Speech by SEC Staff:
Remarks Before the 14th Annual Securities Litigation and Regulatory Practice Seminar
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
Institute of Continuing Legal Education in Georgia
October 31, 2008
Good Afternoon, I’m delighted to be back in Atlanta among old friends. Thank you for asking me to be here today. As I am sure you are aware, this speech expresses my own opinions and does not necessarily reflect those of the Commission, the other Commissioners, or members of the staff.
Let me start by bringing you up to date on the SEC’s various roles. First, I’ll share some recent statistics and then talk about my recent adventures at the SEC.
At the SEC, as many of you know, our mission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. In this time of market turmoil, there is a greater need for the SEC than ever before. I believe deeply that the independence and strength of the SEC has been an important factor in the historical growth of our capital markets and confidence of investors. However, in the past few years, the SEC has not been as active an investor advocate and as I will discuss later — I think that should change.
We are responsible for overseeing more than 12,000 publicly traded companies, approximately 700 transfer agents, 10 registered Credit Rating Agencies (or NRSROs), over 10,000 investment advisers that manage more than $38 trillion in assets, nearly 1,000 fund complexes with over 16,000 separate funds, 6,000 broker-dealers with 172,000 branches, and approximately $44 trillion worth of trading conducted each year on America’s stock and option exchanges.
In addition, the SEC has an oversight role over other securities industry participants such as the self-regulatory organizations (which include 11 securities exchanges, 4 securities futures product exchanges, 9 clearing agencies, the National Futures Association, FINRA, and the Municipal Securities Rulemaking Board (MRSB), the Public Company Accounting Oversight Board (PCAOB), and the Financial Accounting Standards Board (FASB).
Since a majority of U.S. households own stocks either directly or indirectly through mutual funds and pension funds, our oversight responsibilities and actions directly impact the financial health of many Americans.
The SEC, of course, is also a law enforcement agency. Each year the SEC brings hundreds of civil enforcement actions. Many rightly focus on our cases for violations of the securities laws involving insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them — but it is also important to note that we bring cases against people who break our rules that keep the markets operating fairly and efficiently, such as failures by companies to register offerings or make disclosures about their operations, or brokers who fail to obey our rules for keeping accurate books and records. As we’ve seen in the recent turmoil, the failure to have accurate books and records can make it difficult for regulators to understand the full scope of problems, and a lack of public transparency of information can make it impossible for market participants to do business with appropriate confidence.
The SEC's Enforcement Division has been generating a fair amount of press lately. Some of you may have seen the year-end statistics demonstrating that the Commission’s Enforcement staff brought the second-highest number of cases in the agency's history. In the last few months, since my arrival at the SEC, the Enforcement Division also successfully negotiated agreements in principle to obtain $50 billion in immediate relief for investors in auction rate securities after these markets seized up.
While I applaud the tireless work of our staff, I do think the Commission can do more to fulfill its law enforcement role. I am particularly concerned by the potential drop off in large investigations, and by the dramatic decline in the past few years in the amount of penalties the Commission seeks and collects. In light of recent events, it is important now more than ever for the Commission’s enforcement staff to focus resources on cases involving the most egregious behavior with broad market effect and to be able to clearly send a message of deterrence.
This is the end of my third month as a Commissioner — and one thing I have not been is bored.
All of us are painfully aware of the market turmoil. As a new member of the Commission it certainly has made my early days a little too exciting.
As I’m sure you know, in September, the Commission took unprecedented steps in an effort to address these turbulent market conditions and potentially abusive short sales. I do however, believe in the benefits of short selling as a useful and important tool in providing price discovery in the market and in helping to maintain a fair evaluation of a company’s securities and I paid attention to industry participants and media reports that the Commission’s emergency actions related to short selling may have had collateral consequences on market volatility, liquidity, options spreads, transaction costs, and the securities lending program.
Our orders also imposed a requirement for some institutional investors to report daily short sales (something which had not been previously required), and temporarily provided relief under Rule 10b-18 to allow issuers to repurchase up to 100 percent of their stock’s average daily trading volume, rather than the normal 25 percent limit.
After action in September, the Commission in mid-October issued several related final and interim final rules to follow the emergency orders and to take further action to help reduce the opportunity for fails to deliver to affect our markets and help satisfy our investors’ expectation for prompt delivery of their securities. Specifically, the Commission made permanent the elimination of the options market maker’s exception from Reg. SHO and permanently adopted Rule 10b-21, a “naked” short selling antifraud rule which covers short sellers who lie about their intention or ability to deliver securities in time for settlement
The Commission also adopted as an interim final rule a requirement that participants of a clearing agency deliver securities by the settlement date, normally T+3, or immediately purchase or borrow securities to close out its fail to deliver position by the next morning.
The Commission, and in particular our Office of Economic Analysis, continues to monitor the impact of these rules on short selling; we will consider the comment letters we receive regarding the interim final rules as we determine our next course of action.
The market turmoil has also brought excitement into the previously tranquil world of money market funds.
As you know, recently, the Reserve Primary Fund “broke the buck.” When a fund “breaks the buck”, the value of a unit of interest in the fund drops below one dollar. This was a shocking event because market customers treated their interest — rightly or wrongly — like a low-risk cash equivalent. For them, it is as if your savings account was losing money. This was only the second time that a money market fund has ever “broken the buck.” Other funds also appeared to have experienced difficulties and the Commission has had a much greater need to understand the portfolio holdings of money market funds in real time.
Money Market Funds are typically considered to be safe places to place cash, because these funds buy debt that is highly likely to be paid back. However, currently money market funds, particularly money market funds that cater to institutional investors, are facing the perfect storm of significant redemptions and being forced to sell assets into a troubled market, which in turn could cause a cascading series of losses to investors, more fund redemptions, more forced selling and further losses. It is a vicious cycle.
As one response to this storm, the Treasury Department established a Temporary Guarantee Program for Money Market Funds and has requested the Commission’s assistance in administering the Guarantee Program. Most of the nation’s money market funds have elected to participate in the Program.
Under the Guarantee Program, the Treasury Department will guarantee the share price of participating money market funds that seek to maintain a stable net asset value of $1.00 per share (or some other fixed amount), subject to certain conditions and limitations. The Guarantee Program provides coverage only to shareholder of record as of September 19, 2008 — and the coverage is limited to the number of shares they held as of the close of business that day. The conditions of the guarantee include that money market funds disclose their portfolio holdings immediately to Treasury and to the Commission if the Fund’s Market-Based NAV drops below $.9975. Thus, if a money market fund has crossed the threshold and is in danger of breaking the buck, it is required to report its portfolio holdings to the Treasury and to the SEC in real time.
While this is a step in the right direction, it does not provide the Commission with the tools to assess systemic risk across the money market industry as a whole. There is no way to understand the systemic risk across funds unless the Commission collects portfolio holdings disclosure more frequently for all money market funds.
Generally, Commission rules require that money market funds file their portfolio holdings schedule on a quarterly basis and that they file these disclosures on a 60 day delay. Given that most of these funds hold short term paper, often with average maturities of less than 60 days, these portfolio disclosures do not provide the Commission with enough information in real time to assess systemic risk to the industry. Moreover, while the disclosures required in the Treasury Guaranty program are important, they only come into play when a money market fund is already in danger of breaking the buck.
Consequently, I believe that the Commission should propose a new requirement for money market funds that requires more frequent disclosure of portfolio holdings in order to enhance the Commission’s ability to assess systemic risk across the industry. This is an important protection for investors.
In addition, the market turmoil has made it obvious that it is clearly time to address a number of issues in the OTC derivatives market.
Everyone following the news has heard about how credit default swaps contributed to the financial turmoil. As you may know, credit default swaps resemble insurance contracts on bonds and other debt obligations that are meant to pay off if those obligations default. Over time, credit default swaps became a way for banks, financial firms, hedge funds, and even Fannie Mae and Freddie Mac to hedge their risk − but in the process, it also exposed them to new risk from their often unknown counterparties. Let me share some observations about credit default swaps and their effects:
- First, the notional amount at risk under these swaps is some $50 or $60 trillion — no one really knows the actual amount, however, the amount at risk of the debt securities referenced by the swaps is only around $1-5 trillion, which, while lower, is still a very, very large number.
- Thus, the amount at risk on CDS is far greater than the amount of the underlying debt obligations, magnifying the effects of a default. This magnifying effect was made even worse by the opacity of the market. Market participants knew that as bond issuers became less creditworthy, financial institutions who had sold credit protection through swaps were exposed, but didn’t, and arguably couldn’t, know how reliable their counterparty was. This opacity and lack of information raised questions about many, if not almost every, market participant’s reliability as a counterparty in any financial transaction, not just CDSs.
- In addition, because payment under CDSs generally is secured in some manner, such as cash, as credit risks increased, institutions that sold protection under the CDSs had to provide additional security for the position, such as by making additional payments of cash collateral. Making these payments often forced the sale of securities or other assets adding downward pressure in an already depressed market. Because these institutions generally were highly leveraged, the institutions were subject to additional stress.
Not a pretty situation. The experience with AIG and Lehman are just the fiercest examples of these problems.
There are a few lessons here. First, the risk management systems at financial firms of all types need to be questioned and tested for soundness. The dogma that underlies, at least in part, the swap exemption in the securities acts — namely, that bilateral activity between sophisticated institutions needn’t be monitored — has been exposed.
This is especially true because many of these institutions are large only because they aggregate retirement and other accounts of lots of smaller investors who do not necessarily have the ability to bear these kinds of risks. Second, there is a public interest in regulating markets, not just to prevent systemic risk, but to enhance efficiency. The market didn’t appear to provide sufficient information about counterparty risk, price quotations, dealer spreads, among other things that have long been understood as important to an efficient market.
Market participants have been considering a central counterparty for CDSs for at least a couple of years, and clearly the time has come for action. The SEC does not have clear statutory authority to compel swaps to be standardized and cleared in a centralized regulated clearing agency, so any central counterparty that comes into being would involve at least some voluntary steps in this area — which, while welcome, must be followed by a comprehensive solution through legislative action.
I trust Congress will recognize that OTC financial derivatives, particularly given the size of those markets, are too important to leave in the dark or even to regulate passively, and I urge Congress to authorize the SEC to take action toward having these instruments traded in safe, efficient, competitive markets — like the other markets that the SEC regulates.
Although many people are now focusing on CDSs, we shouldn’t lose sight of the fact that these concerns apply to all OTC derivatives. Regulatory reform by Congress should not deal narrowly with CDSs, but broadly for all securities derivatives.
And, of course, whatever solution we work toward, international coordination will be essential to prevent regulatory arbitrage and create the proper incentives for market participants.
The market crisis also has financial experts and legislators revisiting the regulatory structure associated with our financial markets. While these discussions have taken place periodically over the years, it has taken on a new urgency. Currently, many agencies oversee banks, another regulates credit unions, the SEC regulates securities markets, and the Commodity Future Trading Commission plays a role in financial futures, and as I’ve said, nobody regulates a current area of concern, credit default swaps.
Now a growing chorus is calling for sweeping reorganization of the financial regulatory agencies. One particular aspect of those discussions is whether the SEC and the CFTC should merge, and this is not a new discussion. As many of you know, over the years, there have been off-and-on discussions in the financial press and on Capitol Hill about merging the SEC and the CFTC. With the financial turmoil and the problems in OTC derivatives regulation, these discussions have started again — with vigor. It is not surprising.
After all, the markets for securities and the markets for derivatives that can substitute for securities tend to blend into one market. Today’s financial markets are so interconnected that centralized oversight by a single independent regulator may make sense.
Of course an SEC-CFTC merger only answers the question of “who” regulates financial services, market participants, and products. It doesn’t address “how” they are regulated. Personally, I support the SEC’s model of regulation, which provides for strong and broad regulatory authority and vigorous enforcement, coupled with flexible exemptive power to permit dynamic regulation where needed. Our securities markets are the world’s best in large part because of SEC regulation, which provides for fairness, efficiency and transparency — which, in turn, supports investor confidence, low market transaction costs and efficient public capital raising.
As we consider how best to develop a more efficient and modern regulatory structure and update our regulations to address new technologies, globalization and new innovative financial products and services, it’s also important to move as expeditiously as possible to do what we can now to improve how we protect investors and maintain fair, orderly and efficient markets.
One thing regulators can do now is to better communicate with one another. In recent years, the SEC has initiated Memoranda of Understanding with the CFTC, the Federal Reserve, the Department of Labor, and the Department of the Treasury. However, more still needs to be done to make sure that regulators are working effectively in concert. Through an effective sharing of market surveillance information, position reporting, and current economic data, federal regulators would have a more comprehensive picture of capital flows, liquidity, and risk throughout the system.
While it’s important that we continue voluntarily and willingly to communicate better — and in a more “real time” basis, I believe that communication and coordination among regulators must also be a priority for regulatory reform. From my short experience, these arrangements could and should work better and more effectively.
In the meantime, there are other regulatory gaps that seem to require attention. Anyone who is currently watching the news understands that the lack of transparency in our capital markets is a major factor driving the requests for greater regulation. Allowing unregulated entities and markets to exponentially grow without supervision has resulted in a significant threat to our global markets.
As a result, an additional area that calls out for some regulation is the world of hedge funds. In December 2004, the Commission promulgated a rule that effectively required hedge fund managers to register under the Investment Advisers Act.
Under the rule, hedge fund managers were given until February 1, 2006 to register and comply with adviser regulations, including filing disclosures on Form ADV, adopting a compliance program and a code of ethics, and being subject to SEC examinations. However, in June 2006, the U.S. Court of Appeals for the District of Columbia Circuit vacated the rule — as a result, the Commission currently lacks tools in the hedge fund arena to provide effective oversight and supervision.
Given the current climate, it is troubling to me that the Commission lacks basic information about hedge funds and hedge fund advisers. The argument for regulation is reinforced by the fact that retirement assets have been increasingly invested in hedge funds and that hedge funds are such significant players in our capital markets. Because neither hedge funds nor hedge fund advisers are required to be registered, the Commission lacks meaningful information about these entities, such as how many hedge funds operate in the United States, their assets, or who controls them. Additionally, because hedge funds advisers are not subject to periodic examinations like registered investment advisers, the staff does not have the opportunity to identify misconduct prior to significant losses occurring. This is another issue that needs to be revisited.
In addition to addressing our domestic issues, there are also other global and international issues to consider. Today, the Commission is facing regulatory challenges that come with the realities of increasing globalization of the capital markets and demand by U.S. investors for investment opportunities abroad.
As U.S. and foreign markets have evolved and many of the physical barriers to accessing the markets are being eliminated through changing technology, market participants — including the exchanges, broker-dealers and investors — are in a better position to operate across borders. While we seek to develop an appropriate regulatory response to the globalization of the markets that would provide the benefits of U.S. investors’ access abroad, we also want to uphold the Commission’s mandate to protect investors, maintain fair and orderly markets, and facilitate capital formation.
The Commission recognizes that our world is shrinking and that financial markets are interconnected in a Gordian knot. To address the growing issues and opportunities, there are a number of initiatives we’ve undertaken.
The Commission recently made improvements to three areas of its rules relating to foreign issuers. First, we had an old rule permitting foreign issuers to be exempt from Exchange Act reporting if the issuer provided, in paper, English translations of material disclosures required by its home jurisdiction. This rule hasn’t been meaningfully changed for decades.
In August, we modernized that rule to bring those disclosure documents into widely accessible electronic form, either on the issuer’s website or in a publicly accessible database like the SEC’s EDGAR system. I prefer public databases, but either method should be a real improvement in the ability of investors to get this information.
Secondly, for foreign companies that are registered as foreign private issuers, we also modernized their reporting obligations to some extent.
The biggest change, in my view, is that a foreign issuer’s annual report, which used to be filed up to 6 months after a company’s fiscal year end, now has to be filed no later than 4 months after the fiscal year end. This is good for U.S. investors because reports include important information about a foreign issuer that US investors look to in evaluating a company.
Finally, we also updated our cross-border tender offer rules to provide more opportunities for US investors to participate in cross-border transactions. These transactions are important opportunities because they often present premiums to investors.
The SEC is also considering whether and how best to update and modernize the Commission’s disclosure regime to take stock of new technologies and determine whether those technologies could be used to better serve today’s investors’ needs and preferences. To effect true modernization, it is important to take stock of what is working and what could be improved.
Currently, there is a team at the Commission, the 21st Century Disclosure Initiative team, charged with doing just this. The team is tasked with carefully reviewing existing disclosure requirements, the objectives of disclosure, and whether and how disclosure may be improved through the application of modern technology. The team is also tasked with producing a report by the end of the year that describes a modernized disclosure system and recommends future action for transition to that new system. Of course, any update to the Commission’s current system must be designed to enhance the Commission’s ability to fulfill its mission of protecting investors, maintaining orderly markets, and facilitating capital formation. The Commission has asked for public comment on this topic, and I look forward to the comment letters that will be coming in.
As you can tell the SEC has been in the eye of the Hurricane, but its working hard to continue all of its on-going important tasks, while keeping an eye on the future and how best to continue to protect investors and fulfill its mission.
In addition to the matters I’ve mentioned, the Commission is actively considering a number of other matters — revising the rules for credit rating agencies to strengthen their accountability, transparency and competitiveness; at the direction of Congress, we’re analyzing the use of fair value (or “mark-to-market”) in accounting; we’re working toward improving disclosure and comparability of information through the XBRL Interactive Data initiative; improving oil & gas disclosures; adopting a requirement to encourage mutual and money market funds to use a summary prospectus that will be better for the industry and for investors; adopting a rule to allow exchange traded funds — or ETFs — to form and operate without having to obtain an exemptive order from the Commission; and the Commission is considering extensive revisions to the current Form ADV part 2 that would allow investment advisory firms much greater flexibility in how they describe their business and provide investors with more useful data than the current check-the-box form allows. Lastly, the Commission is looking to the possibility of moving away from U.S. GAAP toward International Financial Reporting Standards.
One issue I would hope we revisit is shareholder access. I am a strong supporter of shareholder power to shape corporate governance. There are two reasons to be an advocate of shareholder power. First, it is a matter of rights. Shareholders have the right to make proposals and to have those proposals voted on. Not only is this a state law right, but Congress recognized it back in 1934, and the SEC also has determined such a right exists. The second reason is that shareholder participation contributes to effective corporate governance, which enhances firm value and share value.
A key question is whether the limitations on shareholder rights to make proposals in the company proxy statement and to affect corporate governance that were put in place prior to my tenure at the SEC are appropriate. The nomination of directors has been an area of intense focus over the last few years, and I will certainly be looking at our rules in this area.
As I conclude my remarks, I want to tell you that my first three months have been truly exciting and rewarding. Not much sleep but certainly exciting.
Thank you for the opportunity to speak with you today.