Speech by SEC Commissioner:
Market Upheaval and Investor Harm Should Not be the New Normal
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
Compliance Week 2010
May 24, 2010
Thank you for that kind introduction. At the start, let me issue the standard disclaimer that the views I express today are my own and do not necessarily reflect those of the Commission, the other Commissioners, or the staff.
A year ago I stood here and discussed the perils of "too big to fail," how the capital markets regulator should be structured coming out of regulatory reform, and why the SEC was best suited to that role.1 These issues, and many more, are still very much before us.
In recent decades, financial regulation has been guided by a philosophy that presumed that the market could be trusted to regulate itself, to take care of investors, and to support our nation's economic development. As a result, new products and ways of doing business were developed in unregulated and opaque markets without proper oversight by regulators and without transparency to the public. While a lot of people in the financial sector were enriched,2 the majority of Americans are now paying the price.
The financial crisis and its enormous costs to society were the direct result of years of deregulation, and they have sounded the alarm for change. The perils of fragmented regulation may also be seen in the May 6th market break — the so-called "flash crash." This market breakdown and the difficulty in determining how and why it occurred are yet further stark reminders of the dangers of weak oversight of our tightly interconnected financial markets.
More than a year after it reached its peak, the reasons for the financial crisis are still not fully understood. Moreover, information about how the capital markets actually work is shockingly difficult to obtain. This is disappointing, but it should not be a surprise. While our financial sector expanded at a record pace for years, deregulation was the "order of the day" for those in leadership positions. Regulatory budgets were cut,3 and regulatory authority was curtailed4 or not used.
It is clear that the public is clamoring for significant reform and expects Washington to deliver.5 Against this backdrop of deregulation and confusion, it is apparent that Wall Street and Main Street are in a tug-of-war to see who wins the legislative debate. This struggle will continue as the House and Senate financial reform bills are reconciled in conference. Throughout this debate, the voices of Main Street investors have been few. By contrast, the voices from Wall Street are active, well-organized, well-financed, and extremely well-connected. And they are quick to argue that one proposed reform or another would certainly lead to undesirable effects.6 They argue this even though their powers of foresight failed utterly to anticipate the severity of the financial crisis before they were swept up in it. In fact, Wall Street accepts almost no responsibility for its role in causing the crisis, sometimes claiming instead that it was nothing but a "perfect storm."7 I know that the public casts a skeptical eye on such pronouncements, and so do I.
Although the causes of the crisis are many and complex, it's clear that the responsibility is shared among Wall Street participants, legislators, and regulators. In particular, there can be little doubt that the biggest and most active market participants did in fact contribute greatly to the crisis. The short-term incentives that fueled the growth in the swaps markets, the growth in overly complex securitized assets, and the growth in trading volume came to overwhelm our marketplace and financial sector in general. Our financial sector lost touch with its primary mission — facilitating efficient allocation of capital from investors to productive businesses that provide goods, services, and jobs. After the crisis, which caused trillions in losses and painful levels of unemployment and underemployment, we need to ask how our financial system so badly lost its way, and how so much damage was done to the American economy in the process.
The financial crisis and the May 6th market break vividly demonstrate four points I would like to discuss today:
First, while regulated and unregulated markets and entities are seamlessly connected, regulatory oversight is piecemeal;
Second, the SEC must be able to conduct surveillance and to oversee the capital markets in real time;
Third, we must reexamine the concept of the sophisticated investor, which underlies many regulatory gaps; and
Fourth, as we focus on changes to the regulatory landscape, we must remember the crucial role played by rigorous SEC enforcement of the securities laws.
I. Interconnection Between Regulated and Unregulated Markets and Entities is Seamless, While Regulatory Oversight is Piecemeal
Let's begin by talking about the "flash crash." Today, the SEC-CFTC Joint Advisory Committee holds its first meeting, seeking to understand what happened on May 6th.8 Meanwhile, the SEC is soliciting comment on proposals by the exchanges and FINRA for a pilot program to institute single-stock trading pauses in volatile markets.9 But while the staffs of the SEC and CFTC issued a report on May 18, 2010 stating preliminary findings,10 we still do not know why the markets malfunctioned as they did. The simple truth is that we do not have the tools, resources, and information we need to promptly examine and fully understand the correlations between the equities, futures, options, and OTC derivatives markets and how they may have affected market movements on that day.
The difficulties we have faced in analyzing the market break demonstrate beyond a shadow of a doubt the complexity of, and interconnection among, the equity securities, futures, options and other derivative markets. Orders in one stock directed to one market can now ricochet to other markets and trigger trading in other stocks and derivatives in milliseconds. And that is why, in order to understand what happened on May 6th and how to prevent it from happening again, our inquiry cannot focus solely on the exchange-listed market. As the May 18 Preliminary Findings report notes, the SEC and the CFTC now must undertake a complex analysis not only of trading in underlying individual equity securities that dropped precipitously on May 6th, but also of mutual funds, ETFs, options, futures, equity index options, equity index futures, and related OTC derivatives. 11
There are also serious questions to be answered about the algorithms that are increasingly used by traders12 and add layers of complexity to the market. It's self-evident in the wake of May 6th that even the people who wrote many of these programs failed to understand how the algorithms would respond to trading initiated by the many other algorithms in the market. Whatever initiated the chain of causality that brought us the May 6th market break, it seems evident that we experienced a significant failure in a system so complex that, even after close to three weeks of intensive analysis of only one hour's trading, no one — neither the market participants, nor the regulators — fully understands it.
It's clear to me that effective regulation has been hindered by gaps in regulatory authority and shortfalls in funding, both of which resulted from a deregulatory ideology that continues to threaten efforts toward reform — despite having been so obviously discredited by events over the past two years. I am hopeful that pending legislation will address these problems but much remains to be done.
II. SEC is not currently able to Survey and Oversee the Markets as the Public Expects
First, let me address the impact of shortfalls in funding. It is important for the public to have an accurate understanding of the SEC's capabilities — its actual resources, systems, and operations. Both the financial crisis and the "flash crash" exposed significant gaps between the public's expectations and what the SEC can actually do.
A reasonable person might assume that the SEC can quickly trace a transaction from the account holder who placed the order through to the execution of the trade, clearance, and settlement. That reasonable person, I am sad to say, would be mistaken. And it is unlikely that the public fully realizes the degree to which we are dependent on the entities we regulate to help with our oversight of the markets. Our staff has been working around the clock since May 6th, all doing their level best with the limited resources, technology, and authority we have. But they literally have had to call around to the exchanges, FINRA, broker-dealers, and other market participants, asking for the basic information we need to figure out what happened.13
This information and data gap must be closed as soon as possible. As you may know, in just two days, the Commission will consider taking the first step to creating a consolidated audit trial for securities transactions. The goal would be to have a system that traces in real time securities transactions step by step from placement of the order all the way through to completion. This is an essential system in today's seamlessly connected markets, because real-time market information is necessary for effective regulatory fact-finding, oversight, and enforcement. I understand that the creation and implementation of this system will take a significant amount of time and resources. This just amplifies that the Commission should act now. I have been vocal in my support of this initiative,14 and I look forward to it becoming a reality.
Beyond the development of this system, I am also hopeful that the SEC's chronic funding shortfall will be permanently addressed by the self-funding provisions in the Senate financial reform bill. Without self-funding, we'll continue to have one arm tied behind our back.
There is Only One Market
Now, I'd like to address the problems with gaps in regulatory authority. As I noted earlier, May 6th demonstrated, once again, that our financial sector is complex and tightly interconnected. Despite this reality, current law creates strict perimeters of regulation. For example, the SEC is expressly prohibited from passing rules related to recordkeeping or reporting for swaps.15 In addition, while futures on the S&P 500 index are subject to CFTC regulation, options on the S&P 500 are subject to SEC regulation. On May 6th, as in the financial crisis, market participants conducted transactions without regard for the perimeters of regulation, spreading the crisis, and revealing the weaknesses of our piecemeal regulatory structure.
A concrete example of a crisis crossing the perimeter from the unregulated markets into the regulated markets is the effect on the entire financial system of the potential default by AIG and the monoline insurers on credit protection, such as credit default swaps. As we now know, the problem began with mortgage originators that, with little or no oversight, were writing "liar loans" to borrowers with bad credit because the originators wanted the resulting fees. That was harmful enough to our economy, but then an even greater problem arose when Wall Street become involved. Wall Street firms created huge demand for bundles of mortgages to be packaged, sold, and synthetically resold to so-called "sophisticated investors" — and then they placed bets on these and other securities with swaps. The regulated and unregulated entities and markets transacted seamlessly, but the regulatory oversight that could be exercised over this process was fragmented and severely constrained by the lack of authority and jurisdiction. Regulators were caught totally by surprise when the financial system nearly came crashing down. The aftermath was that the American taxpayer had to pick up the tab, guaranteeing trillions of dollars of liabilities to keep our entire financial system afloat.
One clear lesson from the financial crisis is that the idea that unregulated entities and markets can go about their business without affecting regulated entities, capital raising, and the capital markets as a whole has been proven a dangerous fallacy. The piecemeal regulatory structure must be upgraded to reflect the reality of our seamless markets. Clearly, not only can the unregulated markets affect the regulated markets — they can devastate them.
III. The "Sophisticated Investor Defense" Rests on Faulty Assumptions
In addition to the false premise that unregulated markets can function without effect on the regulated markets, there has been a faulty assumption that the markets underpinned by so-called "sophisticated investors" require little to no investor protection or regulatory oversight. The assumption is that sophisticated investors do not need transparency, disclosure, or other protections because they have the wherewithal and the clout to bargain on equal footing with other market participants and financial intermediaries. They are, it is argued, sophisticated enough to know what information and protections they do and do not need. But it is readily apparent from recent Commission enforcement cases involving auction rate securities16 and pension funds17 that institutional investors, bereft of investor protections, failed to obtain complete and honest disclosure.
A second faulty assumption is that, when institutional investors misjudge the risks of investing, only wealthy or sophisticated investors are hurt. The widespread financial crisis of 2008 clearly disproved this argument, but it is also untrue even on a smaller scale. After all, a single sophisticated institutional investor, whether it is a bank, pension fund, mutual fund, or other entity, often represents investments from many individual retail investors. And these small investors ultimately bear the cost. As Heidi Moore recently wrote in The Washington Post,
What Wall Street would like to ignore when it is taking bets in its casino is that a big pile of chips on the table come from regular consumers — from their bank deposits, retirement accounts, credit-card balances, car loans and mortgages. That's why the distinction between these sophisticated investors and everyone else is nonexistent. When Wall Street banks omit information and draw profits from "institutional investors," that means taking money from your pension funds, your school endowments, and your city and state governments. Other sophisticated investors include hedge funds, which take money from those pension funds, or private-equity funds, which own companies that employ 10 percent of all Americans.18
I agree. Not only were sophisticated investors unable to protect themselves, but the distinction between sophisticated institutions and the shareholders, retirees, and other individuals represented by these institutions melted away when it mattered. The fallacy of these assumptions is an important lesson because the idea that sophisticated investors can be treated differently and do not need protections underpins so many gaps in regulation. In 2000, for example, swaps were excluded from most regulation with the understanding that only sophisticated investors could enter into them.19 As another example, securities offerings such as synthetic collateralized debt obligations can be made to sophisticated investors without any disclosure20 and with little time for careful consideration. 21
We should carefully consider whether the information realistically available in these transactions really is sufficient for these investors, and whether some or all of that information needs to be made publicly available. We should also oppose efforts to limit the applicability of fiduciary standards to institutional investors and, by extension, to the Main Street investors these institutions represent. The more we try to slice and dice which investors receive what protections, the more that all investors, the integrity of the capital markets, and ultimately the American public will bear the costs.
IV. Rigorous Enforcement Is Essential to Effective Regulation
I also want to focus on what the SEC can do to enforce the securities laws and rules thereunder. Rules without rigorous enforcement result in an ineffective and timid regulatory regime. As we strive for meaningful reform, it is important to remember that rigorous enforcement will always be vital to the protection of investors.
Deterrence is Essential
To that end, I believe that a robust and successful enforcement program must focus on effective deterrence. A focus on deterrence means that we need to make sure that our enforcement program embodies the credible threat of punishment for violations. Enforcement sanctions should not be an acceptable cost of doing business for fraudsters. Sanctions should be meaningful so that when others look at what happens to those who violate the law — they stop and say to themselves, "I do not want that to happen to me."
In the remainder of my remarks today, I will discuss ways in which the SEC can improve the deterrent effect of our enforcement actions. First, we must seek meaningful penalties. Second, we must improve our ability to obtain sanctions against natural persons, especially the ability to bar fraudsters from being an officer or director of a public company, or from continuing in the securities industry.
More Meaningful Penalties
A central tool in making sure that enforcement actions deter future violations is the ability to impose civil money penalties. While disgorgement — which is the surrender of ill-gotten gains — is an important remedy, it merely puts fraudsters back in the position they were before the fraud occurred. If committing fraud can leave someone no worse off that if they had been honest, they might begin to think that crime can pay. Penalties are necessary to change that calculus and ensure that fraud does not pay.
Unfortunately, as to corporate penalties, the Commission has been operating for four years under a set of guidelines that have significantly de-emphasized the importance of punishment and deterrence of egregious conduct. For example, the Commission's Penalty Statement of 2006 prioritizes two factors:
Under this framework, the consideration of corporate penalties has too often been dominated by discussions about whether economic models demonstrate that a corporation received a benefit from its misconduct. Rather, the discussions should have focused on the egregiousness of the conduct. A GAO report confirmed that cases were sometimes delayed for months, while various economic analyses were performed.23
Moreover, by penalizing, or not penalizing, corporations based primarily on things other than their misconduct — such as whether the company happened to benefit from a fraud by issuing shares at an inflated price — the 2006 factors misdirect where the focus should be and fail to serve investors. In particular, the focus on the amount of a corporation's fraudulent gain means that penalties are no longer closely tied to the egregiousness of the conduct.24
I also want to address one of the arguments I have heard against corporate penalties — namely that the money to pay corporate penalties comes out of the shareholders' pockets. I think that is a questionable premise for several reasons. I will mention just two today. First, for money to come out of a shareholder's pocket, it first has to be in a shareholder's pocket. Shareholders do not determine their own dividend, much less have day-to-day control over how the company's cash is used. This control is in the hands of the company.
That leads me to my second point. The argument that corporate penalties come out of the shareholders' pockets neglects to consider that management controls how money is spent within a corporation. For example, consider the $150 million penalty paid by Bank of America in the SEC's lawsuit. This penalty pales in comparison to the $5.8 billion in discretionary executive bonuses paid in the company's merger with Merrill Lynch.25 From a real world perspective, it is hard to say the penalty was paid out of the pockets of shareholders. If that $150 million had not been paid as a penalty, it is just as likely it would have been a part of some executive bonus payment.
Perhaps what should happen is that, when a corporation pays a penalty, the money should be required to come out of the budget and bonuses for the people or group who were the most responsible. For example, where appropriate, future corporate penalties could be accompanied by undertakings requiring that the bonuses for the people most responsible for the misconduct be reduced by the amount of the penalty.
Another argument against corporate penalties is that such penalties are an inappropriate substitute for pursuing the individuals who actually committed the violation — as if we are forced into a false choice between corporate penalties and individual penalties. I agree with the distinguished Irving Pollack, a former SEC Commissioner and the first Director of the Division of Enforcement, who has argued that we should get both, saying, "I think it is a mistake only to go after individuals when you have entities that are corrupt . . . Individuals will get hit, but the company goes on and does its usual activities without any kind of correction. So I think you want to impress on companies that they have a responsibility for complying with the law just as you are going to sue individuals who engage in misconduct."26
More meaningful sanctions against individuals
The need to adequately sanction both corporations and individuals leads me to my next point: the SEC must expand its efforts toward individuals.
First, to enhance the deterrent value of its insider trading enforcement program, I believe the Commission should reconsider its long-standing practice of settling insider trading cases for a penalty equal to the amount of disgorgement to assess more meaningful penalties. Even though the Commission is authorized by statute to obtain as a penalty three times the amount of a insider trader's gain,27 the "one plus one" settlement — disgorgement plus a penalty equal to the disgorgement — has become the de facto standard.28 I question whether this is a sufficient deterrent. I think former Chairman Richard Breeden was closer to the mark when he said that people who engage in insider trading should be left "naked, homeless, and without wheels."29
Second, we also need to protect investors by making better use of the remedial sanctions we have been given. For example, we have broad authority to ban those who commit fraud from the securities industry,30 the authority to seek officer and director bars ("O&D bar"),31 and the authority to suspend lawyers and accountants from practicing before the Commission.32 As with penalties, I think that the SEC has been too often willing to compromise on remedial sanctions because they can be a sticking point in settlement negotiations. Defendants and respondents fight hardest against accepting these sanctions is because they are, in many ways, the most meaningful measures we have to protect investors.
Being an officer or director of a public corporation is a position of public trust. These people are responsible for making productive use of the hard-earned savings that investors have entrusted to them. Officers and directors who abuse the public trust by breaking the law are not entitled to be in these positions and should be barred.
The Sarbanes-Oxley Act clearly recognized the importance of O&D bars and included a provision to expand the cases in which these bars are appropriate.33 Unfortunately, not everyone understands the need for these remedies. For example, in one shocking case, after a jury found that a CEO had committed fraud, a federal judge ordered the CEO to pay over $10 million in disgorgement, interest, and penalty, but yet determined that no officer and director bar was appropriate.34 This decision would appear to suggest that engaging in an egregious fraud is not enough to prove that you should not be a public company officer. How can this be? This is simply wrong. I agree with the Senate report for the Remedies Act,35 which said: "Although [an O&D bar] represents a potentially severe sanction for individual misconduct, persons who have demonstrated a blatant disregard for the requirements of the Federal securities laws should not be placed in a position of trust with a publicly held corporation."36 These sanctions are important and worth fighting to impose.
Industry bars are also important tools for the SEC to use. When a broker or an investment adviser defrauds investors, the best way to protect future investors is to make sure that the individual no longer has the opportunity to engage in the securities business. Given the SEC's need to maximize our resources in policing the markets, I don't think we can justify a "catch and release" program that lets bad actors back in the business to prey once again upon investors only a few months, or a couple of years, after they violate the law. We need to be willing to fight for meaningful suspensions and bars. Moreover, I support the House and Senate reform legislation that would authorize the SEC to seek "collateral bars." Because someone who steals investor money as a broker-dealer is a similar risk to steal money if they become an investment advisor, we need the authority to bar a bad actor from the entire securities industry, not just the particular job in which he or she committed fraud.
I believe that, by taking the steps I have outlined, we would substantially enhance our Enforcement program and our ability to protect investors and our markets by deterring future violations.
As I conclude my remarks, I want to assure you that as an SEC Commissioner, I will support legislation and internal policies that work to strengthen the SEC. The faith of the American people in the capital markets, and in their regulators has been severely shaken over the past two years, and we must continue our efforts to rebuild the trust that has been lost. The philosophy of deregulation, with its belief that the market can police itself, has been shown to be a house of cards.
I am committed to working to make sure that the SEC has the resources, the right tools, and the right policies to do its job — to protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation.
Thank you for letting me share my thoughts with you today. I hope you have a great conference.