Speech by SEC Commissioner:
Remarks to the 28th Annual Northwest Securities Institute
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
February 22, 2008
Thank you very much, Mike [Michael Stevenson, Washington Director of Securities], for that wonderful introduction. I appreciate your efforts not only here in the Pacific Northwest, but throughout the country as a board member of the North American Securities Administrators Association. Since the SEC no longer has an office up here in Seattle, it is good to know that we can rely on you as a virtual office.
I also congratulate the steering committee members for organizing this 28th Northwest Securities Institute. This event brings together securities practitioners from not only Washington and Oregon, but from our counterparts in the Canadian provinces as well. It is a privilege for me to address such a distinguished and international audience. I am grateful for invitation . . . and am glad that it was not revoked when the Redskins hired Jim Zorn away from the Seahawks!
As you will no doubt hear from the other SEC speakers today, of course, I need to remind you that my remarks are my own and do not necessarily represent the views of the Commission or my fellow commissioners.
Needless to say, it is an interesting time in the securities markets. Over the past year, the markets for a number of financial instruments have experienced some rather unusual conditions, and financial institutions and investors have had to learn to their detriment what a liquidity drought means. The deteriorating liquidity conditions in the subprime mortgage market and related markets have led to significant volatility in the capital markets. The effects have been felt both in the U.S. and abroad.
It is important to recognize that the current situation is still essentially a liquidity event. The reasons for the liquidity drought are readily apparent. Market participants began to question the value of a variety of financial products, especially those with complex structures and the assumptions underlying their valuation models. Consequently, liquidity in these products fell sharply. The lack of liquidity complicates the task of valuing complex instruments. In many cases, mark-to-market accounting rules resulted in the taking of additional reserves or recognition of lower book values by financial institutions in respect of these instruments.
Treasury Secretary Paulson and the Federal Reserve governors have been taking solid steps to deal with this situation. As Secretary Paulson has said, “The U.S. economy is diverse and resilient, and our long-term fundamentals are healthy.” While demand for complex structured products may be diminished, the flight to quality has still meant strong demand for investment-grade products. As the interest rate environment, itself a product of investor expectations, settles down and as investors gauge the performance of existing structured products, demand will ultimately return to these sorts of products. No doubt that investors will apply what they have learned to the new environment. The great thing about our dynamic marketplace is that where there is a potential reward, sooner or later there is someone at some price who is willing to blaze the trail and take the risk.
We as regulators must not stand in the way of investors’ and market participants’ sorting this situation out. It would be most unfortunate for the economy — investors, workers, consumers — if regulators contribute to market uncertainty through interfering with contracts, judging the merit of products or business strategies (especially with the benefit of 20/20 hindsight), or setting arbitrary criteria based not on economics but on conjecture. Uncertainty breeds aversion to risk, and aversion to risk has the potential to slow down our economy.
These kinds of market situations — uncertainty regarding valuation, integrity of counterparties, or looming regulatory action — have happened before, and our current experience is mild in comparison. In past situations, we have seen the amount of bank commercial and industrial loans decline steadily and their holdings of government or other high-rated securities increase proportionately. Some of this reaction could be attributed to boards’ and credit committees’ being more risk averse. But, unfortunately some of it could be attributed to the cumulative actions of thousands of bank examiners sharpening their pencils, tightening their reviews, increasing their questioning, and substituting their judgment for that of banks. Some of that may be fine and much needed, especially where banks may have lax risk management or credit review systems. The SEC and the bank regulatory agencies issued a joint statement two years ago regarding business and lending practices in the complex structured finance transaction area. I hope and expect that banks have adhered to this guidance. But, we must be concerned about the potential distortions to the credit marketplace and the effect on entrepreneurs and smaller companies (usually the weaker credits) of regulatory overreaction. The pendulum can swing too far in either direction. Fortunately, unlike in the past, the sources of capital today are much more diverse, with private funds taking a larger role in lending and stepping in as lenders when regulated entities do not or cannot.
Another related area where the Commission has jurisdiction concerns the credit rating agencies — the so-called “nationally-recognized statistical rating organizations.” It probably would have been hard to imagine back in 1975 that the NRSRO designation — designed to guide broker-dealers in calculating their net capital — would develop into the tool that is much more broadly used by both regulators and investors today.
Perhaps it is useful to recapitulate the history of credit rating agencies. In 1890, a young man named John Moody got his start as an errand boy for a Wall Street bank. One morning while reading the newspaper — filled with a growing number of securities listings — he thought to himself that investors would probably be very interested in an easier way to distinguish among the issuers. So, in 1909, Moody published a book on the railroad industry, assigning a letter grade to each company based on his opinion of their financial risk. A few years later, in 1916, Poor’s Publishing Co. — which would later merge with another company to become Standard & Poor’s — started rating corporate debt. These ratings were an expression of opinion of the raters. Investors were free to accept them or reject them as they saw fit.
It was only beginning in 1975 that the SEC began to make explicit reference to credit ratings in its rules, thereby creating a legal and regulatory effect for obtaining certain ratings. Initially, the Commission used the term “NRSRO” solely to determine capital charges under the net capital rule for broker-dealers. Subsequently, NRSRO ratings were incorporated into additional SEC regulations, really starting with Rule 2a-7 governing what assets may be in a money-market mutual fund. This rule was promulgated in the early 1990s when some money-market funds came perilously close to breaking a dollar of net asset value because of declining values of certain riskier securities that they held in their portfolios. The new rule looked to high-rated debt instruments as suitable investments. After that, the use of the NRSRO designation continued to expand as a convenience. Congress and regulators other than the SEC also began to make reference to NRSRO ratings.
Before the implementation of the Credit Rating Agency Reform Act of 2006, the practice of the SEC had been to allow staff to designate credit rating agencies as NRSROs through the no-action letter process. If, in the staff’s view, widespread acceptance of ratings issued by a particular ratings agency had been achieved, the staff would issue a no-action letter. In practice, obtaining designation as an NRSRO was rather opaque. Some applications would linger for more than a decade without definitive resolution.
In effect, the unintended consequence of this process was to limit competition and information flowing to investors. Congress reacted to change the situation. The legislative history reflects a genuine concern that the SEC facilitated the creation of — and perpetuated — an oligopoly in the credit rating business. Today, two NRSRO-designated firms collect over 80 percent of the market’s revenues.
Since I came to the Commission in 2002, I have been a vocal proponent of increased transparency in the NRSRO designation process. We have recently promulgated rules that have done just that. My only regret is that Congress left the appellation of NRSRO as “Nationally Recognised,” rather than “Nationally Registered.” They kept the name mainly because that terminology is in such widespread use throughout federal and state statutes and regulations — an indication of how many people have piggy-backed on the definition as a convenient reference. In my view, we are in the registration, not recognition, business. The government should facilitate market-based decisions, not substitute its judgment for them.
The SEC is examining the role played by credit rating agencies in the development of the current subprime market. Credit rating agencies have been criticized about the accuracy of their ratings, for failing to adjust timely those ratings, and for not maintaining appropriate independence from the issuers and underwriters. Our examinations will review whether the rating agencies diverged from their stated methodologies and procedures for determining credit ratings. They will also focus on whether the rating agencies followed their procedures for managing conflicts of interest inherent in the business of determining credit ratings.
We are clearly charged by Congress in overseeing this area. Although we must carefully review the results and recommendations not only of our own examinations and investigations, but those of other regulators, we must keep in mind that ultimately a rating is an expression of opinion — one that, barring self-dealing or lack of integrity, enjoys the protection of the First Amendment. More importantly, we must remember that a triple-A opinion issued by a credit rating agency — no matter how much expertise it may have be — is no substitute for an investor’s making an informed decision and undertaking careful due diligence. We should not create a regulatory regime that creates a moral hazard for investors by encouraging them to rely on credit ratings.
Not all investors were burned or caught off-guard by the subprime problems. I was struck by the comment of one large mutual fund portfolio manager: “We never rely solely on a credit-rating service. We look at what they have to say, but for us it’s just a starting point. Our investments are based on our own independent credit analysis.”
As we carry out these examinations, we must recognize — as mentioned by Chairman Cox in his recent congressional testimony — the explicit intent of Congress that we not substitute the Commission’s judgment for that of the rating agencies.
Given the international makeup of today’s audience, it would be appropriate to touch on a few international topics that will be under consideration by the Commission this year. One of the most significant issues will be where the United States is headed on use of International Financial Reporting Standards (IFRS). Last year, the Commission adopted a rule that permits foreign private issuers who report under IFRS as adopted by the International Accounting Standards Board (IASB) to file their financial statements with the SEC without reconciliation to U.S. generally accepted accounting principles (GAAP).
Now that we have taken that step, the question is raised as to whether U.S. issuers should likewise have a choice to report in IFRS or GAAP. In August 2007, the Commission issued a concept release seeking information about the extent and nature of the public’s interest in allowing U.S. issuers to do so. The comment period closed on November 13, 2007 and we are in the process of reviewing the comments submitted. These comments will be helpful as we further consider the path of convergence between IFRS and GAAP.
In March 2007, we adopted new rules that significantly changed the requirements for exiting the Exchange Act reporting system by foreign private issuers. Unlike the older rules that required a foreign private issuer to have fewer than 300 holders resident in the United States, new Exchange Act Rule 12h-6 permits the de-registration of a class of equity securities if average U.S. daily trading volume is less than five percent of the average worldwide daily trading volume for a recent 12-month period.
A number of eligible foreign private issuers filed to withdraw immediately after effectiveness. After years of pent-up demand and the turmoil of the ill-fated and ill-conceived Audit Standard 2 of the PCAOB, we expected a large number of deregistrations. According to the Division of Corporation Finance, as of the end of last year, approximately one hundred foreign private issuers had filed Forms 15F under the new criteria set forth in Rule 12h-6. This amounts to just under 9% of all foreign registrants, with the largest group coming from the European Union. On the other hand, one of the other hoped-for effects of the new rule was that it might encourage foreign private issues to register with the Commission in the first place — because if you know you can leave, then you just might want to come to the United States in the first place to try it out. So I am happy to note that during 2007 more than 75 new foreign private issuers registered securities with us.
Having utilized relative average U.S. daily trading volume as a measure to exit the SEC registration system, we are now looking to use a similar measurement to determine when U.S. registration would be appropriate. Last week, we proposed revisions in our current exemption under Rule 12g3-2(b). Under the new proposal, a foreign private issuer would be exempt from registration so long as its relative U.S. average daily trading volume was less than 20% of worldwide average trading volume and the issuer electronically publishes its disclosure documents in English.
Of course, there are issues of enforceability and extraterritorial application of our laws. And, after all, it is U.S. investors who have gone abroad to buy those unregistered offshore securities in the first place. But, with such a high percentage of trading in the U.S., it seems unlikely that the issuer would not know about and sanction that trading. Thus, we are seeking comment.
A related proposal that we approved last week was to change the annual report filing deadline for foreign private issuers. Under our current rules, foreign private issuers may file their Form 20-F up to six months after the end of their fiscal year. This deadline is the same as it was when first adopted in the 1970s. That’s when it took about two weeks just to send a package to London — longer elsewhere. In today’s investment world, six months is an eternity, especially when, in many cases, investors are only waiting for the reconciliation to GAAP. The six month filing deadline makes even less sense for IFRS filers, since they avoid the GAAP reconciliation requirement entirely.
Many of these proposals have the potential to affect Canadian issuers and their participation in the U.S. capital markets. As many of you know, in the early 1990s, the SEC and the Canadian provincial securities regulators created the multi-jurisdictional disclosure system. In many respects, it was an early attempt to achieve some of the objectives that we are now exploring on a more global basis as part of our on-going discussions on mutual recognition.
I look forward to hearing the comments about when is the appropriate time for annual reports on Form 20-F to be filed as well as with respect to the other proposed changes to disclosure by foreign private issuers.
Last summer, the Commission published a package of six proposals addressing small business capital raising and private offering reform. In the past three months, we have voted to adopt five of these proposals. In approving these rules, it has been very important to follow through on consideration of the original recommendations by the Advisory Committee on Smaller Public Companies. The ability to quickly and easily raise capital for smaller public companies and private companies is an important factor in maintaining the economic competitiveness of our country.
As a result of these changes, significantly more public companies are now eligible for the scaled disclosure eligibility, which has been raised to $75 million in public float. All companies that are traded on a national securities exchange are now eligible to have shelf offerings and to sell securities on Form S-3, subject to certain limits depending upon the size of their public float. The restrictions under Rule 144 for the re-sale of securities have also been significantly liberalized.
One of the more important amendments that we have adopted is the revisions to Form D, which will no longer be filed in paper but electronically. As a result, the Commission will be able to much more easily analyze and study the information contained in those filings. More importantly — and I know that Mike Stevenson here in Washington has been working on behalf of NASAA with the SEC — is the development of a true “one-stop” electronic Form D filing system that will concurrently distribute filings and fees to the SEC and the states.
The one proposal that remains outstanding is the proposed revision to Regulation D. Under this proposal, a new large accredited investor standard would be added and an issuer could engage in limited advertising to reach such investors. If adopted, this would be a significant change from the current methods of raising money through private placements, which prohibit any form of general solicitation.
Our proposal to update Regulation D also seeks to close a significant loophole that has been at the center of far too many pump-and-dump schemes. In these schemes, issuers and stock promoters have conspired with less than honest lawyers to purportedly issue “free trading” shares under Rule 504. These shares, issued without restrictive legends, rapidly are disseminated into the public markets where their prices and trading volume are pumped up by a variety of methods. When the collapse of the stock finally occurs, many unwitting investors are left holding the bag. I look forward to reviewing the public comments and a final recommendation from the staff.
Now there is one other proposal that has not been proposed — but it should be. It has been a topic of much discussion over the years. It is long overdue for the Commission to consider the issue of private placement broker-dealers, also known as finders. Finders are of critical importance to smaller companies that are seeking capital. For that small start-up that seeks only a small amount of capital to get it to its next milestone, there are few options once friends and family are tapped out. Finders can fill this critical role, but they exist in a regulatory Twilight Zone.
Under our current system of regulation, a person either falls within or without the definition of a broker. If a person conducts activities that cause him or her to be considered a broker, there is only one result: you are subject to the same regulatory requirements as Merrill Lynch and Morgan Stanley. This “all or nothing” scheme simply is not appropriate for private placement broker-dealers, who frequently do not handle or process trades.
The Advisory Committee on Smaller Public Companies made this one of their key recommendations. It has been on the list of recommendations by the annual Government-Business Forum on Small Business Capital Formation for nearly every year since 1999. More importantly, a task force of the American Bar Association put forth a specific proposal for consideration of a “broker-dealer lite” regulatory system to accommodate finders in May 2005. Unfortunately, the Commission has not tackled this issue with the urgency that is probably appropriate. I hope that changes soon.
Finally, I should say a few words about recent developments from the Supreme Court. Some have decried the cumulative effect of Credit Suisse v. Billing, Tellabs v. Makkor, and Stoneridge v. Scientific-Atlanta as “anti-investor.” In fact, these decisions evince a sense of due process and rule of law that protects investors’ investments from those who seek to find new ways to extract large settlements from shareowners outside of the courtroom. We must remember that it is shareowners who ultimately shoulder the burden of large settlements.
In Stoneridge, the Supreme Court recognized what was going on. The Court rejected the philosophy in the dissent, which was written by Justice Stevens, that “every wrong shall have a remedy.” The Court warned that if it adopted the plaintiffs' concept of reliance, the "cause of action would reach the whole marketplace in which the issuing company does business." In other words, had Stoneridge gone the other way, plaintiffs would be able to reach into the pockets of customers, vendors and other firms that simply do business with companies that defraud investors.
As one could expect, Stoneridge sparked an outcry from those arguing that in the name of "fairness" and "justice" someone should be forced to pay if the primary wrongdoer cannot. But justice is not merely finding someone who can pay. Exposing one company to class-action lawsuits because another company defrauded its investors is not fair or just to shareholders who shoulder the burden of class-action settlements.
As the Supreme Court explained, broadening the scope of securities laws can damage capital markets. Subjecting new classes of defendants to lawsuits raises the costs of being a public company, deters overseas firms from doing business here, and shifts securities offerings away from domestic capital markets to the detriment of U.S. investors.
This does not mean that those who knowingly assist others in violating securities laws go unpunished. As the Supreme Court observed in Stoneridge, Congress amended the securities laws in 1995 to allow the Securities and Exchange Commission to bring actions against secondary violators that aid and abet securities fraud. Congress wisely declined to extend that right to private parties, out of concern of abusive securities litigation.
We at the SEC take seriously our ability to bring actions against secondary violators that aid and abet securities fraud. The SEC is well positioned to hold responsible individuals accountable by imposing injunctions, officer and director bars, disgorgement, and civil penalties. The ill-gotten gains that the SEC recovers may be disbursed to aggrieved investors without a generous cut for the plaintiffs' lawyers.
Unfortunately, some at the SEC share Justice Stevens’ philosophy of trying to find a remedy for every wrong, even if it means making new law. The SEC must resist efforts — internal or external — to broaden securities laws beyond their existing boundaries, even when those efforts are driven by a desire to see harmed shareholders recompensed. By respecting legal boundaries and not "pushing the envelope," the SEC provides predictability to investors, individuals and companies as to unacceptable conduct.
We at the SEC have an enormous responsibility not only to enforce the securities laws as written, but also to avoid rewriting and expanding them in the process. The integrity of our capital markets and the welfare of investors depend on the adherence to the rule of law by all participants including regulators.
Thank you very much for your attention. I appreciate the opportunity to meet up with here today and would be delighted to answer any of your questions.