Speech by SEC Commissioner:
Remarks Before the North Carolina Banking Institute
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
Charlotte, North Carolina
March 30, 2007
Thank you for that introduction. It is an honor to be part of your conference and, as a native of North Carolina, I enjoy the opportunity to be back here. I commend the Center for Banking and Finance for promoting this event. Before I begin, I must note that the views that I express today are my own and do not necessarily reflect those of the SEC or my fellow Commissioners.
From my perspective as a securities regulator, today marks the end of an important week. The Supreme Court heard oral argument in two important securities cases earlier this week. On Monday, the Court heard Credit Suisse v. Billing and, on Tuesday, the Court heard Tellabs Inc. v. Makor Issues & Rights. Credit Suisse is actually styled as an antitrust case, but challenges underwriters' activities in the IPO market. Before the Supreme Court is the question of whether antitrust suits can be brought to challenge conduct that occurs in an area that is very heavily regulated under the securities laws. Tellabs deals with the heightened pleading standard that Congress set for private securities fraud actions in the Private Securities Litigation Reform Act of 1995. The Court's decisions in these cases will be important in defining the parameters for private class actions. I know that Supreme Court jurisprudence is on your minds given that one of the panels later today will focus on Watters v. Wachovia, the Sixth Circuit decision on federal preemption of state banking law that is now also before the Supreme Court.
Even at the federal level, banks are in the unenviable position of being regulated by multiple regulators, each with its own statutes and implementing regulations, and its own regulatory style. As the title of one of your panels yesterday acknowledges, the SEC is "The Newest Federal Bank Regulator." As the new kid on the banking regulatory block, the SEC needs to tread carefully, recognize the limits of its regulatory reach, and work closely with the primary banking regulators.
We have many cooperative efforts on which to build. The President's Working Group on Financial Markets (PWG) gives the SEC the opportunity to work closely with the Department of Treasury and the Board of Governors of the Federal Reserve, as well as the Commodity Futures Trading Commission. This group has done important work on, among other things, hedge funds. The PWG issued a report in 1999 on "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management."1 Collaborators on this report included the FDIC, the OCC, and the OTS. The PWG issued another statement on hedge funds and other private pools of capital last month.2 The statement recognized the significance of private capital pools to the financial markets, the importance of market discipline, and the responsibility of investors, counterparties, creditors and regulators to engage in due diligence. The principles underscored government's responsibility to provide clear regulatory guidance that takes into account the latest developments in the financial markets and to work with others both here and abroad on developing regulatory policy. In addition to collaboration within the PWG, the SEC also worked with the banking agencies on last year's Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities.3
Unfortunately, our efforts to cooperate with the banking agencies have not always been seamless. Congress, in the Financial Services Regulatory Relief Act of 2006, intervened to address a few of the roadblocks in the SEC's cooperation with its bank regulatory counterparts. The Act directed the SEC and the federal banking regulators to work together to develop a model privacy form, which the agencies proposed earlier this month. The Regulatory Relief Act also extended the bank investment advisor and broker-dealer exclusions to thrifts. The SEC's 2004 proposal, which the SEC never acted upon, elicited this reaction from the Office of Thrift Supervision: "Given that the Proposal provides no regulatory burden relief to [thrifts registered with the SEC], it is unclear what is accomplished by the proposed rulemaking."4 Is it any surprise, then, that Congress intervened to resolve the issue? One would be justified in asking: Why must it take an act of Congress to resolve an issue like that?
But, of course, that was not all. The Regulatory Relief Act also required the SEC to work with the Federal Reserve to define for banks the relationship between bank and brokerage activities for purposes of implementing the "push out" provision of the Gramm-Leach-Bliley Act (GLB) of 1999. Accordingly, last December, the SEC and the Fed proposed Regulation R.5 December's proposal made a clean break from the SEC's prior regulatory attempts, right down to the name. The earlier proposals had been dubbed Regulation B, which I like to think of as standing for "broken." That would make the new proposal Regulation R for "repaired."
In a nutshell, Regulation R, provides banks with the several exceptions to the definition of "broker." The "networking exception" allows banks to enter into contractual arrangements with registered broker-dealers pursuant to which the broker-dealers provide brokerage services to bank customers. Under this exception, bank employees may not receive transaction-based compensation, but may receive referral fees that vary depending on the type of customer and whether a transaction takes place.
Regulation R also clarifies that banks may conduct securities transactions for customers in a trustee or fiduciary capacity, so long as the bank is "chiefly compensated" by relationship compensation — meaning that over fifty percent of the bank's compensation derives from relationship compensation. The rules specify that banks can make the "chiefly compensated" determination based on an account-by-account review, using a two year rolling average, or alternatively a bank-wide calculation if relationship compensation is more than seventy percent of total compensation.
Regulation R also provides exceptions for, among other things, processing sweep account transactions, transactions for employee benefit plans and related retirement accounts, transactions in Regulation S securities for non-US persons, certain mutual fund transactions, and noncustodial securities lending activities.
Although the suite of exceptions provided in Regulation R is an attractive and needed alternative to the Commission's failed Regulation B proposal, I understand that there is still concern in the banking industry regarding the scope of the exceptions, and the implementation issues raised by the proposal. Specifically, I understand that many feel further clarity and flexibility will be required in all of the exceptions, especially the networking and Regulation S exceptions. In addition, Regulation R has been faulted for failing to address the issue of dual employees. I look forward to reading the comment letters that we have received and fashioning a workable final rule for the banking industry within the timeframe established by Congress in the Financial Services Regulatory Relief Act of 2006.
Regulation R is not the only rule that has been renamed recently to symbolize a clean break with the past. The Public Company Accounting Oversight Board (PCAOB), put out for comment "AS5," which will replace AS2, the current auditing standard that governs auditors assessment of issuers' internal controls. Very few will miss AS2. The standard has undermined the professional judgment of experienced auditors, strained their relationships with their audit clients, and imposed huge costs on audited companies.
AS2 was adopted under Section 404, which requires management to complete an annual internal control assessment and requires the company's outside auditor to attest to, and report on, management's assessment. The difficulties in implementing Section 404 surprised a lot of people. The Senate committee report on Sarbanes-Oxley observed that high quality audits already "incorporate extensive internal control testing" and that the committee did not expect the internal control provision to be the basis for any increased fees or charges by outside auditors.6 Similarly, the SEC estimated that implementation of Section 404 would cost an average of $91,000 per company, for a total of one and a quarter billion dollars. Estimates have put actual average costs at more than twenty times that amount. According to a survey by the Independent Community Bankers Association, the average community bank spent $200,000 and 2,000 staff hours during 2005 on Section 404.7
Had Section 404 been implemented in a principles-based manner, it would have been less burdensome and it could have yielded real benefits that justified the burden. In other words, I do not think that the statute is the problem, so an across-the-board elimination of the requirements of Section 404 is not the answer. I will note, however, that Congressman Barney Frank has suggested an exemption from Section 404 for banks. He described an exemption for banks as "perfectly sensible" given that they are subject to similar requirements under the Federal Deposit Insurance Corporation Improvement Act.8
We also need to be sensitive to the particular concerns of small companies, which feel the costs of Section 404 particularly acutely. Dollars spent on internal control are diverted from already-overstretched budgets for developing and marketing products, hiring and retaining talent, and embracing new technologies. Depending on how things shake out, we may need to consider, as the American Bankers Association suggested, whether a further extension for non-accelerated filers is necessary.
The PCAOB's newly proposed standard goes a long way towards alleviating these problems, particularly when combined with the SEC's proposed additional guidance for management's assessment of internal control. The SEC has sought to provide management with guidance of their own so that their assessments are not driven by the auditors, who have been operating under the PCAOB's much more prescriptive AS2. The PCAOB's proposed standard affords auditors greater room for judgment and employs a risk-based framework to direct their efforts.
Both the SEC and the PCAOB have received numerous comment letters in response to our proposals. I am encouraged by the commentary that we have received — not only by the positive comments, but by the comments that provide insight as to how we can further improve the SEC's management guidance and the PCAOB's audit standard. The PCAOB and we are working to align the new audit standard with our management guidance. Indeed, next week, the SEC will hold a public meeting to discuss the PCAOB's proposed auditing standard and particularly the coordination of that proposed standard with the SEC's management guidance. This meeting should be useful in helping the PCAOB to refine its proposed standard.
Additional changes that commenters have called for include the elimination of the many "shoulds" and "musts" that are prescriptive vestiges of AS2, the elimination of the unnecessary focus on significant deficiencies, a more workable approach to scalability, refinements to the definition of "material weakness," and further facilitation of auditors' reliance on the work of others. As many commenters have pointed out, implementation will be the true determinant of success. The PCAOB, through its inspections, will set the tone for how the new standard is implemented. Management, auditors, and the PCAOB's inspection staff all need to come to terms with the fact that the Section 404 landscape is changing in a manner that demands a new approach in carrying out their respective roles under Section 404.
Last December, the SEC also took a fresh look at another one of its regulatory areas. After a short-lived attempt at mandatory registration for hedge fund advisors — cut short by a court's decision that we had acted outside of our statutory authority — the SEC has taken a new approach. We issued for comment a new proposal that embodies some of the lessons learned from the vacated mandatory registration rule. It is more narrowly tailored — although it does reach beyond hedge funds to other pooled investment vehicles.
The proposed rules would clarify the SEC's authority to bring enforcement actions against investment advisors for fraud against investors and prospective investors in their funds (as opposed to fraud against the funds themselves). Basically, if you had any doubt — thou shalt not rip off thy limiteds. Clarifying the SEC's authority seems like an acceptable step, although I believe that it is not truly necessary given the broad authority that the SEC has under existing antifraud rules. As some commenters have pointed out, this part of the proposal, will need some refining. Commenters' objections to the antifraud rule cannot be dismissed casually as the complaints of would-be fraudsters. We must consider carefully whether the rule, as it is written, is overly broad and insufficiently clear about what is prohibited. If it is, it could actually discourage advisors from communicating with investors.
One noteworthy aspect of this proposed rule is that it is not based on intent, as most anti-fraud rules are. Thus, someone may find that he has violated the rule unintentionally. In that way, the rule is similar to Section 206(2) under the Investment Advisers Act, which outlaws activities that "operate" as a fraud — thus, no intent is necessary. Appropriately, there would be no private right of action under the rule, and the rule would not create a fiduciary duty from the advisor to the investor. This is appropriate because the advisor already has a fiduciary duty to the fund — that is where the fiduciary duty should lie since the circumstances and attributes of each limited can vary quite a bit.
Second, our rule proposal would significantly narrow the pool of investors eligible to invest in hedge funds and private equity funds. The SEC's accreditation standards were put into place in 1982 and are meant to limit hedge fund access to investors who can afford to enlist help in their due diligence before investing and who can afford to bear any losses. 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.
This part of the proposal has drawn much comment. Many of the commenters are frankly irate. Needless to say, it is difficult to draw appropriate lines. We might not have gotten them right in this proposal. Practically speaking, most hedge fund advisors simply do not have the capability to target and service these investors, who have relatively little to invest, but I worry about how the new threshold will affect newly established hedge fund advisors without much of a track record. These advisors will have to try to attract capital from what could prove to be a very small pool of potential investors. The rule, therefore, may be an unacceptably high barrier to entry. I also worry about the large number of investors who now invest in private pools, but will be precluded from making follow-on investments.
Finally, I would like to turn from specific SEC regulatory actions to the broader question of the competitive status of the U.S. capital markets. As you know, many others are also looking at this issue, identifying specific problems, and offering solutions. A constant theme is that excessive, overlapping, and unnecessary regulation in the U.S. is a major reason for our loss of market share in the global capital markets.
Earlier this month, the Commission on the Regulation of U.S. Capital Markets in the 21st Century, a group organized by the U.S. Chamber of Commerce, issued its report with recommendations, including a substantial number of recommendations dealing with policy and internal processes at the SEC. In January, Senator Charles Schumer and New York City Mayor Michael Bloomberg issued a report prepared by McKinsey Consulting on the state of the financial services industry in New York and the country as a whole. The report made a number of recommendations related to the SEC. Last November, the Committee on Capital Markets Regulation, which is chaired by Glenn Hubbard and John Thornton and directed by Hal Scott, issued an interim report that similarly recommended specific reforms to be implemented by the SEC. And, if the written word is not enough, many of the SEC-related concerns found in the three reports were echoed — and even amplified — in a recent summit meeting of business and governmental leaders sponsored by U.S. Treasury Secretary Hank Paulson.
Although the perspectives and findings of each group were unique, there is a common thread of very important SEC-related issues among them. Among other things, each report recommended: (1) quick and substantial changes to the rules and guidance implementing section 404 of the Sarbanes-Oxley Act, (2) streamlined and coordinated regulatory processes that require meaningful cost benefit analyses, and (3) involvement jointly by the President's Working Group to provide transparency and predictability in the enforcement process.
These warnings and recommendations should cause us at the SEC to sit up and take notice. The SEC needs to do more than that though. We need to take action. We need to reconsider our regulatory precedents to determine which should be dropped and which should be modified to reflect changes in technology and innovations in products and processes. In looking back over regulatory precedent, we would do well to ask ourselves a question that Secretary Paulson has recently posed: "Have we struck the right balance between investor protection and market competitiveness — a balance that assures investors the system is sound and trustworthy, and also gives companies the flexibility to compete, innovate, and respond to changes in the global economy?"9 The reports can help us answer this question.
Unfortunately, a chorus of contrarians — we can call it the "What-me-worry?" crowd — has recently begun a campaign to try to drown out the calls for action. The song that they sing is one of complacence. As I understand it, they contend that the U.S. capital markets are perfectly fine. Examination of the calibration of our regulations and how we implement them can wait until another day. In support of this position, they have been citing, among other things, a three-page research report that purportedly contradicts the findings of the three policy groups. The report states that "foreign issuers of IPOs are flocking to US exchanges at unprecedented levels."10 Studies are mixed as to the relevance of IPO figures. In any case, that statement is inconsistent with the study's own statistics, which show that the high-water mark was in the late 1990s. Moreover, this study is merely a tabulation of the number, size, and proportion of foreign IPOs in the US market during the past twenty years, apparently without adjustment for inflation. The relevance of the study is further limited by the fact that it looks at the US market in isolation, something that the three policy groups have very well shown that we no longer have the luxury to do. As Commissioner Charlie McCreevy, a member of the European Commission, recently pointed out in an excellent opinion piece in the Wall Street Journal, the US share of global IPOs has fallen from fifty-seven percent in 2001 to sixteen percent in 2006, while Europe's share has increased from thirty-three percent to sixty-three percent during the same years. Statistics are, of course, useful in this debate, but they must be assessed in context.
The contrarians are right when they say that we are enjoying a period of great market conditions — the Dow near its all-time high, strong macro-economic fundamentals, and healthy investor interest. The fact that the markets are doing well, however, should not stop us from asking whether they could and indeed should be doing better. Likewise, the fact that other markets have grown and liberalized during the past couple of decades is good for everyone, but we should not use the success of other markets to explain away all the problems that we are having. Our job as regulators is to examine the costs that we impose on market participants through our regulations to make sure that those costs do not exceed the benefits.
Listing in the U.S. markets offers foreign firms many benefits including deep liquidity, visibility to U.S. investors, transparency, and corporate finance and business strategy opportunities. In the end, though, companies are rational — they expect benefits to exceed costs. If that is not the case in the U.S. public capital markets, they will go elsewhere or raise capital in the deep and flexible US private markets. This is not a good result for US investors.
I will close with one short anecdote that illustrates why we need to re-examine our position. A friend of mine was the head of a major investment banking operation. He also sat on the board of a successful biotech company with operations in the U.S. and in Europe. When the board of the company considered the $3 million that it would cost to comply with Sarbanes-Oxley in order to go public in the United States, the board voted to list on a European exchange instead. I have heard similar stories from many investment bankers, merchant bankers, lawyers, and issuers.
Thank you for being such an attentive audience. I know that I have touched on only a few of the topics that you are covering in this conference. I would be happy to take questions on any of these issues or others that I did not discuss.