Speech by SEC Commissioner:
Remarks Before the Federal Reserve Bank of Chicago Seventh Annual Private Equity Conference
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
August 2, 2007
Thank you, Cathy [Lemieux], for your kind introduction. I am honored to be a part of this conference. I was a bit shocked to find it hotter here in Chicago than in Mexico City, where I was a week ago. But I cannot complain given that I come from Washington, D.C., which was built on a swamp and where it is even hotter and more humid than it is here. Chicago and Washington are not the only places where it is hot - the private equity sector has been feeling the heat of late, too. Private equity has been grabbing newspaper headlines on a number of fronts, including issues of how private equity managers are taxed, IPOs by private equity firms, and high-profile purchases by private equity funds. So you certainly have a lot to talk about at this conference. Before offering my thoughts on private equity (and several related topics), I must note that the views that I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or of my fellow Commissioners.
At the SEC, we spend a lot of time thinking about U.S. public companies, registered investment companies, registered investment advisors, registered broker-dealers, and the U.S. investors who invest in them or use their services. But today's capital markets include many players who are not on that list. We have struggled over the years to figure out how best to interact with those other market participants. At long last, it is becoming increasingly clear to most people that the SEC's actions have far-reaching effects. By the same token, actions taken outside of the SEC's primary regulatory sphere have substantial effects within the areas that it most directly and intensively regulates. So, at a minimum, it is incumbent upon the SEC to consider these effects as it plots its regulatory course.
The increasing globalization of the capital markets has intensified the SEC's need to be mindful of developments outside of our main regulatory sphere. So, for example, last week, the SEC voted to issue a concept release on permitting U.S. issuers to file their financial statements using International Financial Reporting Standards, rather than U.S. generally accepted accounting principles. Last month, the SEC proposed to allow foreign private issuers to file using IFRS without reconciling to U.S. GAAP, as they are now required to do. Both of these SEC actions come in response to a move by much of the rest of the world to shift to IFRS. A failure to respond in a rational and timely manner to this shift could affect U.S. investors, who seek to invest in non-U.S. companies, and U.S. companies, who seek to compete with their foreign counterparts for capital.
Even within the U.S., however, the SEC is finding it necessary to take a broader view. There has been much talk and analysis of late regarding the effects of Sarbanes-Oxley's internal control provision – Section 404 — on public companies. Some studies have asserted that the costs of complying with Section 404 have affected decisions by companies and their investors on whether to go public or stay public. Stories abound that Section 404 costs, which greatly exceeded expectations, were significant enough to tip the balance against conducting an IPO in the United States for some private companies. Likewise, some public companies have found significant savings after exiting the public markets.
Just in time for Monday's fifth anniversary of Sarbanes-Oxley, the SEC responded by making some significant adjustments to the implementation of Section 404. In June, the SEC issued guidance that is intended to provide management with a risk-based, top-down, tailored approach to complying with their obligations under Section 404. Last week, the Commission approved the Public Company Accounting Oversight Board's new Audit Standard 5, which replaces Audit Standard 2. AS 2 was prescriptive, encouraged auditors to focus on items that were not material, and discouraged auditors from using the work of others. The new standard is intended to refocus the manner in which auditors carry out their responsibilities under Section 404. Under the new standard, auditors should direct their efforts to identifying any material weaknesses in internal control without getting diverted by looking for immaterial internal control issues. As both the SEC and the PCAOB have acknowledged, we will not be able to judge the effectiveness of the new audit standard and management guidance until we see how they are implemented. If these changes are not successful, it may well turn out that private equity will find even more lucrative opportunities for taking public companies private!
As unregistered funds, including private equity funds, have grown to play a larger role in the markets, the SEC legitimately has begun to pay greater attention to them. In some cases, however, this attention has led to inappropriate regulatory responses. It is worth noting that even though our regulatory efforts today may be aimed at only one type of unregistered fund, such as a traditional hedge fund, that does not mean that the some future commission will not extend those regulations to other unregistered funds - especially once a precedent is set for such regulations. Particularly as the lines between different types of unregistered funds blur, you can be pretty certain that measures taken with respect to one type of fund will soon be applied to all the rest. If you live in a townhouse and your neighbor's townhouse is burning, you had better help put out the fire before the flames leap through the walls to engulf your house, too.
This is the message that I sent when, three years ago, over my objection and that of my then-colleague Commissioner Cyndi Glassman, a majority of the SEC adopted a rule to mandate registration for hedge fund advisors. The rule was driven by, among other reasons, a realization of the growing importance of hedge funds in the securities markets, a desire to obtain better information about hedge funds, a desire to deter fraud, and a perceived need to address purported retailization.
Now, these may well be sensible considerations and goals, but I objected to the rule on a number of grounds, not the least of which was that it would not achieve the stated goals and would have had harmful side effects. Former Federal Reserve Chairman Alan Greenspan explained bluntly that "the initiative cannot accomplish what it seeks to accomplish."1 Another problem with the rule was the cost that it would impose by diverting resources. The Government Accountability Office pointed out that the registration mandate for hedge fund advisors threatened to undercut the SEC's oversight of mutual funds.2 Our inspection resources already are spread thin over a large group of registered advisors and mutual funds. It did not seem to make sense to divert oversight resources from the areas in which retail investor assets are concentrated. Hedge fund investors - including the likes of Rupert Murdoch and Rupert Johnson, George Soros and George Lucas, Michael Bloomberg and Michael Milken - have either the financial acumen or the financial wherewithal to look out for themselves or hire someone else to do so for them. Moreover, they likely can afford to bear a loss if they or their advisor makes a poor decision. They are probably not betting their last dollar on a hedge fund manager. If things go wrong, they have the means to take effective steps on their own, including private action and knowing how to report malfeasance to the proper authorities.
The suggestion that hedge funds were drawing increasing numbers of retail investors was not supported by the staff report that preceded the rulemaking.3 There were also worries about retail investors' indirect exposure to hedge funds through pension funds, for example. In such cases of indirect exposure, however, the retail investor is protected by a sophisticated intermediary who makes the investment decisions.
Our brief foray into mandatory hedge fund advisor registration was cut short by the D.C. Circuit Court of Appeals last year in Goldstein v. SEC, just months after the registration requirement took effect and before the rule was able to prove its own futility.4 The Court overturned the rule because of the SEC's "manipulation of meaning" with respect to the word "client," which the Commission had redefined solely for the purpose of forcing all hedge fund advisors to register.5
Rather than petitioning the Supreme Court to reinstate the rule, the SEC decided to take an entirely different approach to unregistered funds. A number of different threads make up this approach. First, the SEC is intensifying its cooperation with other regulators and supervisors, including the Fed, on issues of systemic risk and information collection. Unregistered funds are undeniably significant players in the capital markets. Regulators do need to monitor systemic risk, and have been cooperating in this endeavor for many years. In 1992, the Treasury, Federal Reserve Board, and the SEC provided a joint report to Congress that raised questions about systemic risk in the government securities market.6
The Long Term Capital debacle of 1998 reawakened concern about systemic risk. The following year, the President's Working Group on Financial Markets — which is made up the heads of the Treasury, the Federal Reserve Board, the CFTC, and the SEC - issued a report in response to Long Term Capital. This report focused on ways to control leverage. The report noted that "in our market-based economy, market discipline of risk taking is the rule and government regulation is the exception."7 The report further cautioned, that "[a]ny resort to government regulation should have a clear purpose and should be carefully evaluated in order to avoid unintended outcomes."8
In the past couple of years, these principles of regulatory restraint have been affirmed as the market has continued to demonstrate a capacity to minimize and absorb systemic risk. Last year, Federal Reserve Chairman Ben Bernanke observed that regulators should "focus on counterparty risk management [which] places the responsibility for monitoring risk squarely on the private market participants with the best incentives and capacity to do so."9 As Chairman Bernanke explained, such an approach has the added advantage of avoiding the moral hazard that could result from closer regulatory involvement, which would inspire private counterparties of hedge funds to do less, not more, monitoring. Likewise, Chicago Federal Reserve President Michael Moskow - who, I understand, will be retiring at the end of this month - observed last month, that, "The major challenge for financial regulators going forward is to design regulatory structures that encourage market discipline and thus utilize the inherent efficiency of decentralized markets."10 As President Moskow noted, the recent experience with Amaranth served as evidence that the market is able to absorb even substantial hedge fund disturbances.
In February of this year, the President's Working Group issued a policy statement regarding private pools of capital that supported a market-based approach.11 The statement acknowledged the valuable role that private pools of capital play in the financial markets and recognized that "[m]arket discipline most effectively addresses systemic risks posed by private pools of capital."12 It directed regulators and supervisors to work with "creditors, counterparties, investors, and fiduciaries to foster market discipline."13
In addition to systemic risk issues, the February statement addressed investor protection. It looked to both market discipline and regulatory policies that allow only sophisticated investors to have direct access to private pools. This leads me to a second step that the SEC has taken since the hedge fund registration rule was overturned in court. Last December, we proposed to raise the threshold for investors in private pools.14 The existing investor accreditation standards were put into place in 1982. Years of inflation and rapidly rising housing values have expanded the number and kinds of people who meet the current accreditation standards.
The proposal would create a new category of accredited investor for private investment pools that would include anyone who satisfies the existing $1,000,000 net worth or the $200,000 net income test and owns at least $2.5 million in investments, which would exclude the person's home. The new investment minimum would be adjusted for inflation every five years. Essentially, then, the proposed rule would layer an additional requirement on top of the existing accredited investor requirements for Section (3)(c)(1) funds. Section (3)(c)(7) funds would not be affected since investors in those funds already are similarly subject to a two-part investment test.
Oddly, the changes in accreditation would not apply to venture capital funds. Is there a principled reason for treating venture capital funds differently than other private investment vehicles? I asked a similar question in conjunction with the hedge fund advisor registration mandate, which was directed only at advisors to hedge funds and was intended to exclude advisors to private equity and venture capital funds. In order to achieve this, the rule drew a crude line that excluded advisors to pools with a lock-up period longer than two years. In response, some hedge fund advisors, able to plead that the government made them do it, simply extended their lock-up periods beyond two years. This was a terrible result for investors, who can use the threat of walking out as an effective means of keeping a potentially wayward manager in line. The proposed accreditation rule uses a more sophisticated mechanism than the length of the lock-up period to exclude venture capital funds from its reach. Nevertheless, I continue to believe that venture capital funds should not get too comfortable with their exclusion.
We have received a flood of comment on the proposal. Much of it was – to put it mildly — not very positive. Some of the commenters addressed the mechanics of the proposal. They raised concerns about such issues as the absence of a grandfather provision to allow current investors to make additional investments. Criticism largely centered, however, on the magnitude of the proposed increase in the investment threshold. The following comment was typical: "Stay out of my wallet, stop trying to protect me from myself, stop presuming to know more than I do about my own life, risk-tolerance and financial sophistication. … I am so angry about this type of regulation in our country I could just scream."15 Another commenter suggested that a better approach would be for the SEC to administer a financial sophistication test on its website.16 Only those who passed the exam would be permitted to invest in unregistered funds.
I share these commenters' concerns about the potential unintended effects of raising the accredited investor threshold. It is discomfiting and difficult to draw appropriate lines in this area, and, needless to say, I suspect that the SEC would find it even harder to administer sophistication tests. Practically speaking, low net-worth, retail investors are not the target audience of advisors to unregistered funds. Most advisors to private pools simply do not have the capability to target and service these investors, who have relatively little to invest. To address the concerns of investors who will not satisfy the new test, the Commission should do what it can to pave the way for access to alternative investments through products with appropriate safeguards. Specifically, the Commission needs to be open to new products.
I do worry, however, about how the new threshold will affect newly established advisors without much of a track record. These advisors will have to try to attract capital from what may prove to be a very small pool of potential investors. If adopted, I fear that the rule could prove to be a significant barrier to entry for new advisors.
Indeed, the SEC is continuing to look at whether the proposal got the accreditation levels right. We will solicit additional comment in connection with a forthcoming proposal to amend Regulation D, a series of rules that apply to private placements. Soliciting comment in connection with the proposed changes to Regulation D should help us also to work towards greater uniformity of approach across our rule book.
A third step that the SEC has taken after the court threw out the hedge fund advisor registration rule was to adopt a rule to clarify that the SEC can pursue advisors for fraud perpetrated against investors and prospective investors in their fund, as well as for fraud perpetrated against the fund itself. Basically, in case you had any doubt, the commandment is: "Thou shalt not rip off thy limiteds." We adopted this rule last month.
This rule does not single out advisors to any particular type of fund, but includes the full range of pooled investment vehicles. This is a positive feature of the rule and a move away from the rhetoric about a supposedly growing trend of hedge fund fraud. In the past, some have eagerly slapped the label "hedge fund fraud" on every garden variety fraud that has come along. The SEC's new antifraud rule, because of its comprehensive breadth, should enhance our ability to protect investors from fraud, regardless of how the advisor labels himself.
The one aspect of the antifraud rule that troubles me, however, is the assertion made regarding the level of intent necessary to violate the rule. Although styled as an anti-fraud rule, some assert that a violation can be based just on negligent conduct. Thus, someone may find that he has violated the rule unintentionally. SEC enforcement resources are too scarce to expend on cases based on unintentional errors. I submit that the SEC should have taken the higher - and more legally defensible road - and should have explicitly classified this as a scienter-based rule. Right now, I would say that the applicable standard is at best murky, because it is not clear to me that a court would agree to a negligence-based rule.
I would like to end my remarks today by addressing an issue that the SEC discussed at an open meeting last week and that has been a frequent topic of discussion for many years - so-called proxy access. At last week's meeting, the SEC adopted two different proposals, both by a 3 to 2 vote. Although the debate relates to the ability of public company shareholders to gain access to the company's proxy statements to put forth director candidates directly, I believe that the issue is relevant to a discussion about private equity. The issue, like Section 404, has the potential of affecting the costs of being a public company.
Whereas privately-held companies frequently have a small, concentrated group of shareholders, large public companies usually have a large number of shareholders whose interests often vary greatly. Private equity investors tend to have a significant amount of influence over the companies they control. In the public company arena, however, even the largest institutional investors typically hold only a minority position in the issuer. Thus, there is a significant hurdle to collective action by shareholders in exercising their rights under applicable corporate law. A shareholder who proposes to make a change in the company needs the backing of other shareholders. Who should pay for his quest to seek the support of other shareholders? Given that a particular shareholder's interest in the company might be merely nominal, to what extent should all shareholders bear the costs of a proposal being pushed by a particular shareholder? To be fair, that issue also extends to management's use of shareholder resources to fight against insurgent shareholders.
The SEC's efforts to address this collective action problem date back to the first decade of our agency's existence when we first adopted a rule requiring the inclusion of a proposal submitted by a shareholder. Today, this rule is known as Rule 14a-8 - a rule that has never been particularly satisfactory. Rule 14a-8 generally states that a shareholder proposal must be included in a public company's proxy statement unless the shareholder fails to satisfy certain procedural requirements or unless the proposal is excludable on one of thirteen substantive bases.
Some critics have complained that the Rule 14a-8 is too restrictive and that, as a result, proposals of legitimate concern are excluded from the company's proxy statement. Others have argued that Rule 14a-8 is too lenient, especially as it applies to non-binding proposals, which frequently involve "social policy" resolutions that only rarely, if ever, obtain majority support. It is perhaps because of this struggle that the Commission seems to revisit the proxy rules at least once every several years.
During my early tenure as commissioner, Chairman Bill Donaldson put forth a very controversial, complicated, and divisive proposal. This rule would have forced companies to include nominees of shareholders on the company proxy statement in elections of directors. This so-called "director access" proposal, which mandated a "one-size fits all" approach, appeared to take the Commission squarely beyond the bounds of its statutory mandate to ensure proper disclosure and fair voting procedures in proxy solicitations and into the realm of setting substantive corporate governance standards. After receiving significant public comment, the SEC wisely did not act on this proposal.
Perhaps the director access issue would have lain dormant, but for a decision of the U.S. Court of Appeals for the Second Circuit last year.17 That case arose from a union's demand that AIG include on its proxy statement a proposal to amend the company's bylaws to permit shareholders to nominate directors. The Second Circuit ruled in favor of the union, even though a long-standing SEC interpretation permitted companies to exclude such proposals. The director election exclusion of Rule 14a-8 simply states that a proposal may be excluded if it "relates to an election" for director. The SEC has taken the position that this exclusion not only applies to a proposal that would result in an immediate contested election, but also to any proposal that creates a procedure that might result in a future contested election.
The rationale behind the SEC's position is simple: the proxy rules are designed to provide appropriate disclosure to shareholders. Contested elections are governed by rules that call for special disclosure, such as conflicts-of-interest disclosure by the challenger-nominees. These special disclosure provisions, however, would not be triggered if a contested election were being waged on a single proxy statement, and shareholders would not get the disclosure that we have deemed necessary.
The Second Circuit arrived at its decision on procedural grounds. It found that the SEC staff had been inconsistent in applying the director election exclusion in certain prior no-action letters and therefore rejected the interpretation that we had submitted to the court. Importantly, the court stated that it would "take no side in the policy debate regarding shareholder access" to the company proxy statement.18 The Second Circuit observed that "Congress has determined that such issues are appropriately the province of the SEC, not the judiciary"19 and noted that the [SEC] could certainly interpret the exclusion in the manner unsuccessfully argued to the court, provided "that it explains its reasons for doing so."20
The SEC did just that at last week's open meeting. We specifically adopted a current interpretation of the director election exclusion that is consistent with the SEC's long-standing interpretation and the interpretation that we put forward to the Second Circuit. As directed by the court, we have provided a thorough explanation for that position. This interpretation, which now governs our administration of that provision, will provide the necessary clarity and uniformity for both investors and companies alike until an amendment is adopted in the future.
Thank you all for your attention. I hope that you enjoy the rest of your conference. I would like to hear your thoughts about the issues that I discussed or anything else. I would also be happy to hear from you later by phone or, if you plan on being in Washington, in person.