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Speech by SEC Chairman:
'Building on Strengths in Designing the New Regulatory Structure'


Chairman Christopher Cox

U.S. Securities and Exchange Commission

PLI 40th Annual Securities Regulation Institute
New York, New York
November 12, 2008

Thank you, Mary Jo, for that kind introduction. This 40th annual Institute is already off to a roaring start, and I'm delighted that as has been our custom in years past, the SEC is once again contributing our top leaders to these proceedings. One of them, of course, is Mary Jo's husband, who has done a splendid job these past several years leading the Division of Corporation Finance. John recently announced that he will be returning to Cravath at the end of the year, but his accomplishments as Division Director will live on long beyond his tenure.

On day two of the Institute, as you know, you'll be treated to an update not only from John White, but also the Division's Deputy Directors, Shelley Parratt and Brian Breheny, who will review our current initiatives. And at the annual SEC Q&A picnic lunch, you'll be regaled with war stories not only from the current Division staff, but also such distinguished alums as Alan Beller, who served of course as the leader of this morning's pre-Conference briefing.

I'd like to extend a special thank you to Alan, as well as to co-chairs Steve Bochner, Stan Keller, and Mary Jo White, and Program Attorney Laura Shields from PLI, for all of the energy and effort that you devoted to making this a successful program.

This Institute, of course, is an opportunity for continuing education credit. Since these PLI programs feature all of the trappings of the classroom — faculty members, course handbooks, lectures — it seems the only thing we're missing is exams and grades. That is all to the good, as far as I'm concerned, because I remember having to grade the final exams when I used to teach federal income tax at Harvard Business School. The final exam was four hours long — and the students filled up a half dozen blue books with their answers. It was a bear to read over 1,000 exam books.

There was one student, however, who used only one blue book. I'll never forget that — I can't tell you how excited I was to open the cover and review this model of brevity and concision. And you can imagine how surprised I was when I opened his test book and I discovered he'd only used one page.

Here's what he wrote: "Dear Prof. Cox: What I have learned in your course is that federal income tax is extraordinarily complicated; and when I go into business I'll be sure to hire someone who knows what he's doing in this area."

Sadly, I had to fail him. But after all that, he did graduate from Harvard Business School, and undoubtedly with that kind of creativity and knack for delegation, he's become a success in business. He's probably one of your clients.

This morning's focus on Lessons Learned from the Market Meltdown, and the upcoming panel discussion on the Causes and Consequences of the Credit and Liquidity Crisis, provide a very timely framework for all of the issues that you will have to consider as lawyers in new ways. Whether it's advising boards of directors on risk assessment issues, assessing the impact of current events on the direction of securities law enforcement and securities litigation, or dealing with the remarkably challenging accounting and auditing issues that have surfaced in 2008, it is difficult to see what hasn't changed in the last few months.

Precisely because the disorienting and dramatic changes of recent months have called so much of what we think we know into question, I'd like to begin this keynote address by focusing on what remains constant amidst all the turmoil. Despite the fact that we face profound economic challenges as a result of the bursting of the mortgage credit bubble, it is worth remembering that we remain the most productive nation on earth.

Compared to 40 years ago, when these Institutes first began, our country is remarkably united and stable. In 1968, you'll recall, the nation was not only deeply divided over an unpopular war, but rioters laid waste to whole sections of the nation's capital and other cities. Dr. Martin Luther King's dream seemed shattered. Contrast that with today, when one of the most momentous transfers of political power in our nation's history is being conducted with a remarkable grace and shared national pride, and we are taking a huge step towards realizing Dr. King's dream.

Today our nation's 305 million people represent only 4-1/2% percent of the world's population, but we produce over 25% of the world's GDP. Our capital markets remain the largest, deepest, and most liquid in the world. As of the end of the second quarter in 2008, the U.S. share of global securities trading was 50% — by far the largest of any nation or region. And despite the shocks that our economy has endured, American investors continue to do the constructive work of investing and trading that drives our markets every day. It is emblematic of our nation's durability that in the midst of a global flight to quality, the world's investors are turning to the U.S. dollar.

But we as policymakers have to ensure that our regulatory support and protections for investors match their faith in the capital markets. And the truth is our regulatory framework hasn't kept up with the dramatic changes in markets or the globalization of finance. The fact that firms and investors in every sector of the financial services industry have been vulnerable to the effects of the toxic mortgage contagion highlights the weaknesses and gaps in our existing system of stovepiped responsibility and parallel regulation. Not only investment banks but also commercial banks and thrifts such as Wachovia, Washington Mutual, and IndyMac — not to mention the enormous government-sponsored enterprises Fannie Mae and Freddie Mac, as well as the nation's largest insurance company, AIG — proved vulnerable in this year's crisis. And yet insurers, investment banks, commercial banks, and thrifts — as well as derivatives dealers, futures traders, and scores of others — all have different regulators and legal rules. Beyond this, there is the challenge of international gaps and the significant opportunities for international regulatory arbitrage. As the failures and the near-failures of banks and financial institutions in Europe and Asia have made clear, regulated enterprises around the world have proven just as vulnerable as those in the United States.

The Emergency Economic Stabilization Act signed into law last month ordered a report to Congress by April 30 on market conditions and the financial regulatory system. This is designed to provide the basis for Congress to reorganize our current, disjointed system of financial regulation. There is every reason to expect that our nation's lawmakers will be serious about a top-to-bottom restructuring that will affect every one of the federal government's seven major financial regulatory agencies and their over 15,000 employees. At the same time, history has shown that genuine reform will be difficult to achieve, because it requires overcoming jurisdictional barriers and turf wars not only among the agencies but within the Congress itself. If even the shock of 9/11 was insufficient to truly integrate information sharing and threat assessment among the many agencies of government, it is safe to assume that even this extraordinary financial crisis will not eliminate the inertial tendencies in the system. As the renowned SEC historian Joel Seligman recently testified in Washington, "the politics of Congress and the agencies themselves tend to fortify inertia."

That is why it is so important for the Congress to appoint a Select Committee, with representation from each of the existing standing committees with responsibility for financial services regulation, to rationalize the current dysfunctional patchwork of our regulatory system. I know from experience how difficult it will be to challenge the jurisdictional status quo. As you know, I chaired a Select Committee for two years after 9/11, prior to becoming the chairman of the permanent Homeland Security Committee in the House of Representatives. Without the Congressional leadership appointing a select committee, Congress could never have cut across the existing jurisdictional boundaries to address these urgent national security questions from a comprehensive standpoint. Today, we're confronted with a similar challenge, because legislative jurisdiction in both the House and the Senate is split so that banking, insurance, and securities fall within the province of the Financial Services and Banking Committees, while futures fall within the domain of the Agriculture Committees in each chamber. This jurisdictional split threatens to forever stand in the way of rationalizing the regulation of these products and markets.

One tangible outcome of appointing a Select Committee on Financial Services Regulatory Reform could be a consolidation of the SEC and the Commodity Futures Trading Commission into a single agency with a clear mandate to protect investors by regulating the markets in all financial investments, including securities, futures, and derivatives. Similar consolidation is needed in the banking arena, were a half-dozen federal regulators overlap not only with each other but with state agencies.

The lessons of the credit crisis all point to the need for strong and effective regulation, but without major holes and gaps. They also highlight the need for a strong SEC, which is unique in its arm's-length independence from the institutions and persons it regulates. For example, banks regulated by the Federal Reserve Bank of New York elect six of the nine seats on the board of the New York Fed. Both the CEOs of J.P. Morgan Chase and Lehman Brothers served on the New York Fed board at the beginning of the credit crisis. In contrast, the SEC's regulation and enforcement are completely institutionally independent.

Some have tried to use the current market crisis as an argument for replacing the SEC in a new system that relies more on supervision and less on regulation and enforcement. That same recommendation was made before the current crisis a year ago, for a very different and inconsistent reason: that the U.S. was at risk of losing business to less-regulated markets. But what happened in the mortgage meltdown and the ensuing credit crisis demonstrates that where SEC regulation is strong and backed by statute, it is effective. And where it relies on voluntary compliance, or simply has no jurisdiction at all, it is not.

Not only the current crisis, but the significant corporate scandals such as Enron and WorldCom earlier this decade, have amply demonstrated the need for independent, strong securities regulation and enforcement. That's why an independent SEC, regulating at arm's length, will remain as important in the future as ever it has been before. If the SEC did not exist, Congress would have to create it.

As lawmakers address the gaps and weaknesses in the current system, it's imperative to understand the SEC's existing function and the agency's comparative strengths, so that we can build on those strengths in a newly designed regulatory structure.

First and foremost, the SEC is a law enforcement agency. Each year, the SEC brings hundreds of civil enforcement actions for violation of the securities laws involving market manipulation, insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them. This enforcement work makes an enormous contribution to market confidence. That is because enforcement is not simply a cost of maintaining the rule of law, but rather a precondition for deep and liquid securities markets, in our own country and in other jurisdictions as well.

There is a demonstrated correlation between the level of securities law enforcement and the health of capital markets as determined by objective measures. For example, research published two months ago by Howell Jackson and Mark Roe of the Harvard Law School highlights the importance of public enforcement to strong financial markets. They found that robust public enforcement is regularly associated with deeper securities markets around the world. In fact, they found that it plays just as important a role in maintaining healthy markets as does the entire system of disclosure.

It is because we understand the direct connection between strong markets and securities law enforcement that the SEC now devotes more than one-third of the entire agency staff to our enforcement program. That is a higher percentage of the SEC's total staff and resources than at any time in the past 20 years. Our 2008 budget for enforcement was the highest in the agency's history.

What I find particularly impressive about the professional men and women in our Enforcement Division is that in these particularly difficult times, they have truly shown their perseverance and dedication. We constantly measure the rate of staff turnover as a measure of morale and the health of our program — and I am happy to report that enforcement turnover is at a modern low, down from 14% in 2000 to less than 5% in 2008.

In this past year, we have also increased the number of enforcement personnel by 4%. And our results show it. In our fiscal year just ended, the SEC started the second-highest number of enforcement actions in agency history, and completed the highest number of actions by far.

The SEC also brought a record number of enforcement actions against market manipulation in 2008, including a precedent-setting case against a Wall Street short seller for spreading false rumors.

Not just in 2008, but in each of the last two years, we have set the record for the highest number of corporate penalty cases in the agency's history. And for the second year in a row, we also returned more than $1 billion to harmed investors using our Fair Funds authority under Sarbanes-Oxley. The recently announced settlements in principle in the auction rate securities cases will return over $50 billion to investors — by far the largest settlements in SEC history.

This track record of success, which is so important to the maintenance of investor confidence and healthy markets, is a fundamental strength of the SEC that should be embraced and enhanced in any regulatory reform. And as the Congress does so, it should recognize that for securities law enforcement to be effective, it must remain fiercely independent.

Just as important to investor protection and capital formation is the SEC's leading role in providing transparency about issuers and their securities. Administering the now well-developed regime of public disclosure, including the periodic reporting system for public companies, has been a fundamental role of the SEC since its founding 74 years ago. So too has providing transparency into trading activities and the functioning of markets. But here the limits of the Commission's authority have led to regulatory gaps that have left entire portions of the market in darkness. Perhaps the most important change to the marketplace in recent years, from the standpoint of investor protection, is the enormous growth in financial products that exist wholly outside the regulatory system.

We simply cannot leave unregulated such products as credit default swaps, which can be used as synthetic substitutes for regulated securities — and which can have profound and even manipulative effects on unregulated markets. The risk is too great. The unprecedented government rescue of AIG, now totaling over $167 billion, was necessitated in substantial part by others' exposure to risk on its credit default swaps, and it's but one of several recent alarms.

To improve transparency for credit default swaps, the SEC is working to strengthen the market infrastructure for their trading and to establish a disclosure regime that would not only result in the public reporting of prices and trading volumes, but also give regulators access to trade and position information for the purpose of monitoring market trends, identifying potential issues, and preventing market manipulation and insider trading. Along with the Federal Reserve Board and other members of the President's Working Group, the SEC is working to provide the regulatory approvals necessary to the establishment of one or more central counterparties for credit default swaps. And to facilitate that process, we are working with both the Federal Reserve and the Commodity Futures Trading Commission on a Memorandum of Understanding that will establish a framework for consultation and information sharing.

But while we are already working with industry participants to accomplish these goals on a voluntary basis, using the authority we currently have, Congress could provide support for these efforts by authorizing federal regulators to mandate the use of one or more central counterparties for the credit-default swaps market. As it is now, it is often impossible even to know who stands on the other side of a swap contract, and this increases the risk involved. Congress could also give regulators clear authority to rein in fraudulent or manipulative trading practices so that every market participant can better assess the risks involved. As we have learned from experience, ignorance of the facts about where CDS risks lie can needlessly magnify the concern of market participants and breed excessive caution beyond what likely would occur if the true risks were clearly understood.

Regulatory reforms need to address other regulatory gaps as well. The multi-trillion dollar municipal securities market entails many of the same risks, and is subject to the same abuses, as other parts of the capital markets. As the economic slowdown makes it increasingly difficult for many states and localities to meet their obligations, and as many municipalities continue to use interest rate swaps in ways that expose them to risk that the financial institution on the other side of the contract may fail, investors need to know more about what they own. The problems in Jefferson County, Alabama, are only the most recent reminder of what can go wrong. The multi-billion dollar fraud in the City of San Diego, in which the SEC charged five former city employees this past year, has injured both investors and taxpayers alike. That's why, repeatedly over the last two years, I've asked Congress to give the SEC the authority to bring municipal finance disclosure at least up to par with corporate disclosure by repealing the Tower Amendment. And it's why, within the next few weeks, I will ask the full Commission to improve the current disclosure of information regarding municipal securities by requiring that secondary market disclosure information be provided, in an electronic format, to a single repository. This will permit the MSRB to expand its Electronic Municipal Market Access system, or EMMA, to accommodate secondary market disclosure information.

Throughout its 74 year history, the SEC has done an outstanding job of regulating registered broker-dealers, and protecting their customers. This is another of the agency's great strengths and areas of fundamental expertise. The SEC's investor protection role has consistently been vindicated when financial institutions fail. For example, following the bankruptcies of Drexel Burnham Lambert, and more recently Lehman Brothers, customers' cash and securities have been protected because they were segregated from the firms' other business. They've also been covered by insurance from the Securities Investor Protection Corporation.

But fulfilling this role is very different than what the government has done this year. Prior to the Federal Reserve's unprecedented decision to provide funding for the acquisition of Bear Stearns, neither the Fed, the SEC, nor any agency had as its mission the protection of the viability or profitability of a particular investment bank holding company.

Indeed, it's been a fact of life in Wall Street's history that investment banks can and will fail. Wall Street is littered with the names of distinguished institutions — E.F. Hutton, Drexel, Kidder Peabody, Salomon Brothers, Bankers Trust, to name just a few — which placed big bets and lost, and as a result ended up either in bankruptcy or being sold to save themselves.

Not only is it not a traditional mission of the SEC to regulate the safety and soundness of diversified financial conglomerates whose activities range far beyond the securities realm, but Congress has given this mission to no agency of government.

To fully understand why this is such a serious regulatory gap begins with an appreciation for the enormous difference between an investment bank and an investment bank holding company. The holding company in the case of Lehman Brothers, for example, consisted of more than 200 significant subsidiaries. The SEC was not the statutory regulator for 193 of them. There were OTC derivatives businesses, trust companies, mortgage companies, offshore banks, and reinsurance companies. Each of these examples falls far outside the SEC's regulatory jurisdiction. What Congress did give the SEC authority to regulate was the broker-dealers, the investment companies, and investment advisor subsidiaries within these conglomerates — and the agency has consistently done these jobs very well.

What we have learned is that when SEC regulation is backed up with statutory authority, it is strong and successful. One year before I became Chairman, the Commission embarked upon an experiment in which the Division of Trading and Markets would review only the consolidated information for vast global investment bank holding companies that we did not regulate, and which could opt in and out of the program on a voluntary basis. During my tenure, the staffing of the Consolidated Supervised Entities program was increased by 30%. But when I ended the program earlier this year, it was in recognition of the fact that voluntary regulation does not work.

For this reason, it's important that Congress close yet another regulatory gap, and address the fact that there is still no statutory regulator for investment bank holding companies. This problem has been temporarily addressed by changes in the market, with the largest investment banks converting to bank holding companies. But it must be directly addressed in the law.

Still other regulatory gaps persist, including a statutory divide at the SEC itself between the supervision of broker-dealers under the Securities Exchange Act of 1934 and that of investment advisers under the Investment Advisers Act of 1940. One of the agency's significant efforts to reconcile the supervision of these overlapping financial services was struck down by the courts last year. Congress has an important opportunity to modernize the more than half-century old legislation in this area in any comprehensive overhaul of the regulatory system, and the SEC stands ready to provide its expertise.

As Congress remakes the federal regulatory system, and as the regulators respond with new rules to the changed environment, it's vitally important that we base our decisions on the best available information. Understanding the various causes of the financial instability that still persists is vital to restoring investor confidence and the full functioning of our markets.

To achieve this, Congress should authorize a thorough study to evaluate the reasons for the extraordinary recent market volatility. Investors have watched the stock market gyrate wildly in recent months — down 700 points one day, then up 400 the next. In fact, five of the 10 biggest daily point losses in history occurred in the past two months, as have five of the 10 biggest gains. One widely used indicator of market instability is the CBOE Volatility Index, which has been used for more than 15 years to track the volatility of the S&P 500. That index shattered its old intraday high on October 24, and remains far outside its historical range.

I believe that a study similar to that conducted by the Brady Commission, which reported on the 1987 crash, would be of immense benefit in understanding the sources of this recent volatility, as well as in considering for potential improvements to our rules and our regulatory structure that will help maintain orderly markets.

The SEC is, of course, carefully analyzing market information in real time. But to thoroughly deconstruct, down to the trade level, the significant quantities of technical information (including trade execution and other market quality data) that would have to be reviewed in order to answer these questions in the way this was done by the Brady Commission would require funding resources beyond those that are currently available to the SEC. As the Congress undertakes a top-to-bottom review of the framework for regulation of our financial markets, I will therefore recommend that they authorize the resources necessary for the SEC to lead such a study.

There is one additional reason that we should make every effort to base significant legislative and regulatory change on the best available information. We must be careful not to fall prey to the age-old response of fighting the last war. There is much to be learned from history, but today's market conditions are in many important ways different from what has existed in the past. If we continue to rely upon the regulatory creations of past decades, and just add more of it, we will undoubtedly repeat history.

I remember working in the White House in 1987, helping to determine how to respond to a 25% drop in the markets in one day. I see the very real similarities to current events — institutions borrowing short and lending long, housing bubbles in California and Florida, pressure to change accounting rules to give S&Ls time to write their balance sheets. The nation subsequently spent upwards of $150 billion to clean up the wreckage.

While the nation learned much in 1987, and Congress made some constructive changes in regulation, people and institutions too quickly fell back into old habits and old ways. We read now with disappointment the history of regulatory turf battles and missed opportunities.

It's time to think anew. We should begin with a clear eyed view of the purpose of our capital markets. The financial system administered by Wall Street institutions exists not as an end in itself, but rather to raise money for productive enterprise and for the support of millions of jobs throughout our economy. Our capital markets provide the means by which millions of Americans put their savings to work in our economy. But the financial system has failed recently to fulfill that purpose. It must not become merely a baroque cathedral of complexity dedicated only to its own limitless compensation in the short term, without regard to the long-term risks it has created that now threaten the entire nation's sustenance and growth.

In redesigning the regulatory structure, we should also bear in mind the advantages of market forces over government decision-making in allocating scarce resources, including capital, throughout an economy as vast as America's. Government intervention, taxpayer assumption of risk, and short-term forestalling of failure must not be a permanent fixture of our financial system.

The last several months have been difficult for the country and for markets, but this adversity has brought out the best in the people with whom I work at the SEC. Every day, the Commission's professional staff devote themselves with passion to protecting America's investors and ensuring that our capital markets remain strong. I am humbled to work side-by-side with them. It is now abundantly clear that their role, and the role of the SEC, has never been more important.

The same should be said of the role that each of you plays. Here in New York City, you have been learning the lessons of our financial meltdown through daily experience. Your continued devotion to the health and preservation of our financial markets, and to the integrity of our regulatory system, deserves our respect and gratitude. Thank you to all of the men and women here today whose vocation it is to sustain and improve our market economy. In particular, congratulations to PLI for producing 40 years of outstanding programs such as this. At the SEC, we are proud to be your partners.



Modified: 11/12/2008