influential than they were a decade
ago, is there still a need for aggressive oversight of these
firms?
Mr. Quaadman. Yes. Let me answer that in a couple of
different ways, Congresswoman. Number one, you have the Ertimur
study out of the University of Colorado, which shows that ISS
and Glass Lewis control about 36, 37 percent of the vote.
You have the Larcker study, which shows that the ISS
recommendations are not necessarily geared towards better
economic return.
And just lastly, I spoke to a CEO last year who received a
negative recommendation on a comp plan, and 33 percent of the
shares were voted within 24 hours of ISS and the Glass Lewis
recommendations. And 90 percent of those shares were voted
against the company. I think that, in and of itself, shows that
they are still pretty influential.
Chairman Garrett. Thank you. The gentleman yields back.
The vice chairman of the subcommittee, Mr. Hurt, is
recognized for 5 minutes.
Mr. Hurt. Thank you, Mr. Chairman. I had a question for Mr.
Cherry-Seto and hopefully be able to get to Mr. Quaadman and
Mr. Gallagher.
But I wanted to begin with you, Mr. Cherry-Seto. You are
the CFO of Blue Wolf Capital Partners, is that right? And
obviously, your firm has to engage in a lot of compliance with
regulatory agencies. Is that correct?
Mr. Cherry-Seto. That is right.
Mr. Hurt. You take--is that expensive?
Mr. Cherry-Seto. It definitely takes a lot of time and
attention.
Mr. Hurt. And it is time-consuming?
Mr. Cherry-Seto. Yes.
Mr. Hurt. Do you take it seriously?
Mr. Cherry-Seto. At all levels of the organization.
Mr. Hurt. Do you think that the SEC's responsibility for
investor protection is important?
Mr. Cherry-Seto. Absolutely.
Mr. Hurt. And do you all take that seriously?
Mr. Cherry-Seto. Absolutely.
Mr. Hurt. I guess my question really deals with a couple of
things that Professor Taub said. You touched, in your testimony
about the advertising rule and the necessary change that this
bill would bring to that rule.
But I was wondering if you could talk a little bit about
the custody rule and the recordkeeping and the Form PF? And A,
do these changes, these proposed changes, in any way jeopardize
investor protection? And B, if they do not, how do they help
your company or your firm and the employees that they hire?
Mr. Cherry-Seto. Let me try to take a stab at the books and
records piece of this legislation. Part of the issue here is
that engagement with the industry is important so that we can
figure out how to come up with regulations that are common
sense with the way that the industry operates.
In the case of books and records, I think the intent of
that section is really talking about keeping records of
investment advice. When the laws were made, it was very clear
what you meant by investment advice.
If you engage a broker and that broker comes to you and
says, ``I think you should buy this stock,'' they have made an
investment recommendation to you. And then the SEC could say,
well, let me look behind and see what the research was for them
making that recommendation.
In the private funds space, you have engaged a private fund
manager like Blue Wolf to work on your behalf to make
investments. In this case, we are not coming back to the
investors every time we are looking to invest in a company.
We are doing that in our own governance structures where
there may be an advisory committee of L.P.s that help look
over. But on a day by day basis, we are making recommendations
to our investment committee, which is within the firm, on
investments that should be made.
I think what this legislation is trying to address is that
in the course of doing work, we look at all sorts of
investments, many of which don't get consummated. Those
investments that don't get consummated are most of the
recordkeeping that we are talking about. And where is the
investment advice in a prospective investment that never
happened?
Mr. Hurt. And what does that have to do with investor
protection?
Mr. Cherry-Seto. Well, if the investment is not made, I
don't think it is really doing much to protect investors. If an
investment is made in a portfolio company, we do have an
obligation to keep the investment committee minutes, the
information around the investment committee, the investment
committee memos that are put together to support an investment.
But there are many, many more investments that never make it
that far.
Mr. Hurt. Okay.
Mr. Gallagher, from your time at the SEC, I would imagine
that you have--and I know that you have struggled with a lot of
the things that these firms have to go through now that they
have to register.
I guess my question is, Ms. Taub couches this as an either/
or thing and investment protection is at odds necessary with
capital formation. And I guess my question is is does it have
to be that way? Aren't there ways to promote capital formation
and at the very same time maintain investor protection?
Mr. Gallagher. Absolutely, Congressman. In fact, you know,
one might look at it and say, as I used to when I was on the
commission, promoting capital formation is increasing investor
opportunity and and the ability to choose service providers,
the ability to choose products that otherwise wouldn't exist,
which is good for the overall economy.
But really good for investors and creates more competitive
market in which, you know, the malfeasors might not succeed.
Because there is real competition.
And so there is a natural regulatory inclination to reduce
opportunity to protect, a very nanny state-like instinct, in
the regulatory agencies these days to reduce opportunity. And I
think that is the actual detriment and a loss of protection for
investors.
Mr. Hurt. Thank you. I yield back.
Chairman Garrett. The gentleman yields back.
Mr. Scott, you are recognized for 5 minutes.
Mr. Scott. All right. Thank you, Mr. Chairman. Very good
hearing. It seems to me that these bills are sort of put
forward to maybe spur a greater concern with the SEC to move
faster in doing its job. However, I have a couple of pertinent
questions that go to this point.
Back in 2010, for example, there was a staff report from
the Federal Reserve Board of New York that argued, and I quote:
``Along the chain of intermediaries in the shadow banking
system, the weakest link in that chain is the pinch point that
can destabilize the entire chain.''
Now when that staff report was released in 2010, we were on
this committee, finishing up passing Dodd-Frank. And one of
Dodd-Frank's main objectives was to fill the regulatory gap
that was created by this shadow banking system thereby making
our chain stronger.
And to that end--and I was a co-sponsor of the Dodd-Frank
bill. We were working on the bill. And at that point, we made
sure that Dodd-Frank brought private fund advisers with more
than $150 million in assets under management out from the
shadows and into the bright light of the oversight of the
Securities and Exchange Commission.
So my question is, given all that we have done, what
evidence do we have today to suggest that now is the right time
to loosen the SEC's grip? Any one of you.
Ms. Taub. I would be happy to respond to that. And I have
read that report. But first, I do want to respond to something
that Mr. Hurt said, suggesting that in my testimony I stated
that investor protection was at odds with capital formation. In
fact, I have always stated the opposite.
And my written testimony indicates that they actually are
perfectly aligned. And that it is trust in our financial
markets that encourages people to invest and actually can
decrease the cost of capital because there can be a premium on
capital if you think someone is going to cheat you.
But back to the question about shadow banking and Dodd-
Frank and how this bill could affect that. In particular, the
provision in the bill that would allow private equity firms and
some hedge funds to no longer complete Form PF, I think it is
very important.
The Form PF, as you know, is provided to the SEC
confidentially and access is given to the Financial Stability
Oversight Council. And these data have only started, has only
been collected since 2011. And getting a picture of the
behaviors in broader market is really important.
And the part of the form we are talking about is Section
Four, for the private equity firms. And it provides important
information related to leverage and counterparty risk and also
geographic and industry breakdown. And the importance of
knowing about, obviously, leverage is a key factor in the
financial crisis, but counterparty risk is important because of
the links that you are talking about.
The second thing, though, that goes really to the heart of
shadow banking is Section 1(c). This is a part that is only
filled out by hedge funds. If this bill were to pass, hedge
fund advisers with between $150 million and $1.5 billion assets
under management wouldn't--
Mr. Scott. I have only--
Ms. Taub. Yes.
Mr. Scott. Sorry to interrupt you, but I have--
Ms. Taub. It is okay.
Mr. Scott. Appreciate that response, but I did have one
other question I wanted to get in concerning Mr. Garrett's bill
because I have a belief and support a cost-benefit analysis.
But I do what to raise the issue because back in, I think,
around 2013, SEC Chair Mary Jo White said that she was
conducting economic analysis.
And I would just like to clarify your statement, Mr.
Gallagher, because it goes to the point that the chairwoman of
the SEC made that perhaps Mr. Garrett's legislation would
hamper the SEC's ability to do rulemaking in a timely manner. I
wanted to get you on the record to please explain that. At
least give some response to the chairlady's concerns of the
SEC.
Mr. Gallagher. Sure. Thank you for the question,
Congressman Scott. I am an end user of economic analysis. I
have gone through many rule-makings, mostly Dodd-Frank related,
over the last several years. Economic analysis has never once
slowed down the process.
In fact, my experience is that it speeds up the process
because it provides decision points and optionality for
policymakers like myself who need to vote on these rules where
you otherwise wouldn't have it. Where it would be one size fits
all.
It lends itself to negotiation. There were several Title
VII rules on derivatives. My first year in 2012, that but for
the economic analysis, we would have had split votes of the
commission. Instead, we got 5-0 votes. And we got them in a
timely manner.
So I think this bill is actually, to Chairman Garrett's
original point, only incremental in its burden on the agency
over what the agency's committed to in 2012. What it does is,
it clarifies and codifies, which is incredibly important, in a
standalone way, these obligations that the agency has mostly
already committed to. So I think it is a very positive step.
Chairman Garrett. The gentleman's time--
Mr. Scott. You do understand Chairwoman White's concerns
are legitimate? I just want a yes or no on that.
Mr. Gallagher. When you run the agency, you are always
worried about pressure to get things done, running the agency.
The chairman has so many other duties than the other
commissioners so any other imposition, any other mandate coming
from Congress right now, if you are trying to run the SEC, I
can see it would be a burden in her eyes. But I don't think
this is a real material one at all.
Mr. Scott. Okay. Thank you, Mr. Chairman.
Chairman Garrett. Thank you both.
The gentleman from Texas is now recognized.
Mr. Neugebauer. Thank you, Mr. Chairman.
Mr. Cherry-Seto, do you believe that private equity funds
represent a systemic risk?
Mr. Cherry-Seto. Do I personally feel that they are--
Mr. Neugebauer. Yes.
Mr. Cherry-Seto. I wouldn't say that I was an expert on the
matter, but there have been a number of folks that I think are
better messengers than me have said that that is not the case.
Mr. Neugebauer. Do you think that private equity firms had
any cause to the financial crisis that we had in 2008?
Mr. Cherry-Seto. I don't think I am an expert to speak on
that. But I would say that a lot of private equity firms,
especially small ones, look much smaller than any holding
company. You have the holding company that happens to not be
run by a private equity firm, is either privately held or
public, that are much larger than our firm.
I mean, our firm is fairly typical for the middle market.
There are thousands of firms of our size, manage under a half
billion of capital. We have majority interest in 10 or 12
companies.
Mr. Neugebauer. So I think one of the things I want you to
do is maybe explain who is a typical client of a private equity
company?
Mr. Cherry-Seto. Here often pension funds are big investors
in private equity assets.
Mr. Neugebauer. So they are sophisticated investors. Is
that right?
Mr. Cherry-Seto. They are definitely investors that have
access to legal support. Most of them have advisers, that this
is the only business they advise on, not only for investments,
but specifically on alternatives in the private equity market,
very sophisticated advisers.
Mr. Neugebauer. Mr. Gallagher, would you concur that--what
is your position? Do you think that private equity companies
are a systemic risk?
Mr. Gallagher. Absolutely not.
Mr. Neugebauer. And you don't think they had anything to do
with causing the crisis?
Mr. Gallagher. Absolutely not. I think they got swept up
into Title IV. Lord knows why. I wasn't here for that process,
and I don't think the regime fits the business model.
Mr. Neugebauer. And the President signed an executive
order, 13579, which requires an independent regulatory agency
to perform an analysis of rules that are ``ineffective,
insufficient, excessively burdensome, and to modify, streamline
and repeal them in accordance to what they have learned.''
While you were commissioner at the SEC, were you aware
whether the SEC took part of any kind of analysis like that to
comply with Executive Order 13579?
Mr. Gallagher. No. Unfortunately, Congressman, it never
happened. There was a lot of talk about it, but it never
happened.
Mr. Neugebauer. Why do you think that was?
Mr. Gallagher. Well, it was a very regulatory time during
my tenure on the commission, and the emphasis was on
promulgating rules, not reviewing them, not writing them off
the rulebooks.
Mr. Neugebauer. In your testimony I think you said that SEC
was ``constantly bombarded with pressure from special interest
priorities.'' Could you describe some of the examples of what
you see as SEC's missteps in terms of setting its own
priorities?
Mr. Gallagher. Look, it is since 2010, since Dodd-Frank
when the SEC was mandated by Congress to conduct roughly 100
rulemakings, studies and the like, the agenda has effectively
gotten away from the agency. As you well know, a lot of those
mandates had 2-year timeframes.
Here we are. It will be 6 years I believe here in July
since the enactment of Dodd-Frank and the agency still has
roughly 35, 40 percent of the final rulemakings to do.
So that the rulemaking agenda has been dominated by Dodd-
Frank and, you know, I think within the Dodd-Frank mandates is
where I often squabbled with my colleagues on the commission.
Prioritizing those mandates I thought were askew.
The best evidence of which is that my first 10 months on
the commission a quarter of my time was spent on Sections 1502
and 1504 of Dodd-Frank, conflict mineral disclosure and
extractive resource disclosure when here we sit today and the
Title VII, derivatives rulemakings, remain unfinished.
Mr. Neugebauer. But you talk about the external, I guess,
special interest priorities. Do you think that was influencing
more of the agenda or are they trying to knock out some of the
Dodd-Frank?
Mr. Gallagher. Congressman, I think the squeaky wheels got
a lot of the grease. So, you know, the 1502 rulemaking here,
again, is instructive. That was why did I spend 20, 25 percent
of my first 10 months on it? Because it was a steady parade of
special interest groups on all sides of the aisle, pro, for,
you know, and against the rule coming in to meet with us and
push this to the front of the agenda.
The 1502, you know, accept the wisdom of Congress. This was
something that had to be done. It is the law of the land.
Someone needed to realize that it was not going to happen. You
know, that these 100 mandates were not going to be completed
within 2, 3 years, and 1502 should have been at the end of the
pile not at the beginning.
Mr. Neugebauer. I thank the gentleman.
I yield back.
Chairman Garrett. The gentleman from Connecticut is
recognized for 5 minutes.
Mr. Himes. Thank you, Mr. Chairman.
I would love to just direct a few questions to Professor
Taub and by way of background, I worked with Mr. Hurt on a bill
a number of years ago that would have provided exemptions from
registration to larger and more leveraged private funds.
And at the time the theory was that they are not
systemically dangerous, which I happen to continue to believe.
And that limited partners in these funds as sophisticated
investors don't require quite the same oversight and assistance
that retail investors do.
I look back on that with some ambivalence because I still
think that those two things are true, but obviously the SEC
used the filing of Form PF to identify a not inconsequential
amount of skullduggery with respect to fees, conflicts of
interests.
And many of their exams resulted in some disclosures that
were really pretty uncomfortable for the way limited partners
in these funds were treated. So I approach these questions with
ambivalence.
I continue to believe, Professor Taub, that a private fund
is not the same as a mutual fund. They tend to hold private
securities as opposed to public securities. They tend to deal
with sophisticated investors.
So I am wondering if we can drill in, and as you look at
the elements of the proposed Hurt legislation here, I am really
interested in your opinion because I think your critique was
pretty good. But is everything in here a bad idea?
I mean, let me just rattle off a couple to get your
hopefully quick opinion on. You know, the delivery of brochures
to clients, that exemption would apply only if a prospectus had
been delivered. So I am wondering should I be concerned about
that?
The exemption from annual independent audits and surprise
examinations is only in the case of limited partners that are
insiders, family members, family offices. You are shaking your
head. I will give you a chance because I am asking this
honestly. I am not making a rhetorical point here.
And, you know, on the client notification on consent to
ownership changes, that strikes me as sort of administrative in
nature. So I do, Professor Taub, want to give you the
opportunity. Is everything in this bill a bad idea or is it
possible that some of these things, including what I have just
listed is in fact a tailoring of legislation to the fact that
private funds are not in fact mutual funds?
Ms. Taub. Thanks so much, Congressman. I appreciate those
questions. I want to answer it but you also made a comment
which I thought was interesting about sophisticated investors.
And I did write a paper entitled, ``The Sophisticated Investor
in the Global Financial Crisis.''
And what is interesting is, I am sorry to bring up Bernard
Madoff again, but if you think about a lot of his money came
through feeder funds. And the feeder funds were giant,
sophisticated investors, so themselves.
These were a fund-to-fund structure. So if a sophisticated
investor is being lied to and provided false information I am
not exactly sure how that benefits capital formation. But
seriously, I think--
Mr. Himes. I don't want to cut you off. Look, I don't think
we can build an entire regulatory structure around a Madoff
possibility. Obviously Madoff undertook a lot of very illegal
activity, but I really am interested in--
Ms. Taub. Yes.
Mr. Himes. --whether your opinion is in particular those
three areas that I highlighted. Is this a collection of totally
bad ideas? Or am I right that some of these things actually may
be fairly reasonable tweaks to the regulations?
Ms. Taub. Well, quickly since you mentioned the brochure,
the brochure is basically part two of this Form ADV that has to
be filed. And the reason why it is still important even if a
prospectus has been given, is that it is written in plain
language. It has to be updated. And in this brochure the
advisor has to disclose if there has ever been any disciplinary
actions.
Listen, there are so many good--
Mr. Himes. Does that not have to be disclosed in a
prospectus though?
Ms. Taub. It would have to--no, because if a disciplinary
action happened after the--not the prospectus, but the offering
document, that it would not have appeared. So if they get in
trouble I think--like I said, there are so many good advisors.
Why shouldn't there be a fair playing field and those that do
have disciplinary actions disclose that?
The thing with custody is it is not just for firms that
only have the limited partners. It is family members. It is
anyone who has a relationship. And the term ``relationship''
can--it is is not defined. So that is of concern.
So I, you know, if you wanted to go line by line I would be
happy to define, you know, something in here that I didn't find
troubling. I only highlighted the things that struck me as
problematic. Thanks.
Mr. Himes. Okay. Thank you. Let me ask one last question in
my limited time. It does seem that Form PF did, and I will look
at the whole panel on this, give the SEC some information that
it used to find some troublesome behavior with respect to fees
in particular and conflicts of interest.
Professor Taub cites in her testimony the work of a
Professor Coll who--
Chairman Garrett. Do you have a question before your time?
Mr. Himes. --had a $10,000 cost associated with Form PF.
Does the panel disagree that Form PF in and of itself is not
outrageously burdensome?
Mr. Gallagher. I don't think that these fee issues were
discovered through PF if that is my recollection. It was a
regular way examination by SEC examiners of the books and
records of the advisor. PF is wholly separate information to be
provided for systemic--
Mr. Himes. So we are back to the independent audits and
surprise audits. Is that what--
Chairman Garrett. The gentleman's time has--
Mr. Gallagher. It is regular audits. PF doesn't make any
sense for private equity.
Mr. Himes. Okay.
Chairman Garrett. The time has expired.
Mr. Himes. Thank you, Mr. Chairman.
Chairman Garrett. Yes.
Mrs. Wagner?
Mrs. Wagner. Thank you, Mr. Chairman, and thank you all for
joining us today for this important hearing and discussion on
reforms we can introduce at the SEC in order to make sure that
capital is allocated as efficiently as possible and that
shareholder value is prioritized.
Increasingly we have seen government get in the way of our
capital markets and the ability of public companies to grow and
expand their business on behalf of their employees and
shareholders. For small companies that are continuing to expand
and grow, this often results in them staying private longer
than deal with extraneous issues of being a public company,
especially when the cost of going public is estimated to be
$2.5 million at first with continuing annual costs of $1.5
million.
Mr. Quaadman, welcome back. Good to see you. In your
testimony you note that, and I quote: ``For 19 of the last 20
years we have seen a number of public companies decline. We now
have fewer than half of the public companies than we did in
1996.'' Could you please explain why you think that this has
occurred?
Mr. Quaadman. I think you put your finger on one of the
reasons in terms of the IPOs and difficulty there. The other,
quite frankly, is what is called the Michael Bell problem,
where you have an entity that is a public company that is faced
with a lot of these costs, burdens, and the annual fights that
they have to go through in terms of shareholder proposal and
director elections.
And that takes up so much time and effort that--
Mrs. Wagner. Mm-hmm.
Mr. Quaadman. --management actually begins to move away
from managing the corporation for the long term. So there you
actually had a company that decided to go from public to
private, and Michael Bell said he would never operate a public
company again because he would rather manage the company than
having to deal with these fights.
So I think if we had, you know, as an example with the
proxy advisory firms, if we had more oversight there and we had
openness and transparency that we expect in other areas, that
might alleviate things. But we do not have a hospitable
environment either to create or remain a public company in the
United States.
Mrs. Wagner. Well, moving off of that and expanding a
little bit there, for small companies that are looking to go
public, they have to see all of these pressures that you have
talked a little bit about here briefly that they will encounter
from activists and battles on proxy votes that promote
priorities.
And this is my biggest concern. They promote priorities
that have nothing to do with long-term--
Mr. Quaadman. Yes.
Mrs. Wagner. --shareholder value. How much of a
disincentive does this make for those small businesses that are
looking at going public and how can we improve, outside of what
you mentioned vis-a-vis oversight, this corporate governance
climate, so to speak?
Mr. Quaadman. Yes. I think we can spend a whole day
answering that one question. Number one, I think just creating
the small business advocate, which this subcommittee has been
in the lead on, is really important to get a voice for capital
formation and competition in the SEC, one.
Two, I think it is really important, not only that we get
more oversight, but that we have more emphasis on what we need
to do in terms of capital formation. So, if we take a look at
it and we have a very diverse capital system, we need to have
private equity but we also need to have public companies.
So in order to deal with, let us say, proxy advisory
issues, that is a very important thing to deal with because
companies just will not decide to go public because of issues
like that. In fact, if you go to Silicon Valley, the two
reasons why they will tell you they will not go public, one,
are proxy advisory firms.
Mrs. Wagner. Right.
Mr. Quaadman. Two is the internal control costs placed on
them by the PCAOB.
Mrs. Wagner. Okay. Okay. Let me move on. Mr. Quaadman,
thank you very, very much.
Mr. Gallagher, good to see you again. I am increasingly
concerned that shareholders' interests are not truly being
represented by this proxy system. How has the current
complexity of the proxy system contributed to inaccuracies in
the processing and reporting of proxy votes?
Mr. Gallagher. Congresswoman, I have heard over the years
anecdotally so many stories of failings on the part of the
proxy advisory firms, whether they be bad recommendations or,
you know, mechanical issues and the like. And that is one of
the reasons I got so inspired to pay attention to the issue.
As a commissioner you often act as an ombudsman for
complaints and the like. And so--
Mrs. Wagner. In my limited time, Mr. Gallagher, is there
any way we can simplify the system to make it more beneficial
for the owners and I should say on behalf of the owners for the
intermediaries? When was the last time that we did something
like this?
Mr. Gallagher. You know, I think it is about time that
Congress take a look at what I had called as a commissioner of
the Federalization of corporate governance.
Mrs. Wagner. Right.
Mr. Gallagher. Find the touch points where the Federal
Government has been inserted to which otherwise is a state law
system dominated by Delaware in particular, and decide does it
make sense? 14(a)(8) shareholder proposal rule is out of
control and needs to be revisited. If not the SEC then it
should be this Congress. You know--
Mrs. Wagner. It is past time that we update the process.
Mr. Gallagher. It is past time and there are these touch
points. And I do favor--
Mrs. Wagner. All right. Thank you very much. I am out of
time. I yield back, Mr. Chairman.
Chairman Garrett. The gentlelady yields back.
The gentleman from California is recognized.
Mr. Sherman. Okay. A couple comments on proxy advice. I
think it is an attack on capitalism to tell investors that it
is virtually illegal for them to consider anything other than
earnings per share in making their investments. That they are
silly or that they are not to be given the information they
want.
And if investors want to prevent companies from investing
in Iran, if they want to be interested in the political
contributions that are made with their money, if they want to
avoid their companies or at least know how their companies are
engaged in blood diamonds and conflict minerals, that investors
have a right to that information. And they have a right to even
vote on whether the company should engage in those activities
or not.
And to say that investors must only consider earnings per
share is to say that the investor doesn't own their own money;
cannot make decisions that reflect their own values.
So I would say I believe in openness and transparency with
proxy advisory firms, but not if the purpose is to prevent
openness and transparency by the operating companies which
solicit those proxies. And likewise openness and transparency
includes a real audit that we can rely upon that includes many
times internal controls.
Commissioner or Former Commissioner Gallagher, I want to
direct your attention to the bill to deal with the NMS. We have
that playing an important role in SEC regulation of the
exchanges. The exchanges on the one hand are a regulator.
On the other hand they are market participants. They are
for-profit companies who derive most of their money to making
sure that some investors know about what is going on a
microsecond before other investors know what is going on. So
they are profit-driven and they are in favor of transparency
but some are more entitled to transparency a millisecond before
others.
The NMS includes the exchanges but doesn't include other
industry participants such as the consumers of the exchange
service, namely the brokers, and also the asset managers, those
on the buy side. Does it make sense from the NMS plan to
include folks other than the exchanges themselves?
Mr. Gallagher. Well, thank you for the question,
Congressman. As a commissioner I heard lots of complaints on
both sides of this debate. You had the brokers come in in
particular complaining that they didn't have a real voice or
ability to impact the direction of NMS plan participants. I
heard from the exchanges making the exact counterpoint.
Without sitting in these rooms, you know, during the plan
debates it was hard for me to actually decide where the truth
lied. And I know that this committee and, you know, others in
Congress are interested in this issue.
If there is legislation I think it is appropriate actually
for Congress to weigh in. This all derives, of course from the
1975 Act amendments.
Mr. Sherman. I would point out that certainly if you are
going to have an advisory board to a public utilities
commission you include people who represent the consumers
including the very large consumers of the utility services, not
just the utilities themselves.
Mr. Cherry-Seto, there is the bill to change the Form PF to
provide some information on the companies. Mr. Himes points out
that Form PFs have disclosed certain things about fees. I will
point out, though, when it comes to Madoff everything was filed
with the SEC and they didn't do anything with it.
Mr. Cherry-Seto. Right.
Mr. Sherman. So does it make sense--our purpose here is to
focus--I mean, the reason we passed this was to deal with
systemic effects, not to protect, although we always want to
protect individual investors and we should have a comprehensive
scheme for doing that.
Do the prudential regulators need all the information on
that form? And is private equity, dealing with private equity
part of dealing with systemic risk?
Mr. Cherry-Seto. I think in the case of Form PF there is
definitely additional information in there. Its primary purpose
is to look at systematic risk and that is the lens that one
should use to look at the information there.
But I would like to point out this legislation is not
looking to exempt anyone from today reporting Form PF. If this
was passed, no advisors would have an exemption from reporting
Form PF. This is looking at information like you mentioned that
is maybe trying to get at the question of systematic risk, and
it doesn't serve a purpose for investors.
You look at the private market, I mean, I would also go
back to, like, the custody rule. Like when we talked about
delivering the brochure to our clients, keep in mind that a
client in this context is not what was originally meant when
they look at delivering to clients. The client is the fund
itself.
So technically the bill is saying you need to deliver the
brochure to your fund. And when people want to do that,
technically follow that rule they save it on their network
because they delivered it to themselves.
Mr. Sherman. Hmm.
Mr. Cherry-Seto. That is what they are talking about
delivering a brochure. And the brochure is extremely important
in this case and here we are just saying that it should only be
updated when there is a material change. If there are material
changes you still need to update your brochure.
Mr. Sherman. Thank you.
Chairman Garrett. Thank you.
Mr. Hill is recognized for 5 minutes.
Mr. Hill. Thank you, Mr. Chairman. I appreciate you and the
ranking member holding this important hearing on these issues.
Mr. Quaadman, as you know, last October the Department of
Labor released an interpretive bulletin for economically
targeted investments and investment strategies environmental,
social and governance factors, which now allows these factors
and collateral benefits to be considered when selecting an
investment in an ERISA plan.
Now, it is been kind of 3 decades in the study of and the
participation in the asset management industry, and I have read
the document and it is very, very carefully worded. But I still
am concerned that this guidance undermines ERISA's mandate that
plan assets are invested solely in the interest of plan
participants and that these factors, other factors might take
precedent an deviate from maximizing returns for beneficiaries.
In passing ERISA, Congress chose specifically not to
include any provision that would allow plan assets to be used
to pursue any societal purpose other than protecting plan
assets. To the contrary, Congress included Section 404(a) which
says, ``In order to make a law of trust applicable to the plans
and eliminate such abuses as self-dealing, imprudent investing
and misappropriation of plan funds.''
Recently, both of the main proxy advisory firms have
partnered with ESG research firms. Glass Lewis announced their
partnership with Sustainalytics to integrate Sustainalytics'
ESG research and ratings into Glass Lewis proxy research and
vote management platforms.
This is an issue that I don't think has received very much
attention. And I would be interested in your thoughts on the
bulletin, any thoughts and concerns you might have first. And
then secondarily, any ties to proxy advisors and their advisors
that we are discussing today?
Mr. Quaadman. Yes. Thank you very much, Congressman Hill.
Let me address that in two separate points. We are very
concerned about that bulletin. We had written to Secretary
Perez before the bulletin was released where we asked for
empirical evidence as to why they were considering some of the
changes they were.
Unfortunately with the bulletin today, environmental,
social and governance concerns now rank on par with investment
return for ERISA pension funds, and that is now migrating out
to other areas.
So as an example, the New York State Common Fund, which has
an ERISA-type fiduciary duty, issued 75 shareholder proposals
last year on proxy access. But they were very open about the
fact they were not going for good corporate governance issues.
They are actually looking to put a pressure point on
companies regarding climate change proposals. So rather than
having that open debate there it was wrapped up in a corporate
governance debate.
You know, the second point to it is when you take a look at
the proxy advisory firms, and this is what the 2014 SEC
guidance did and where the Duffy bill goes even further, is
that the proxy advisory firm guidance or recommendations need
to be correlated to the fiduciary duty of their clients, just
as the institutional investor that they are providing
recommendations to.
So that if we are now beginning to muddy those waters, all
the debates that we are having today about enhancing long-term
shareholder value are going to go out the water. And we are
going to have situations like the Illinois Pension Funds where
you have a very active pension fund on things other than good
return now suddenly going underwater, and unfortunately it is
going to be the taxpayers that are going to foot the bill.
Mr. Hill. Well, this is concerning to I think taxpayers
because public pension funds are severely underfunded in this
country. And also use, in my judgment, hypothetical actuarial
return statements that are far too high to today's market
conditions. So I do have a lot of concerns about it.
Commissioner Gallagher, your thoughts on that subject?
Mr. Gallagher. Thank you for the question, Congressman. I
saw the circular, too, last October. For me, you know, similar
reaction to what Mr. Quaadman said. More though it for the
first time caused me to think about what I see is a trend or a
push for the Federalization of the retirement system, you know,
more generally where there seems to be interest with ERISA
waivers coming out of DOL.
This policy statement and elsewhere, a move towards, as we
have seen very publicly, state-sponsored private sector
retirement plans, which, you know, if they add an option if
they are in a competitive market you might think that is a good
thing. But I am not sure that is the case.
So I do think this is something for the Congress to watch
and watch very carefully. That, you know, the track record of,
you know, government oversight of retirement plans has been
checkered in some ways and expanding it might not be the best
thing.
Mr. Hill. Thanks, Commissioner.
Chairman Garrett. The gentleman's time?
Mr. Hill. Thanks, Mr. Chairman. I yield back.
Chairman Garrett. All right.
Mr. Carney is recognized for 5 minutes.
Mr. Carney. Thank you, Mr. Chairman. Thank you for holding
this hearing today, and thank the panelists for coming and for
sharing your expertise.
I represent the whole state of Delaware. We have a lot of
people at my state with considerable interest in and expertise
in corporate governance, corporate law and providing corporate
services to three-quarters of the Fortune 500.
And I have been involved as a result of that, that we have
a lot of expertise both in the State Division of Corporation
within the corporate bar in the state of Delaware, as well as
in the provision of corporate services.
And so I pay attention to some of these issues and advice
that I receive from folks back home I meet to--my involvement
with when we saw the downturn a few years ago and the decline
in IPOs, companies doing initial public offering, which led to
my involvement with Mr. Fincher and the IPO onramp. We are
working on beneficial ownership issues today as we speak.
And it has also led me to my involvement with Mr. Duffy
when he came to me to talk about this bill, this draft bill
that we have here on proxy advisory firms. And so I would just
like to--got to get on the record some of what I think you said
earlier, Commissioner Gallagher, about the need for the bill as
you see it, in summary please?
Mr. Gallagher. First of all, Congressman, I wanted to thank
you for your collegiality during my tenure as a commissioner.
You know, your positive approach to these capital formation
issues and it was always great to work with you, even bothering
you on the Amtrak train on your commute home.
Look, I pushed for years as a commissioner to get some
movement, some reform of the proxy advisory oversight system to
the extent there was one. The culmination of that was SLB 20 in
2014. I think it was a positive step forward.
What I have heard since then, though, it was just simply
not enough. And if you look at the legislation that is being
debated by this committee, I think it is very incremental in
its nature. I think--
Mr. Carney. It is pretty straightforward. I mean, not
that--
Mr. Gallagher. It is very straightforward. It gives us
the--if I am the SEC, again, it gives the SEC the look into
this industry into the conflicts and into the business
practices that this Congress 10 years ago gave the SEC with
respect to credit rating agencies.
And now unfortunately that was a little too late in time to
stop some of the things we saw in 2005, 2006, 2007 with credit
ratings, but I think that sort of incremental step, that
transparency is hard to argue against.
And so I do think based on everything I hear, there are
academic studies that will tell you one thing on the left and
one thing on the right, you know, you look--
Mr. Carney. Is there something in the bill that you
wouldn't do or something that is not in the bill that you think
we ought to think about?
Mr. Gallagher. Look, I actually pause and I have said this
to Gary Retelny at ISS and others. I don't have, you know,
anything against the industry. If they provide a service and it
is done in good faith then it is a good quality product, then
they should be there in the market.
Where they get the imprimatur of Federal regulation, where
the no action letters and the rule interpretations basically
give them a monopoly, that is something that you shouldn't
abide.
And so I don't see anything in this legislation because,
again, I think you could have gone further. I think it is very
incremental in its transparency focus.
Mr. Carney. Maybe we could talk about those.
Mr. Quaadman, do you have any more to add to that?
Mr. Quaadman. Yes. Let me just add, one, you know, we did a
survey with NASDAQ and public companies last summer where we
wanted to see how public companies were dealing with the SEC
guidance. What we found was when companies were looking for a
conflict of interest with a proxy advisory firm, they were
finding it 45 percent of the time. That is a pretty high and
dramatic number.
And I also have an email. I know Mr. Bartl had mentioned an
email, but I have an email here from ISS offering services to a
company that was issued after the 2014 guidance was issued. And
I would like to submit this for the record.
I think there are still significant problems that exist. I
do agree with Commissioner Gallagher. SLB 20 was an important
step forward. I think the Duffy-Carney legislation is a very
balanced way to push the ball forward, to have more oversight,
to make sure we have a balanced system that benefits investors
and companies, and allows the SEC to do its job.
Mr. Carney. Thank you.
Anyone on the panel have something in the bill that they
don't like or something that they would like to see us think
about in the bill?
Mr. Bartl. Well, Congressman Carney, I was just going to
say that I think that the one aspect of this bill that can't be
emphasized enough is that where there has been this specific
oversight, and I go back to the peer group episode in 2012
which got SEC attention. It got press attention that caused a
change and this ongoing, regular oversight will be effective.
Mr. Carney. Thank you, sir.
Mr. Bartl. So I think that is the positive side of the
bill. I don't have anything that I would change at this point.
Mr. Carney. Thank you.
Ms. Taub. Hi. Yes. I don't like this bill and I am
surprised at, you know, this is the free enterprise system that
we have sophisticated investors that we spoke about before
entering freely into contracts, not required to with these
enterprises that provide an important service for them.
And we have regulators who have the tools that they need to
deal with those conflicts of interest at advisory firms as well
as fiduciary duty at the institutional investor firms.
And reportedly we are doing this because the regulators
can't deal with those issues and somehow there is a monopoly if
you create this giant complex regime it is going to create
barriers to entry.
And secondly, one of the biggest concerns I have with this
bill is the private right of action that it gives to issuers if
they are not satisfied with the resolution of their complaint
when they are given a copy in this very tight, you know, 6-week
window to look at the recommendation.
And why wouldn't an issuer be unsatisfied if there wasn't a
vote the way we want to recommendation? And so I am deeply
confused why this committee in particular would be either
trying to entrench a monopoly or try to shut down a successful
business.
Mr. Carney. Thank you. Well, we disagree but thank you and
I yield back.
Chairman Garrett. You disagree? Okay.
The gentleman from Vermont--oh, no, from Maine.
Mr. Poliquin. There were some people--
Chairman Garrett. Thought we had a fellow put down. That
is--
Mr. Poliquin. Mr. Chairman, there are some people who are
envious of not coming from Maine, and I do recognize for the
record that you are from New Jersey.
[laughter]
And I appreciate very much, Mr. Chairman, this terrific
hearing today. I thank all of the witnesses today.
When I was a boy growing up in Maine, our State was dotted
with dozens of paper mills, textile mills, shoe factories. And
our families could take care of themselves and they had the
option of going right from high school directly into working at
these mills with good jobs, with benefits that they could keep
and take care of their families.
You know, over the past 30 years, a lot of these mills have
closed. I don't know if you folks have ever experienced it. I
have. When a small town loses a mill it devastates that
community, absolutely devastates it. Schools get smaller, some
of them close. The collection baskets at church dwindle.
Hospitals struggle and a lot of families leave and go down
state to New Jersey.
That being said, there are a lot of issues that cause these
mills to close. Taxes are too high, regulations are too tough,
a lot of which are brought on by us or by the people that set
the rules in government.
Now, sometimes you can't control it, like foreign
competition or different products that are being offered that
are no longer used, like newsprint or catalogs. Now, one of our
great paper mills in the state of Maine, which is healthy, is
Twin Rivers Paper Madawaska.
Mr. Cherry-Seto, you are from Blue Wolf Capital, invested
in our mill, in that mill. Now, this is in northern Maine right
against the Canadian border, 600 jobs in the St. John Valley,
600 paychecks, 600 mortgage payments. Thank you sir, very much
for that investment in our state.
Now, that mill does not make some of the products that it
did, I am sure, a number of years ago. They make paper bags for
McDonald's French fries. I love it. Every time I am on the road
in that district I go to McDonald's and I buy two bags of
fries.
[laughter]
And they make that thin paper that we print medication
instructions on. Now, I take pills like everybody else--not
that pill--and we should continue to print that paper like you
do up there, and also the thin paper that our mutual fund
reports are printed on.
Mr. Cherry-Seto, as you know, I would like to ask you a
question. You invested in that mill. That mill was in
bankruptcy in 2010. You folks invested in it in 2013. Tell me
why you invested in that mill, sir, and tell me what changed at
the mill that made it so successful. It continues to be a
thriving employer in that part of our state.
And tell me about the Investment Advisers Modernization Act
that Mr. Hurt and Mr. Vargas are putting forward today. Tell me
how that can help you and companies like yours invest in paper
mills like this and keep those jobs and those communities
going?
Mr. Cherry-Seto. Thank you, Congressman. I think Twin
Rivers is a good example of where there is a company that has a
strong reason to exist, but there are challenges that they face
that make it difficult to invest. As you had mentioned, they
came out of bankruptcy in 2010. There were cuts to the pensions
coming out of bankruptcy.
There was a lot of animosity and mistrust. People didn't
know what the future was going to hold. Coming out of
bankruptcy you find situations where there are liabilities left
on the companies that nobody knows with certainty of the
company surviving.
And I think firms like Blue Wolf and other private equity
funds in different parts of the market, they come with a
certain expertise. And we felt that we could understand the
risks of investing in a business and be a partner to help.
You know, as you mentioned, it is on the border of Maine
and New Brunswick. Part of the company is over on the Canadian
side of the border.
Mr. Poliquin. Right.
Mr. Cherry-Seto. And you can imagine what the complexities
are of coming out of bankruptcy and having both the Maine
government and the New Brunswick government involved.
Mr. Poliquin. Thank you, Mr. Cherry-Seto. And tell me
specifically, tell us specifically how if the Investment
Advisers Modernization Act of 2016 offered by this committee
would help private equity firms like yours invest in mills like
this so we can show compassion for the people that work there
and we can grow these businesses and create more jobs?
Mr. Cherry-Seto. Sure, Congressman. I think the issue is on
focus, right? Investors invest their money with us because they
believe that we can find good investments like that, create
good jobs like that. And so that is what we do best.
I think in some sense it would be analogous to looking at
Members of Congress and the unfortunate situation where you are
asked to spend a lot of time on fundraising. And if you could
free up some more time from fundraising, you would be able to
spend more time on what you really want to do here, which is
govern and pass legislation.
We look at it somewhat the same way for us. All right. Here
we are. Compliance is important. Fundraising is important. It
is part of who we are. That is not going to go away.
But we are successful by focusing on investing money. And
so I think in this case having the legislation be more rational
would help us to focus more time on looking for companies and
building jobs.
Mr. Poliquin. Thank you very much, Mr. Cherry-Seto, again,
for your company, your investment in our great state.
Mr. Chairman, since you picked on my state, I have one more
question, and with all due respect--
Chairman Garrett. Well, we are going to actually do a
second round I think here.
Mr. Poliquin. My schedule is such that I cannot, but if you
can award me another minute or two because of the way you
picked on our state, then I would consider it an even fight.
[laughter]
And I would consider it we are even, sir--with all due
respect.
Chairman Garrett. I will look to Mr. Hultgren whether he
can hold off and without objection the gentleman is recognized
for--
Mr. Hultgren. Just because Maine is so beautiful.
Mr. Poliquin. Thank you. Thank you, Mr. Hultgren. I
appreciate it.
Thank you, Mr. Chairman, very much.
Chairman Garrett. And be forewarned if you say anything
against it.
Mr. Poliquin. Yes, sir. I will talk quickly.
Chairman Garrett. The gentleman is recognized for 1
minute--
Mr. Poliquin. Thank you.
Chairman Garrett. --without objection.
Mr. Poliquin. Thank you, sir.
Mr. Gallagher, Professor Taub in her written testimony
notes that the SEC has the authority to inspect and discipline
institutional investors who ``mindlessly follow advice without
considering their fiduciary duty.'' She further states in her
testimony that ``the status quo is far better than any changes
offered by Mr. Duffy.''
Now, you spent some time at the SEC. Do you agree with her?
Mr. Gallagher. Thank you, Congressman, and I love Maine.
The professor is correct. The SEC does have that authority to
discipline the institutional investors through the anti-fraud
provisions. Finding that activity though is the real key.
There are 11,400 registered investment advisors with the
SEC, a couple hundred examiners, so to find evidence of voting
abuse that would implicate the proxy advisory firms, you are
going to have to send those couple hundred off into the several
thousand as opposed to registering and examining basically two
firms that control 97 percent. So it seems pretty logical that
you would take the latter route.
Mr. Poliquin. Therefore I can conclude that you agree that
Mr. Duffy's bill has merit?
Mr. Gallagher. Beyond that, yes.
Mr. Poliquin. Thank you, sir.
Thank you, Mr. Chair, very much for the additional time.
Thank you, Mr. Hultgren, very much.
Chairman Garrett. Thank you. And I think we all can agree
that we all like the teddy bears that come from--oh, wait. That
is the other state, too.
[lLaughter]
So Mr. Hultgren is recognized?
Mr. Hultgren. Thank you, Mr. Chairman.
Thank you all for being here.
Mr. Bartl, I am going to address my questions to you at
first, if that is all right? You note in your testimony that
the Center on Executive Compensation is, and I quote you, ``is
concerned that the lack of sufficient resources on the part of
the proxy advisors leads to a check the box mentality.'' You
also note that ``the ability to understand and summarize pay
programs, for example, requires time, resources and
diligence.''
You testify, however, that the, and I again quote you,
``The irony is that issuers are responsible for ensuring the
accuracy of proxy advisory firms' reports, even though proxy
advisory firms are supposed to be the experts providing the
information that investors rely on to execute a fiduciary
duty.''
I wonder if you could please explain this ``irony,'' as you
said, and how can an issuer be tasked with reviewing the
accuracy of a proxy advisory vote recommendations?
Mr. Bartl. Well, thank you for the question, Congressman
Hultgren, and I think the issue is really currently only one
firm gives companies that opportunity. And that is in the S&P
500. They often have a very narrow window, between 24 and 48
hours, and that is assuming that the draft report goes to the
right person at the company, because sometimes it does get
lost.
For the rest of, you know, publicly held companies, they
are, you know, at the mercy of somebody getting a hold of that
and then going back and, you know, either dealing with the
proxy advisory firm, whether that be ISS or Glass Lewis or more
likely going directly to investors.
And if you are a small company, the resources you have to
be able to change that within the time you have, because, you
know, those reports are typically issued within about 3 weeks
of the annual meeting, the barriers are extremely high.
So the opportunity is fairly small for those, you know,
investors or those companies, rather.
Mr. Hultgren. Okay. Following up, Mr. Bartl, Professor Taub
references in her written testimony that an article by
Professors Choi, Fisch, Kahan, entitled, ``The Power of Proxy
Advisors, Myth or Reality?'' in 2010, that found a substantial
degree of divergence, and ``a substantial degree of divergence
from ISS recommendations, refuting the claim that most firms
follow ISS blindly.''
However, you note in your testimony that several research
reports and economic studies have catalogued the influence of
proxy advisory firm recommendations on votes on shareholder
proposals. I wonder if you could please explain your
understanding and the claim that proxy advisory firms are
capable of influencing shareholder proposal votes?
Mr. Bartl. Yes. I think some explanation of this happened
earlier, too, Congressman Hultgren, but I think that if you
look at that study, if I recall correctly, the Choi study dealt
with the, you know, non-contested director elections, you know,
previous to Dodd-Frank. So one, you were dealing with a
different subset of votes.
Secondly, she was looking at mutual funds with large
governance research arms. The research that is out there, both
pre Dodd-Frank and after Dodd-Frank, Bethel-Gillan, for
example, talked about I think a 20 percent influence of ISS on
director elections.
The Larcker research that talks about significant influence
on say on pay votes post-Dodd-Frank. There is a lot of research
out there. And then, you know, anecdotal research just from the
say on pay votes that shows an influence, definitely an issue.
The other thing to keep in mind is influence is different
for different investors. The large investors are going to use
this information as a bit of a prioritization. When you get a
negative recommendation their research departments are going to
pay more attention typically. That is our experience.
For the middle tier they are going to take the
recommendation significantly and those that, at least for ISS,
have ISS vote on their behalf, will take it absolutely
directly. So I mean, you are talking about a wide band of
investors that are using this for various forms that are
influential.
Mr. Hultgren. Okay. Thanks.
Mr. Gallagher, if I can ask a quick question to you? You
note in your testimony that recommendations provided by proxy
advisory firms may be tainted by conflicts of interest. I
wonder if you could provide a scenario where a proxy advisor
has a conflict of interest that prevents it from providing
independent, objective advice? I wonder if there are any
specific examples you might be able to provide?
Mr. Gallagher. Thanks for the question, Congressman
Hultgren. You know, there are two that really come to my mind.
One is the more obvious in which a proxy advisory firm also
provides consulting services to an issuer that it is providing
recommendations about. And that is one that is, again, obvious
and one that was addressed in SLB 20, which would need to be
disclosed, an obvious conflict.
The other one that we talked about in the SEC Roundtable
December 2013 is less obvious and may be one that is more
pernicious, which is the control of its certain advisory
clients over the substance of the recommendations coming from
the proxy advisory firms.
How do you find that? Where is it in the books and records?
How do you prove it? That is, you know, a much less obvious
question. But it is one that anecdotally I hear exists.
Mr. Hultgren. Okay. Thank you. My time has expired. Thank
you all for being here.
Since the chairman has been very kind to the state of
Illinois, I will yield back without asking any further
questions.
[laughter]
Chairman Garrett. There you go. Thank you. The gentleman
yields back.
So without objection I am going to suggest we go around for
a second round if the panels up to it. Obviously there are not
that many here and they all may not use their 5 minutes. And
with that, no objection, so ordered.
So just a couple, and it is getting even less people
apparently.
[laughter]
Just a couple of quick questions on the proxy advisors. I
will go to Mr. Bartl, two or three questions real quick. In
your testimony that the Center on Executive Compensation
conducted a survey that found inaccuracies in the data and
facts that the two predominant firms relied upon with the
recommendations. Can you just briefly explain the findings of
the survey again?
Mr. Bartl. Yes. So the survey, first of all, found that,
you know, about 55 percent of respondents found that they had
an error or an inaccuracy, and about 70 percent talked about
actually, you know, changing a recommendation in advance of a
recommendation because of a proxy advisory firm policy or
practice in the prior 3 years.
So in terms of, you know, the errors and inaccuracies, you
have companies that are taking advantage of the research
because of this belief, and our study did deal with that as
well, because of the belief that there is some influence from
the consulting side over to the research side. So you get that
fairly regularly.
Chairman Garrett. Okay. So I got that. So these issues have
not been just for a short period of time. We have looked at the
issue or the SEC has looked at investment advisors to some
extent and knew that they were out there advising for some
period of time. And the SEC took some steps, right? They issued
guidance 2 years ago, 2014.
Mr. Bartl. That is right. That is right.
Chairman Garrett. So I guess I will start with Mr. Bartl.
So that guidance comes out and that is supposed to be dealing
with the problem. I guess a short question very blunt is has
that guidance been sufficient? Have you seen changes in the
operations of the firms?
Mr. Bartl. Yes. We haven't seen changes, Mr. Chairman.
Chairman Garrett. Have or have not?
Mr. Bartl. We have not seen changes, Mr. Chairman, and I
think the issue is that, you know, the guidance reiterated
what, you know, investors needed to do to monitor proxy
advisory firms. It then also said that for investors that are
using the proxy advisory firms as a direct--you know,
incorporating the recommendations and having them vote the
proxies on their behalf, there is a higher level, a higher
standard that the proxy advisory firms issue.
But when you look at that middle tier that I was talking
about or even the lower tier, the SLB does not impact those.
And that is where I think where we talked about this impact of
ongoing oversight as we saw with, again, I mentioned the peer
group issue back in 2012.
And we saw it again when, you know, the SLB was issued and
the roundtable happened. There is a lot more attention paid to
the processes that the advisory firms use because of that
attention. And this would elevate that ongoing attention for
what Commissioner Gallagher talked about a minute ago.
Chairman Garrett. I got that. So, you know, the professor
used a word that what we don't want to do anything, you said,
that would reinforce the monopoly. And I guess actually the
correct term--or duopolies. I think of it as a monopoly, which
is your words. That came about. So we do have a monopoly.
So you are saying we have a monopoly, and that is, to me in
any framework is a problem when there is no--if you are going
to have a monopoly maybe there should be some involvement there
for the government to make sure that things are actually
running correctly.
The monopoly came about not just because of the nature of
the marketplace. My understanding the monopoly came about--
somebody said this, maybe Dan Gallagher said this, as far as
the no action--I am sorry, Commissioner Gallagher--came about
due to what the no action letter, right? You do the no action
letter. That basically gives carte blanche to the firms out
there to say, ``I guess we don't have to do anything.''
This is my simple way of looking at this. We really don't
have that responsibility anymore. No one is going to come back
at us. We can just abdicate this responsibility out there. And
there are two firms out there. It coalesces around them. And is
that in a nutshell, Mr. Bartl?
Mr. Bartl. Yes. Mr. Chairman--
Chairman Garrett. How that came about?
Mr. Bartl. --I think the issue here is that, you know, all
of us on the panel I think at one point or another has said you
have to be careful about entrenching the current players.
Chairman Garrett. Right.
Mr. Bartl. But as a practical matter the current players
haven't changed over the course of the last, you know, 6 or 7
years. And therefore, you know, we view this as a preferable
alternative to the status quo because it has the ongoing
approach. The market for proxy advisory firms globally has been
condensing not expanding.
Chairman Garrett. And I am going to throw one last one back
on my bill, professor, to--
Mr. Bartl. Yes.
Chairman Garrett. You are a professor so you have your
students. And I will just throw out this question to you. Don't
you advise your students when they are looking and trying to
make any of the decisions they have to make that they should do
what? Look at the pros and the cons of that decision.
And when you make them look at the pros and cons, basically
it is the costs and the benefits of the decisions that they
have to make in life or in business. And isn't that simply
really what we are trying to do?
Ms. Taub. I am so glad you said that, because I mean to be
clear--
Chairman Garrett. Uh-oh.
Ms. Taub. --we are not talking about dispensing with cost-
benefit analysis.
Chairman Garrett. Okay.
Ms. Taub. What I was talking about is what type of cost-
benefit analysis--
Chairman Garrett. Okay.
Ms. Taub. --should be used, right?
Chairman Garrett. Yes.
Ms. Taub. And secondly, whether it should be subject to
judicial review by unelected judges who are not experts in the
area. So for example, cost-benefit analysis, should I buy this
car or that car, is largely going to be economic concerns and
some preferences. Cost-benefit analysis, should I marry my
husband, isn't going to be, at least for me, an economic
question. It is going to have other factors.
And so what we have learned, especially with the D.C.
Circuit when we looked at--sorry, the D.C. District Court
decision in National Association of Manufacturers, they said
you can't compare apples to bricks.
So I do think that agencies including the SEC should engage
in a cost-benefit analysis process. And I think it should be of
their choosing. It can be conceptual.
My problem is the illusion of precision because it is a
Catch-22. If you say reduce this to a number we all know it
can't be done. Years later then they can be questioned and
mocked--
Chairman Garrett. Well, thank you, but I think--
Ms. Taub. --for are not coming up with the right number.
Chairman Garrett. And Mr. Gallagher's comment was they were
able to make decisions not entirely on that, but at least to
have that there as your factor. I see my time went way over.
I will now recognize, rather, the gentlelady from New York.
Mrs. Maloney. We are talking about all these bills, cost-
benefit analysis. I would just like to reflect a little bit
about why did we pass all these regulations? And that was
because of the worst financial crisis certainly in my lifetime.
And I would just like to ask Professor Taub, how much did
this, in terms of analysis, how much did this crisis cost the
American people? I have heard that everything from 9 million
jobs to 9 million people losing their homes. What did this
economic crisis cost the American people? How many billions,
trillions I guess? Trillions.
Ms. Taub. You know, the actual dollar figures have been
estimated in ranges, but in terms of lost economic output I
have heard in the many trillions. And I can't point to a
figure. I am not an economist, and there are many different
studies that are out there, but in the many trillions.
But the problem is, again, it is not just about things that
we can quantify. When more than 7 million people, sorry, 7
million homes are lost to foreclosure or short sales, that has
impacts beyond economic ones. There are also other economic
impacts.
And the, you know, the run up to the crisis, the bubble,
the gains of that were not felt evenly and neither was the
crash. And so, you know, the numbers are large. I don't think
we can even still quantify the impact at this point.
Mrs. Maloney. Well, would you generally like to express
your belief on how these bills would affect the SEC's ability
to oversee and enforce reforms that Congress passed as a result
of the financial crisis? Some reported that it was $21 trillion
or $13 trillion, a range from $13 trillion to $21 trillion? It
is many people haven't recovered.
Congress put in place reforms to prevent another financial
crisis and to better protect Americans from losing their homes,
losing their jobs, another economic downturn. I always get
reports every now and then that they think the next crisis is
on the verge, but do you believe that?
What about these three bills? Do you think that these bills
would prevent the SEC from really overseeing and enforcing
reforms that Congress put in place to protect the American
economy?
Ms. Taub. So I think what is ironic about some of these
bills is there are some really good tools that the SEC has and
information they are given and these bills want to take that
away.
But then the third bill, then the proxy advisory bill wants
to foist onto the SEC without any specific designation of which
division would handle it and not any earmarked money, a
structure that I don't know that the agency, or at least I
don't know the investors have asked for or need, really need.
Mrs. Maloney. And like you said, it would take away
protections that the SEC has put in place to protect the
American economy.
Ms. Taub. One of the most difficult things is in any cost-
benefit analysis you need inputs and estimations. And you need
good data, and there isn't yet good data on the incidence of
fraud within firms. That could be banks or it could be other
types of firms. And there are not good data on the amount of
fraud.
So when you look at a cost-benefit analysis it is not as if
we are taking precise numbers, putting them into a computer and
then boom, there is this precise answer. There are lots of
estimations and incomplete data.
And also these--but again, I think the SEC should engage in
economic analysis. All I am saying is I don't think the problem
with adding this on, creating--you know, it doesn't eliminate a
private cause of action.
Even previous iterations of bills might have, but forcing
them to go through this particularly quantitative cost-benefit
analysis portending to be able to reduce something to a bottom
line figure, then becomes evidence in a APA case and so on.
It may not, as Commissioner Gallagher says, slow the
commission down at the beginning, but it certainly slows them
down afterward when they are in court.
Mrs. Maloney. Well, thank you, and I yield back the balance
of my time.
Chairman Garrett. The vice chairman is recognized for 5
minutes.
Mr. Hurt. Thank you, Mr. Chairman.
Mr. Gallagher, Professor Taub in her testimony makes
reference to a report prepared by Better Markets called,
``Setting the Record Straight on Cost-Benefit Analysis and
Financial Reform at the SEC.'' She goes on to state that the
organization opines that what sounds like a benign cost-benefit
analysis is actually an industry-only analysis.
And I was wondering if you could comment on that and
whether you agree with that characterization that a cost-
benefit analysis is just an industry-only analysis?
Mr. Gallagher. Well, thanks for the question, Congressman.
I am not familiar with the Better Markets reports. I don't
spend time with special interest group reports like that
because they are typically one-sided on their own. And so, you
know, I think this all just boils down to, as I mentioned
earlier, you know, just good government.
And, you know, we have a disparate body of congressional
mandates that the D.C. Circuit has interpreted to require the
SEC to conduct an economic analysis today. I think what you are
doing, what Chairman Garrett is doing with his bill is tying it
all together and making it clear, making it followable and
predictable.
It doesn't mean--Professor Taub may be absolutely right
that it changes a posture in a litigation that follows a
rulemaking, but I don't think it is necessarily for the worst.
I think it is such a bowl of spaghetti right now that it is
incumbent upon Congress to clarify it.
Mr. Hurt. Thank you. And I yield back the balance of my
time.
Chairman Garrett. The gentleman yields back.
And the gentleman from California is recognized.
Mr. Royce. Well, thank you very much, Mr. Chairman,
appreciate it.
And I had a question for Mr. Quaadman. You note in your
written testimony that rule writing entities, such as the PCAOB
and Municipals Securities Rulemaking Board are subject to the
same requirements and enhancements contained in the SEC
Regulatory Accountability Act. Could you please explain why
that is beneficial and also should the SEC require FASB conduct
similar cost-benefit analysis when setting accounting and
reporting standards?
Mr. Quaadman. Yes, thank you, Mr. Royce. So first off, we
propose for any subordinate organization of the SEC that if
they are involved in rule writing that has a force of
regulation, there should be a cost-benefit analysis. So that
would include FASB. I believe FINRA has committed to do that.
The PCAOB, as an example, their standards have to go
through the SEC rulemaking process before they go final, so you
should have a cost-benefit analysis there.
And as one example, the PCAOB, because they could not get
standards done over the last several years for a variety of
different reasons, had a very aggressive inspections program.
And because they had a very aggressive inspections program
2 years down the line, companies suddenly started to see that
their internal control costs were going up by 300 percent.
So that shows, number one, the dramatic impact the PCAOB
could have on companies, but more importantly, why you need to
have actions go through a formal process so you can understand
what the costs and benefits are rather than through a circular
route.
Mr. Royce. So that is one of my concerns.
Let me go to question Mr. Bartl. I am struck by the
inherent conflict of interest that you described in your
testimony when the ISS consulting arm uses its relationship
with ISS research to sell business. Is this a common
occurrence, I would ask? And do investment advisors take this
into account when hiring a proxy advisory firm? And should
they?
Mr. Bartl. Thank you, Congressman Royce. I appreciate the
question. And so I think the answer is we have seen a much more
aggressive push by the consulting arm of ISS against the
research side.
The one email exchange that we included in our testimony is
just an example. In fact, the irony is that that one was
actually repeated to another company using the wrong company's
ticker in rapid fire succession.
I think what we have seen is that there are certain types
of investors, pension funds particularly, that have a tendency
to use Glass Lewis because of the lack of consulting arm there,
even though there are other conflicts inherent in Glass Lewis,
as we talked about in our testimony.
And so I think there is a knowledge. In fact, when Glass
Lewis came on the scene back in around 2002, that was one of
the things that led to that occurrence. But both proxy advisors
suffer from, you know, conflicts of interest that certainly
deserve greater oversight and scrutiny. And that is, I think,
one of the redeeming factors, one of the best reasons for
Congressman Duffy's bill.
Mr. Royce. And Mr. Gallagher, so you are saying it is that
added transparency Mr. Bartl was saying or knowing a conflict
exists as part of the solution here. Your thoughts quickly on
how Mr. Duffy's bill helps get at that problem?
Mr. Gallagher. Thank you for the question, Congressman.
Look, I think it gets right to the heart of the matter with
transparency and disclosure, the basic tenets of the securities
laws. If there are conflicts, disclose them. If there are
conflicts that Congress can't abide you might want to prohibit
them, and that has happened, too, in other scenarios.
But just the basic knowledge and disclosure of these
conflicts can help investors and voters make better decisions.
And we don't have that.
Mr. Royce. Maybe, but I think there is more that has to be
done here because there should be more competition in the proxy
advisory space. But instead what we have created is a
government-approved duopoly that is not serving investors.
Do you go back to Mr. Bartl's testimony where he said we
now have a check the box mentality with little review of the
accuracy of proxy advisory firm reports. What could be done to
change this dynamic to really introduce competition given the
duopoly?
Mr. Gallagher. In addition to the legislation that is being
debated here, I think the SEC could rescind the two no-action
letters that followed the 2003 rulemaking that basically
created that duopoly for the two firms.
And I think after that, I will tell you, Congressman, one
positive thing is--a lot of this is couched in the negative.
Since SLB 20 we have seen the adviser community pay more
attention to these issues.
We have seen the larger asset managers resource their
voting function. We see the message trickling down to medium-
and small-size advisors that A, you don't have to vote every
share every vote, that B, you can do things other than rotely
relying. But I would take--
Mr. Royce. Yes.
Mr. Gallagher. --Mr. Bartl and Mr. Quaadman's word, you
know, on its face that this still isn't enough.
Mr. Royce. Well, in closing I would thank the chairman for
holding this hearing, and I certainly want to thank my
colleague for the legislation that he is putting forward here.
Thank you, Mr. Duffy.
Mr. Chairman, thank you.
Chairman Garrett. Thank you.
And with that, I will now yield 5 minutes to the sponsor of
the legislation, Mr. Duffy.
Mr. Duffy. Thank you, Mr. Chairman. I apologize. I had to
step out for a little bit. Rarely have I been in this committee
and been advocating for more regulation. This is, I think, a
first for me, so duly noted.
Mr. Bartl, just again, I think you have had several
questions about conflicts of interest in regards to proxy
advisors. Kind of lay that out for me again. You did it in your
testimony, but lay out conflicts of interest in regard to proxy
advisors?
Mr. Bartl. Sure. I mean, there are really--and I really
appreciate the bill and the question. There are really three or
four depending on how you slice it. One is the role of ISS in
providing consulting to companies, and on the other side
providing research that is so-called independent and this
firewall that, you know, so-called firewall that exists.
Mr. Duffy. It doesn't exist.
Mr. Bartl. Right. Well, and that is again why oversight is
necessary. Probably even more importantly is this notion of
providing consulting on shareholder proposals by investors,
investor proponents and providing cursory disclosure on the
fact that they do so because they then provide recommendations
on those same proposals. And, you know, hopefully that is--
Mr. Duffy. So in fact you could be giving advice on a
shareholder proposal and then to other investors how they are
going to vote on the proposal--
Mr. Bartl. Right.
Mr. Duffy. --and to the company in which it is effected?
Mr. Bartl. That is correct.
Mr. Duffy. And does this go to the highest bidder? I mean,
if you pay the most money you win the day?
Mr. Bartl. And again, we have the separation--
Mr. Duffy. Right.
Mr. Bartl. --that is there. But this is, you know, of the
issues that probably have the most impact that is probably the
one. And then you have beyond the operational side the
ownership side, which is on the Glass Lewis front and its
ownership by the Ontario Teachers' Pension Plan both a private
equity and the--
Mr. Duffy. Do they give advice on companies in which they
invest?
Mr. Bartl. They disclose the fact that they are giving
advice on companies in which--
Mr. Duffy. So they do.
Mr. Bartl. --OTTP exists, or OTPP there.
Mr. Duffy. Does the panel all agree that this is a problem?
That there is a conflict of interest here? Shaking--
Mr. Quaadman. Yes. Mr. Duffy--
Mr. Duffy. So we are--
Mr. Quaadman. --I agree with Mr. Bartl's characterization.
I would also just add, too, Glass Lewis. They are owned by an
activist investor fund. And we had actually written twice to
the SEC in 2011 and 2012 asking them to look into the apparent,
or at least the appearance of, a conflict of interest with
activities by the Ontario Teachers' Pension Fund and also Glass
Lewis recommendations as well.
Mr. Duffy. So we are looking at a lot of companies and a
lot of shares. Do these proxy advisory firms have the staff to
provide adequate advice, Mr. Quaadman?
Mr. Quaadman. As I had mentioned earlier, you have one firm
that has 180 analysts looking at tens of thousands of companies
globally, making recommendations on 250,000 shareholder
proposals and director elections over a very compressed time
period. And you would just have to look at that as you can't
possibly do the due diligence that you need to do.
The other thing is, as others have mentioned here, there is
an extremely high error rate. And I have to say Mr. Retelny at
ISS has made some changes over the last year where they are
starting to issue new reports where there is an error that has
been found and fixed.
But that was not done up until about a year ago.
Mr. Duffy. So the answer is they don't have the staffs,
right? I mean, they are not big enough?
Mr. Quaadman. The other--
Mr. Duffy. Mr. Gallagher?
Mr. Quaadman. I would just--
Mr. Gallagher. Yes.
Mr. Duffy. Go ahead.
Mr. Gallagher. That question, anecdotally I hear they do
not, but again, everything I have heard is just an anecdote. I
haven't gone to the physical plant. They are not SEC
registrants other than the registered investment adviser
subsidiary of ISS.
Mr. Duffy. So you had a different Chair in the not too
distant past at the SEC. Is it your opinion that the SEC can
act without legislation or do you think that we have to have
legislation here to instruct the SEC to act on this issue?
Mr. Gallagher. So this is the metaphysical question I have
been wrestling with for years because I was trying to get the
SEC to act in a manner that would obviate legislation. I think
the SLB 20 was a step forward. You know, rescinding the no-
action letters, revisiting the 2003 rulemaking and the
interpretation thereof would have been other positive steps,
but they were not taken.
But to tell you the truth, at the end of the day even if
all of that had been done you would probably be sitting here
today debating legislation.
Mr. Duffy. And do we agree this has a huge impact on
corporate governance, that you have two firms that control 97
percent of proxy advice?
Mr. Gallagher. Absolutely.
Mr. Duffy. Two firms?
Mr. Bartl. Yes.
Mr. Gallagher. Yes.
Mr. Quaadman. Yes.
Mr. Duffy. And so it would be incumbent upon us to actually
take action, instruct the SEC to make rules and let us get this
taken care of. Anyone disagree with that?
Mr. Bartl. No.
Mr. Gallagher. No.
Ms. Taub. I do.
Mr. Duffy. Okay. Go ahead.
Ms. Taub. I am not an anti-trust expert and I don't
recall--
Mr. Duffy. My time is up. If I could have 1 minute and let
her--
Ms. Taub. Well, so--
Mr. Duffy. --answer the question--
Chairman Garrett. If she says she is going to agree--
[laughter]
Now--
Ms. Taub. I don't want to take your time.
Chairman Garrett. No, no, I am sorry. You have the
additional minute to respond.
Mr. Duffy. I am sure the ranking member wouldn't oppose
either.
Ms. Taub. Thank you. I mean, I don't recall referring to
the two companies as a monopoly. I think that is referencing
something someone else had said. But in terms of this, if you
are concerned about two firms having a larger share, having the
majority of, you know, 90 plus percent share of the market,
then I don't see how creating a more complex regulatory regime
that would, you know, possibly create barriers to entry solves
that particular problem.
Also I am hearing two different things. I am hearing folks
say we need more people doing this. And then I am also hearing
it is not possible to be done. But what is the status quo if
these firms don't exist?
Large institutional investors are choosing to rely on them
as one data point. Smaller investors rely on them. What would
happen to small investment funds?
Would they have to create, you know, duplicative in-house
proxy voting staffs that were going to read all of these, you
know, all these proxies? There is nothing wrong with going to a
third party and getting investment advice.
As for the conflicts of interes, let me just say--
Chairman Garrett. Sure.
Ms. Taub. --other fields there are conflicts of interest
and how are they dealt with and whether it is law or finance?
The first step is disclosure. And if we look not just at the--
Mr. Duffy. And you agree with disclosure, right?
Ms. Taub. I agree with disclosure--
Mr. Duffy. Disclose conflict?
Ms. Taub. --and I would also agree with the first step is
best practices. And if you look at what is happening in Europe,
you look in the U.S., Glass Lewis and others--
Mr. Duffy. And I want to give Mr. Gallagher--
Ms. Taub. --are part of--yes.
Mr. Duffy. --a chance. Are you a lawyer?
Ms. Taub. Yes, I am.
Mr. Duffy. As am I. It was pretty tough. I never could
represent two clients in the same case. It was a conflict of
interest. Invariably they have competing interests and you
can't represent both of them aggressively. And that is why we
say, listen. You have to pick one.
Mr. Gallagher, want to quickly respond? Do you agree with
Professor Taub?
Mr. Gallagher. Yes. I agree on that conflict analysis and
just want to point out that one of--there are two big things
that came out of SLB 20. It was clarification from the
commission to the advisory community that despite what you read
into the 2003 rulemaking, this wasn't Department of Labor. This
wasn't the Avon letter.
You don't have to vote every share every vote. Well, that
is still not going to be appetizing to most advisors. They are
going to feel they need to vote.
The second part was that we said you can predetermine your
voting. You can tell your clients, your advisory clients, we
are going to vote with management every time. You can tell them
we are going to vote with CalPERS every time. It can suit your
fiduciary duty, as Mr. Bartl said earlier.
We haven't seen that take up. That would obviate the
necessary reliance on ISS and Glass Lewis. We haven't seen it
yet, so--
Mr. Duffy. As always, great point, Mr. Gallagher. Fantastic
panel. Thank you for all of your agreement.
With that I yield back.
Chairman Garrett. Thank you. The gentleman yields back.
I will concur, this was a great panel. Thank you for your
input and your information.
The Chair notes that some Members may have additional
questions for this panel, which they may wish to submit in
writing. Without objection, the hearing record will remain open
for 5 legislative days for Members to submit written questions
to these witnesses and to place their responses in the record.
Also, without objection, Members will have 5 legislative days
to submit extraneous materials to the Chair for inclusion in
the record.
With that being said, thank you again. And this hearing is
adjourned.
[Whereupon, at 5:12 p.m., the hearing was adjourned.]
A P P E N D I X
May 17, 2016
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