Speech by SEC Commissioner:
Remarks Before the Coping with Broker-Dealer Regulation Seminar
Practising Law Institute
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York, New York
September 13, 2006
Thank you, Harry, for that kind introduction. It is a great pleasure to be here with all of you today to talk about the broker-dealer regulatory environment. Before I begin remarks, however, my own compliance people insist I tell you that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow Commissioners.
First, I am sure that all of us remember where we were and what we were doing five years ago this week. I dare say that many of you in this room were probably touched directly by the attacks of September 11th. For the way the people of this city reacted, the heroic efforts of people in uniform, and the resilience in which the financial markets were able to get back up and running, the rest of the country and world owe a deep debt of gratitude. And, most of all we owe tremendous gratitude to all of those people in uniform, be they civilian or military, who in the five years since have made such enormous personal sacrifices to defend our freedom against those who would destroy us.
As you all know very well, there is a complex web of laws and regulations affecting the day-to-day activities of all U.S. broker-dealers. In order to stay on the right side of the rules, people like you are actively involved in the training of others. Of course, you, too, are trained in the latest rules and regulations -- hence this seminar.
The SEC sits at the top of the broker-dealer regulatory hierarchy. As you might expect, just as there are rules that apply to a broker's work, so are there guidelines that cover the activities of the SEC and its Commissioners. Some of these provisions are more pertinent to my day-to-day duties than others. There are even a few that are relevant to my remarks today. For example, Commissioners are asked to scrutinize continuously our internal organization to make sure that it can handle matters efficiently and expeditiously.
In my view, one of the most pressing organizational issues currently facing the Commission is the question of whether our Office of Compliance, Inspections and Examinations should continue as a stand-alone office or be bifurcated and housed within our Markets Division and Investment Management Division. This issue came to the fore last year with the introduction of a bill in the House of Representatives -- H.R. 4618, the "Compliance, Examinations, and Inspections Restructuring Act of 2005," which was introduced by Congressmen Fossella (NY) and Castle (DE). The bill proposes the following:
- Placing - I should say Re-Placing -- the Commission's examination authority within the Markets Division and Division of Investment Management;
- Requiring regular status updates by the relevant Divisions to subjects of examinations or investigations, and requiring that the SEC send a closing notice to the subject within 10 days of a determination to close a matter;
- Requiring Commission approval of sweep exams, and notification to the Commission of inspections,
- Limiting the scope of documents requested in inspections and sweep examinations to required books and records; and
- Establishing an ombudsman to be the liaison with issuers and regulated entities.
Of course, the SEC already has the authority to take most of these actions. If nothing else, the bill is a call and a challenge for the SEC to act.
By way of background, OCIE was created in 1995 to try to improve the efficiency and effectiveness of the examination programs run by the Markets and Investment Management Divisions. Eleven years later, OCIE has more than 800 very hard-working, talented employees resident in all of the Commission's offices throughout the country, and is second in size only to the Division of Enforcement. The theory behind the creation of the new office, as I understand it, was that combining examinations personnel into one office would help to cross-fertilize between broker-dealer examiners and investment-management examiners and help to break down internal bureaucratic and communication barriers that had built up over the years. In fact, I have heard that in the past Investment Company Act examiners in one regional office had been told that they could not collaborate even with Investment Advisers Act examiners! That clearly made no sense and is an example of what a new structure like OCIE was meant to end.
Over the years, some of these barriers, but by no means all, have diminished through management attention and individual efforts. New barriers, however, have cropped up. Consultations between OCIE and the divisions out of which it was pulled are not occurring as routinely as when examiners were directly in their respective divisions. The rule-writers need to hear from the people who are out in the field visiting registrants, and the compliance folks need to check with the rule-writers to make sure that their messages are consistent with the purposes of the rules. As a result, sometimes conflicting messages come out of our regulatory and compliance staffs. This puts registrants and the SEC in a very difficult position.
Every organization should periodically engage in self-reflection to see if its structure meets its mission. At the Commission level, we certainly have heard concerns regarding the inefficient use of Commission resources in sweeps and other examination actions. OCIE has referred a record number of matters to Enforcement for further investigation. Are these referrals in fact good "leads" for our enforcement attorneys? Has it become more advantageous for the examiners' own careers for them to refer matters to enforcement without a filter as to importance? Is there a concern that some of these matters are referred to enforcement before the relevant regulatory staff have been consulted as to whether the rules are sufficiently clear to support any enforcement action?
An essential element of any regulatory examination program is its ability to effectively ferret out illegal behavior by entities subject to the regulator's oversight. The SEC needs as proficient and smart an examination program as possible, considering the high stakes that are involved for investors and our marketplace if illegal activity is allowed to fester and flourish. But what we have seen even in the late trading and accounting fraud scandals of the past few years is that the vast majority of people and firms are trying to get it right. They often are looking for guidance in what everyone acknowledges is an increasingly complex world.
How do other regulatory regimes approach their examination functions? For example, bank and insurance regulators in the United States and financial services firms elsewhere in the world? These regulators use a variety of means to keep tabs on regulated entities and to take steps to ensure that regulated entities are in compliance with their legal and ethical obligations. Public enforcement actions certainly are one means in the arsenal, but there are other, sometimes more effective, prudential approaches.
One of the attractions that our consolidated supervised entity ("CSE") program offered from the beginning was precisely such an approach. The CSE program seems to have successfully integrated prudential regulation into our oversight of participating firms. So far, we have been able to maintain a Chinese wall between OCIE and the office in the Markets Division that runs the CSE program. In fact, in devising the CSE program, our staff made the Chinese wall a cornerstone. Is this the shape of things to come? It may well be. Based on our experience gained as time goes on, I hope that we will be able to expand this program.
One of the salutary by-products of an effective compliance examination should be the opportunity for a registrant to learn ways to improve its compliance programs. We ought to work cooperatively with those intent on following the rules so that we can better focus enforcement resources on those whose intentions are sinister or who have no interest in getting things right. Our examinations should not be focused just on adding to our enforcement statistics.
One example of how our staff works with those who want to do the right thing is the chief compliance office outreach program. The program, a joint effort of the Office of Compliance Inspections and Examinations and the Division of Investment Management, gives mutual fund and investment advisor Chief Compliance Officers ("CCOs") an opportunity to meet with and obtain guidance from the Commission staff. It provides CCOs with an informal forum in which to ask questions and discuss issues that they might not feel comfortable raising during an examination.
Understandably, however, because of the likelihood of enforcement referrals, firms have begun treating requests from OCIE and SRO examiners as if they have been subpoenaed. This reaction to examinations may be a factor in the skyrocketing legal and compliance costs over the last few years. According to the SIA, compliance costs in 2005 totaled $25.5 billion -- a significant number, and approximately 10% more than 2004.
If the Commission decides that structural changes to our examination program are not necessary, we will still need to address the concerns raised in Congressman Fossella's bill -- most importantly the level of Commission control over OCIE activities. We will need to consider what is the best balance from the investor's perspective, with the realization that investors ultimately pay directly or indirectly for all regulation. We will also need to respond to the concerns of the regulated industry -- yes, there are some brave souls who actually reach out to the Commission to tell us what we can do better! And we will need to ensure that there is consistency in regulatory interpretations to ensure that OCIE is as uniform in its approach as possible, and so that regulated entities know whom they can talk to in the Markets and Investment Management Divisions for ongoing guidance.
To underscore the need for increased Commission oversight of OCIE activities, I will share with you an example of a formerly used OCIE request to which I believe that a compliance officer would find it almost impossible to respond. As part of the investment advisor examination process, OCIE has apparently asked registrants to provide the following:
[A] written summary of any business transaction, investment opportunity, deal, side deal, arrangement, or similar matter that, since 2003, Registrant was asked to consider but rejected because the proposal was deemed inadvisable, inappropriate, unethical or possibly illegal. The summary should include a detailed description of the matter, the name and contact information of all involved firms and persons, and the reason(s) for the proposal being rejected. Copies of any pertinent documents including letters or electronic communications should also be provided.
To me, requests like this - requests for information that is inherently privileged in most firms - will chill open communication among business people and legal and compliance departments. We all can imagine what this request is meant to get at, in light of the side agreements that were revealed in the late trading scandals. But, this request is written very broadly and would catch in its sweep all sorts of ideas and proposals generated even internally.
A person on the business side should be encouraged to come up with new ideas - within reason, of course, and using good judgment, but which might be as innovative as they may be - and run them by the legal side, which should be encouraged and empowered to shoot them down in open debate as "inadvisable, inappropriate, unethical, or possibly illegal". That is what the lawyer is being paid to do. That would be the sign of a healthy, dynamic, innovative organization that is serving its customers' and shareholders' needs. But, for the government then to demand, using very vague standards, that all of this be documented, catalogued, listed, and handed over to government examiners is not appropriate - truly a chilling effect on open discourse, lawyer-client relationships, and innovation.
In fact, I am not sure as a lawyer how I would counsel my client on determining what is "inadvisable, inappropriate, unethical, or possibly illegal". "Inadvisable" in what context? "Inappropriate" in what context? Business? Strategy? Is there a materiality component? All of this is left open, plus there is always the fear of potential liability for lying to the government. What if you undertake the list but leave something off? I understand that, after receiving complaints, OCIE stopped making this request to investment advisors. I would be interested to hear from you if there are any analogous requests in the broker-dealer examination context.
Let's turn now to a new regulation that I would bet is on the minds of most of you these days -- Regulation NMS. Another internal SEC rule directs commissioners to maintain contact with the persons outside the agency who may be affected by the SEC's rule-making. The Commission's internal rules also provide that Commission rules should never tend to stifle or discourage legitimate business enterprises or activities, or be interpreted so as unduly and unnecessarily to burden those regulated with onerous obligations.
Together, these rules require the Commission actively to seek feedback from the regulated community and to address those instances in which our rules are unreasonably burdensome. This corresponds nicely with the Commission's statutory obligation, in Section 3(f) of the Exchange Act, to consider when making rules whether our actions will "promote efficiency, competition, and capital formation."
Over the last few years, the Commission has run afoul of these obligations. With the promulgation of the mutual fund director rule, the hedge fund advisor registration rule, and Regulation NMS (all of which, by the way, I dissented from), the Commission clearly failed adequately to consider the costs and burdens of our regulations before we acted. The D.C. Circuit has appropriately admonished us in vacating two of these rulemakings, but Reg. NMS was never challenged in court and therefore remains on our books.
In a nutshell, Reg. NMS rules fall into four categories: (1) the trade through rule (it is an understatement to say that the sweet-sounding appellation "Order Protection Rule" is a misnomer); (2) the access rule; (3) the sub-penny rule, and (4) the market data rules. Some of these rules are much more problematic than others.
In my view, Reg. NMS represents a massive regulatory intrusion into our secondary trading markets that was completely unwarranted, given the lack of evidence of market failure and the availability of substantially less intrusive means to advance those goals. Reg. NMS has the potential to do significant harm to our markets by unduly interfering with the operation of the competitive forces that over the years have benefited investors immensely by reducing trading costs and increasing market efficiency. It is a carte blanche for unsupervised meddling in the marketplace for years to come.
Dissenting from the adoption of Reg. NMS does not in any way make me less interested in the implementation process. Quite to the contrary, I have been fully engaged in the process to ensure that the rules are implemented in the least burdensome and most cost-effective manner possible and to limit their potential harm to our markets' competitiveness. I am grateful that market participants have been providing crucial feedback to the Commission on Reg. NMS implementation, and I must say they have given us a good deal to think about.
As most of you know, the original compliance date for the heart of Reg. NMS - the trade-through rule and market access rules - was June 29, 2006. As with other, lesser components of Reg. NMS, this deadline had to be delayed, and there is now a complicated phase-in schedule. Why the extension? Although the Staff will claim that the creation of new, electronic trading systems by the exchanges was the basis for the extension, the real reason for the delay is that the rules are unduly complex and burdensome. I suspect that the implementation process already has been a rude awakening for many.
When you consider the various interdependent elements involved, the Commission's previous majority set a naively ambitious original timetable for the implementation of Regulation NMS. Deadline extensions have proven this to be true. Although some work has been done already, the hardest work lies ahead before the rules can take effect. That's because when the majority of the Commission approved Reg. NMS, it conveniently decided to "punt" on the hard decisions and analysis. The staff was given the authority to make those hard decisions in "rules" created along the way by staff guidance (I should say, "informal rulemaking") or outright through general authority delegated from the Commission.
Although the Commission needs to issue a great deal of interpretive guidance and take action on a host of SRO and NMS Plan rule proposals, the real burden of NMS implementation lies with the industry. SROs and the SIPs need to develop specifications and code changes to their systems. Broker-dealers need to revise their own systems and develop compliance policies and procedures. Industry-wide testing needs to occur to ensure that all the pieces work individually and together. Industry participants also need some live working experience with new SRO rules, SIP processes, and concepts introduced by Regulation NMS -- in particular the intermarket sweep order.
With that in mind, I believe it is useful to "take stock" (sorry for the bad pun) of where we are now with Reg. NMS.
As I mentioned earlier, the compliance deadline for Rules 610 and 611, the market access and trade-through rules, has been extended. The new, phased-in deadline schedule is as follows: (1) October 16, 2006 is the deadline for SROs to publish technical specifications; (2) February 5, 2007 is the deadline for full operation of Reg. NMS compliant trading systems; (3) May 21, 2007 is the start date for full industry compliance, but this is only on a pilot basis involving 250 stocks - this will be the first deadline directly affecting the folks in this room; (4) July 9, 2007 is the deadline for full industry compliance for all stocks; and (5) October 8, 2007 is the completion date for the phased-in compliance process. I will be interested to see if the industry can meet these timelines. I believe it is still ambitious, both for market centers and for broker-dealers. It will also be very hard for the Commission to show some "teeth" by declaring a marketplace to be "slow" -- effectively a death sentence - if it misses the deadlines.
The two easiest requirements in NMS, the prohibition on subpenny quotations and the reduction in the Regulation ATS fair access threshold, were scheduled to be implemented by August 29, 2005. Mind you, these rules required minimal systems changes. Yet when market participants looked closely at the implications of the rules on their business processes, interpretive questions arose, which delayed both the implementation of the Regulation ATS threshold and the subpenny prohibition. When the deadline for subpennies rolled around on January 31, 2006, it was hardly a surprise when we learned that several exchanges were not prepared for the subpenny implementation - they could not support subpenny trading in stocks priced under $1. With the locked/crossed market rule not yet implemented, the exchanges' inability to trade the stocks in subpennies has resulted in many locked and crossed situations. In addition, we had to exempt Liquidnet from Rule 612 because its system allows participants to negotiate a "midpoint" price that is usually a subpenny amount. That is one example of why former Commissioner Glassman and I said that Reg. NMS could stifle innovation - how many trading systems with new ideas like Liquidnet's will never get off the ground because of these arbitrary rules? Will these experiences with Rule 612 be a harbinger of things to come?
The staff, by delegated authority, recently provided an exemption from Rule 611 for "Qualified Contingent Trades." This means that the trade-through restrictions will not apply to trades defined as "a multi-component trade involving orders for a security and a related derivative, or, in the alternative, orders for related securities that are executed at or near the same time." As stated in the SIA's request for an exemption, the parties to contingent trade transactions are focused on the spread or ratio between the transaction prices of each component instrument, rather than on the absolute price of any single instrument. To me, this is yet another step towards the opt-out provision that was originally proposed in Reg. NMS. In fact, given the significance of the trades covered by this exemption, I would say this is an important step towards the full opt-out. Maybe it is time for the Commission finally to reconsider a full opt-out provision?
The staff has issued over 50 "Responses to Frequently Asked Questions" for Rules 610, 611, and 612 over the last year. It is my understanding that more guidance is still needed in these areas, and -- believe it or not -- the Responses have generated questions of their own!
There will be more exemptions, more questions, and maybe even more delays as we make our way through the next 13 months. I implore you and your firms to provide us with feedback as we continue to slog through the NMS quagmire! We are about to welcome a new Director of our Markets Division - Erik Sirri - who will start on Monday. He has a full plate, but tremendous opportunities. Many of you, along with me, already know Erik and are looking forward to working with him. He will sorely need your input and support. I think that the next few years will be exciting and productive.
You have been a very patient audience, and I appreciate your attention. I welcome your active involvement in the issues I discussed today, and all of our issues. My phone and office are always open to you. Please call or stop by if you have any comments or concerns. Thanks again for your time and attention.
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