Speech by SEC Commissioner:
Remarks Before the Exchequer Club
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
January 14, 2009
Thank you, Karen, for that warm introduction and for the kind invitation to join you this afternoon. Before I begin, let me remind you that my remarks today represent my own views, and not necessarily those of the SEC or my fellow Commissioners.
I’d like to start with a word of thanks to many of you here today who have served as a great resource over recent months, providing valuable real-time information and “boots on the ground” intelligence about some of the stresses our markets and various market participants have endured. Your insights have been very helpful. In particular, let me thank you for mustering and sharing useful, timely information with the SEC at critical junctures. I look forward to working in that same open and cooperative spirit in the coming months as we welcome new leadership at the Commission and as we continue to address some of the ongoing challenges our markets face. Thank you again.
In that same spirit, I wanted to speak this afternoon about some of the issues the SEC faced in 2008, some of the lessons we are learning from a period of sustained market turmoil, and how I think these challenges should inform how the Commission approaches its mission as we move forward.
Like other financial regulators, policy makers, and market participants, we faced no shortage of issues in 2008 and I expect we will be absorbing lessons from these times for a long while to come. The key will be taking away the right lessons from recent events and ensuring that they inform how we address the challenges and risks that confront our markets today and in the future.
Any number of challenges could illustrate the point, but let me begin with short selling.
In the months following the precipitous fall of Bear Stearns last March, the Commission focused increasingly on the role and impact of potentially abusive naked short selling and other manipulative market practices in the securities of financial firms.
Last July, the SEC issued an emergency order aimed at preventing naked short selling in the securities of Fannie Mae, Freddie Mac, and certain primary dealers. The order came amid growing concerns about significant downward pressures on financial institutions identified by the Federal Reserve as “systemically important” and it required anyone effecting short sales in these securities to arrange beforehand to borrow the securities and deliver them at settlement.
After the expiration of that temporary order, diminishing market confidence continued and, indeed, grew more acute, culminating in the unprecedented events we witnessed in September, including at Fannie, Freddie, AIG, and Lehman Brothers.
As a result, the SEC took further action in mid September, adopting three key short-selling provisions that still remain in effect:
- a requirement that short sellers and their broker-dealers deliver securities by close of business three days after the sale transaction date, or T+3;
- a rule eliminating the options market maker exception from the close-out requirement of Regulation SHO; and
- a new antifraud rule, Rule 10b-21, which expressly targets fraudulent short-selling transactions.
The very next day, and with great reluctance, the SEC took even more extraordinary action by issuing an emergency order prohibiting short selling in the securities of a wide array of financial institutions.
We took these actions in close consultation with the Federal Reserve and Treasury. In addition, the SEC also consulted and sought to coordinate with other securities regulators around the world. From the outset, the short sale ban was intended to be a temporary protective measure to give Congress and the Administration the requisite time to adopt broader stabilization measures. After the Emergency Economic Stabilization Act of 2008 was signed into law in early October, the ban expired, as planned, three business days later.
While the effects of the ban, as well as the previous emergency orders, are still being formally studied, we know, based on the review of the SEC’s Office of Economic Analysis, as well as studies and feedback from both academics and market participants, that the short selling ban created significant disruptions and distortions in markets and across the business activities of a wide spectrum of financial market participants.
At the time, undertaking such action required us to balance several important considerations. We had real fears about the downside of such a ban.
While extraordinary market conditions and great pressure led us to impose these temporary measures, we sought to carefully balance concerns about potentially abusive short selling against the likelihood of increased volatility, diminished liquidity, and inhibited price discovery. We also know that emergency actions by their very nature can add a further element of uncertainty to an already sensitive market environment and that such uncertainty may actually contribute to market instability.
We are looking to market participants, our economists, and colleagues around the globe to help us learn lessons from the impact of the temporary ban. In particular, SEC staff are participating in a newly formed IOSCO Task Force, which is working to develop a common approach to naked short sales, delivery and reporting requirements. The Task Force will seek to minimize the adverse impacts of short sales regulation on legitimate securities lending, hedging, and other types of transactions that are critical to capital formation and reducing market volatility. A draft report on these issues is expected to be submitted to the Technical Committee in February.
Through these efforts, I hope that, in the future, we can fine tune our responses to market events, minimize the potential collateral consequences of our actions, and make decisions based on facts and data and not as concessions to fear.
Fair Value Clarification and Mark-to-Market Study
In addition to short selling, fair value accounting occupied much of the Commission’s attention last year.
Accounting issues often find their way to center stage in severe market environments, and the current period of subprime turmoil and credit crisis has been no exception.
It has been said that, “Amid the pressure of great events, a general principle gives no help.” So, too, we saw certain principles underlying mark-to-market accounting tested as issuers dealt with the considerable pressures caused by inactive markets and illiquid securities.
Recognizing the need for clear direction to the markets last year, the SEC’s Division of Corporation Finance issued guidance on fair value measurements and other disclosure issues that preparers should consider in preparing their periodic filings. In late September, the SEC’s Office of Chief Accountant, in coordination with the staff of FASB, jointly issued a release providing clarification on certain aspects of FAS 157, itself a guide to fair value measurements. The FASB Board supplemented this guidance shortly afterward by finalizing additional authoritative guidance relating to the application of FAS 157 in an inactive market.
Beyond these immediate regulatory measures that the Commission took on its own initiative, Congress also directed the SEC to review and study the use and effects of fair value accounting standards. The Emergency Economic Stabilization Act included among its provisions a requirement that the SEC conduct a study of “mark-to-market” accounting, in consultation with the Secretary of the Treasury and the Board of Governors of the Federal Reserve System.
In late December, the SEC delivered the mandated report. While recommending against the suspension of fair value accounting standards, the report offers several important recommendations to improve their application, such as developing additional guidance and other tools for determining fair value when relevant market information is not available in illiquid or inactive markets and enhancing existing disclosure and presentation requirements related to the effect of fair value in the financial statements.
Among its key findings, the report notes that investors generally believe fair value accounting increases financial reporting transparency and facilitates better investment decision making. The report also observes that fair value accounting did not appear to play a meaningful role in the U.S. bank failures that occurred in 2008. Rather, the report indicates that these appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.
Further, during the course of our study, existing accounting standards for recording impairments was identified as one of the most significant areas of necessary improvement. The report recommends consideration of a number of improvements, including the evaluations of alternatives that have the potential to provide investors with both fair value information as well as transparent information regarding the cash flows management expects to receive by holding investments, rather than through accessing the market currently.
The FASB has already taken a number of important steps and I am pleased that the FASB chairman, prior to the finalization of the study, announced a decision to tackle a project (jointly with the IASB) to address the complexity in existing standards of accounting and reporting for investments. Further, I am hopeful that our study will be a helpful tool as the FASB and IASB address these issues.
Finally, the study also highlights a number of important recommendations of the SEC's Advisory Committee on Improvements to Financial Reporting (“CIFiR”). For example, the report points out that the use of judgment in accounting, auditing and regulation has increased due to the focus on more objectives-based standards (such as FAS 157) and recommends consideration of a CIFiR recommendation that the SEC adopt a policy statement related to the application of judgment in accounting.
The report also advises implementation of a CIFiR recommendation related to the creation of a financial reporting forum. Certainly the current financial reporting challenges have highlighted the benefits of such a forum that could serve an important role in timely identification and resolution of issues.
I believe that the report will be a useful source of information and guidance not only for us, but also for policymakers in Congress and independent standard-setters as they continue to consider these important issues.
Money Market Funds
Another area where the SEC both witnessed and sought to address some of the consequences of market turmoil during 2008 was in the money market fund space. A stable source of liquidity for investors and the capital markets over the years, these funds have been large participants in the market for commercial paper — agency and asset backed. As a result of recent disruptions, however, liquidity all but evaporated in this critical market.
And in September, several series of a money market fund known as the Reserve Fund were affected by write-downs of holdings in distressed companies such as Lehman Brothers. One SEC-registered series, the Reserve Primary Fund, “broke the buck” — only the second time we have witnessed such an event in the nearly forty years since money market funds were first established.
In light of larger concerns about the money market fund industry, the Commission took several actions. The SEC’s Investment Management Division worked with Treasury to establish a $50 billion Temporary Guaranty Program to help money market funds avoid a similar threat of “breaking the buck.” The program has been extended through April 30, 2009, and I understand that virtually all qualified money market funds continue to participate.
Before and after the Primary Fund incident, the SEC staff also provided guidance and relief to money market funds to allow affiliates to provide support through capital infusions or through the purchase of distressed securities, to relax shadow pricing requirements for certain short-duration instruments, and to foster participation in the Guaranty program.
Each of these examples represents part of a larger effort to help restart and revive the troubled credit markets where money market funds have been such significant participants.
Credit Rating Agency Reforms
When Chairman Cox spoke to you in early December, he touched upon another key area of focus during the current crisis: the role and failures of credit ratings and credit rating agencies, particularly with regard to structured finance ratings.
For nearly a century, rating agencies were self-regulated. That changed in 2006 with the passage of the Credit Rating Agency Reform Act, whose primary purposes were to promote competition in the rating industry, establish a transparent and rational registration system, and grant the Commission comprehensive supervisory authority to conduct a robust inspection and examination program to ensure that the rating agencies are complying with the federal securities laws and operating in a manner consistent with their disclosures.
Under the timetable established by the Act, the SEC quickly proposed and adopted initial rules that established a registration scheme for NRSROs, required important disclosures relating to their business operations and policies and procedures, and addressed certain conflicts of interest.
In early December, we adopted critical rule amendments and proposed additional requirements designed to address concerns about credit ratings of residential mortgage-backed securities backed by subprime mortgage loans and collateralized debt obligations linked to subprime loans.
The amendments include enhanced ratings performance measurement statistics, disclosures of rating methodologies and rating histories, annual reports to the SEC of credit rating actions, and a series of prohibitions relating to certain conflicts of interest.
The rules we adopted in December pave the way for important change, but I do not believe our work in this area is complete. I continue to believe the Commission should act in the near future on the other releases published for public comment in 2008 that were not part of the final rules. The first would seek to meaningfully enhance disclosure to investors of the different risk characteristics of structured financial products and traditional debt products. The second would address the oligopoly in the rating industry and the overreliance on NRSRO ratings by removing the regulatory requirements embedded in SEC rules. The third would require that rating agencies make publicly available ratings history information for 100% of their current issuer-paid ratings. This is a significant, pro-competitive reform proposal. In my view, it is vital that 100% of the credit ratings are disclosed to investors and market participants. This will permit maximum comparability of ratings on an obligor-by-obligor or instrument-by-instrument basis. The fourth would require the disclosure of the information a rating agency uses to issue a structured finance rating. It would facilitate competitive analysis by other rating agencies that are not paid by the issuer to rate the product. These firms could issue unsolicited ratings, and the marketplace could decide whose performance is superior. I believe these measures are necessary and advisable, and I hope that we see them come to be adopted in the near future.
We will also continue to assess the rules we have in place to determine whether they are effective in achieving their intended purposes and to see what more may need to be done in this area.
Credit Default Swaps
In the midst of recent events, we have also taken steps to reduce counterparty risk and to bring more transparency, efficiency, and structure to the credit default swaps market.
In late December, we approved temporary exemptions designed to facilitate the development of centralized clearing.
The temporary exemptions are designed to enable central counterparties and their participants to implement centralized clearing quickly, while providing the Commission time to review their operations and evaluate whether registrations or permanent exemptions should be granted in the future.
The conditions that apply to the exemptions are designed to provide that key investor protections and important elements of Commission oversight apply, while taking into account that applying all the particulars of the securities laws could have the unintended consequence of deterring the prompt establishment and use of central counterparties.
The Commission developed these temporary exemptions in close consultation with the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Commodity Futures Trading Commission, and the U.K. Financial Services Authority.
While Congress considers the necessity and appropriateness of potential legislation in this area, I believe the actions we have taken so far should begin to provide some much-needed transparency and discipline in the credit default swaps space.
Addressing the Challenges Ahead
These are just a few of the key challenges we faced in 2008. I could touch upon others, including significant rulemakings that spanned the Commission’s various divisions, groundbreaking enforcement proceedings, and other important initiatives carried out by the SEC staff, which has been working under considerable pressure, but with outstanding professionalism and steadfastness despite the tumultuous times we faced this year.
Without question, it has been a challenging time. But I think it is important to try to keep some of the challenges we have faced in perspective.
In one of my first speeches as a Commissioner, in the relatively news-free month of February 2007, I had occasion to remark that, “Oftentimes, when things go right, we don’t make headlines. But when things go wrong, even when the SEC may be doing its job well, we do make headlines.”
In 2008, the Commission certainly saw its share of headlines.
And importantly, even when we try to do what is right, there will be room for us to better our performance. Not only the recent market turmoil, but allegations of a high-profile Ponzi scheme you have all been reading about, will doubtless give us occasion to reexamine and improve upon how we approach and execute our mission.
Just last week, we heard proposals from the incoming administration, adding an important voice to the debate on the need for financial services regulatory reform and calling for “better enforcement, better oversight, better disclosure, [and] increased transparency.”
Of course, the idea of regulatory reform is not a new one — both in the broader financial services context and with regard to the SEC itself. And in light of recent market events, there is clearly growing momentum for such change.
As the Commission will play a role in this debate, I’ve shared some of the key principles that I believe should inform regulatory reform, including enhancing transparency and efficiency in the marketplace, rationalizing the regulatory structure by eliminating overlaps, gaps, and weaknesses, maintaining a focus on investors, and ensuring regulatory flexibility and cooperation.
But the idea of “better enforcement” is something that we also hear about from time to time, particularly in the wake of a headline-grabbing case. As far back as you care to look, nearly each generational “scandal” — Bernie Cornfeld in the late 1960s, ESM and Bevill Bresler and Levine and Boesky in the late 1980s, and Enron and WorldCom at the start of this century — has been followed by blue ribbon panels, Commission studies, or GAO reports that have discussed in some manner how our enforcement program should be reformed and improved.
Periods of challenge and stress — and moments where questions have been raised about some aspect of our performance — have come before. I would say that they are inevitable. Indeed — like our colleagues in the intelligence community — I think we will always be measured by the ones we don’t catch, not the ones we stop.
But I also believe that history has shown that we have learned much from such circumstances and that the SEC has emerged from such times having found ways to improve our performance and sometimes with additional, useful tools in our arsenal to do our job. The key is that we draw the right lessons from these challenges and that we solve the right problems and not unintentionally create new ones.
In recent years, the Commission has made significant efforts, some in response to recommendations by the GAO, to increase the transparency, consistency, and efficiency of our Enforcement program by, among other things, centralizing the review and approval process for new investigations, improving our information management systems, streamlining the Fair Funds Distribution process, and making our Enforcement manual available online as a “living” document. We have also published a statement on penalties and launched a pilot program for negotiating such settlements to further ensure transparency and consistency in our actions. Such changes are important elements of a dynamic Enforcement program that seeks to be rigorous, effective, and fair. We have more to do, but we continue to make great progress.
But in such times of scrutiny and stress as we find ourselves now, I also believe that, while we continue to critically evaluate and, where appropriate, seek to improve our programs, it is just as important that we keep our eye on the ball and continue to execute the fundamental mission that has been set for us as an agency.
In order to protect investors, now, more than ever, it is essential that the SEC seek to do what is right, regardless of the pressures we face or the prevailing winds.
In recent weeks, there have been calls that the new chairman should stage a series of “regulatory show trials” in the wake of recent market events.
No doubt, where they are appropriate, high profile cases involving well-known managers and companies send a message to would-be wrongdoers that crime doesn’t pay and they remind investors that the regulators are on the beat — looking out for them. And without question, the Commission does not shy away from bringing such cases. Indeed, to the contrary, it has become one of the defining characteristics of the SEC’s enforcement culture and what has drawn many of the talented lawyers and professional staff who work at the SEC.
But while big cases will always be important, it is essential that we remember that the not-so-notorious cases matter as much, if not more, in times such as these because they help ensure that rank-and-file retail investors continue to feel secure investing in our capital markets.
As enforcers, we must continue to be just as dogged in pursuing pump-and-dump schemes, affinity frauds, unregistered offerings, Ponzi schemes, boiler room scams, internet intrusions of every size — not just the “big ones.”
What is more, it is often hard to know whether a seemingly small scam might turn out to be much more than it appears at first, or whether it may help us flush out similar or related crimes that others are perpetrating. Indeed, we often unearth big frauds in old, tried and true schemes.
And, just as we cannot look to size alone, we also must be careful about being seduced by numbers. While it would be easy to look at the number of cases brought or resolved by the Commission in any given year or over a period of time and to use these figures as a proxy to say we are doing “too much” or “too little,” we must remember that mere numbers are never going to be an adequate metric of the enforcement work we do.
Gross statistics simply cannot convey the complexity of some of the cases we bring, the time necessary to conduct vigilant preliminary detective work, or the care required to develop, assess, and conclude cases in a way that is both fair and firm.
Just a year and a half ago, we were hearing complaints from some that overly rigorous oversight was driving financial market participants from our shores. Now, we hear complaints that we have not gone far enough.
Such criticisms of “too much” or “too little” will always be with us. Indeed, each such criticism can have its validity in certain respects and can serve as the catalyst for useful introspection and improvements. But, again, I believe that it is essential that the SEC not be swayed or moved to act merely by dint of criticism.
Doubtless, we will be criticized and sometimes that criticism has merit, but if our focus remains on being steadfast, firm, and fair in our oversight and enforcement processes, then we are doing our job.
In responding to allegations of wrongdoing in our securities markets, and particularly where there is a bright public light on potential wrongdoing that may have systemic implication, enforcement agencies carry a heavy burden.
We are expected to respond, and to respond swiftly, but we are also expected to get it right at every stop along the way. We are judged if the public and investors believe we are not acting quickly or comprehensively, but we are also judged throughout the process — not just for our tenacity and toughness, but for our fairness. This is important, because we enjoy a public trust and scrutiny encourages our best efforts.
If, at the end of the day, our efforts are marked by a commitment to rigor, fairness (no fish too big or too small), consistency, and transparency, then we are doing our job.
I firmly believe those with whom I work at the Commission share such a commitment. And I look forward to working with them to meet the challenges and seize the opportunities that 2009 will surely bring.