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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Empowering the Markets Watchdog to Effect Real Results


Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

North American Securities Administrators Association's
Winter Enforcement Conference
San Diego, California
January 10, 2009

Good afternoon.

It is a privilege to speak at the North American Securities Administrators Association's Winter Enforcement Conference, and I thank you for inviting me. It is a pleasure to look across the room and know that, as regulators, we all have similar objectives. As I am sure you are aware, these remarks express my own opinions and do not necessarily reflect those of the Commission, the other Commissioners, or members of the staff.

In preparing for my remarks, I read the NASAA's Core Principles for Regulatory Reform. I was struck by how much these core principles are in harmony with the SEC's own mission and generally, where I think its reform agenda should go. Although I know that each of you is familiar with the Core Principles, I think they are well worth repeating. Here's a quick summary:

  • Improve state and federal collaboration;
  • Close regulatory gaps by subjecting all financial products and markets to regulation;
  • Strengthen standards of conduct, and use "principles" to complement rules, not replace them;
  • Improve oversight through better risk assessment; and
  • Strengthen enforcement.

The SEC's mission is very clear. It is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. A fundamental component of this mission is to have a strong and vibrant enforcement program.

In this time of market turmoil, where confidence in the integrity and trustworthiness of the securities markets has been damaged, there is an overwhelming need for strong enforcement of the securities laws — by the states, foreign regulators, and the SEC.

I believe deeply that the historical independence and strength of the SEC has been an important factor in the growth of our capital markets and confidence of investors.

I want to emphasize this point, because in my view it is a bedrock principle of securities regulation. The capital markets and financial services in this country are in a position of public trust. They must operate under the highest standards of integrity and honesty. After all, these markets and financial services are necessarily about the allocation and management of other people's assets. The securities laws reflect these principles — capital raisers must speak the truth in their offering documents and reports, brokers must execute transactions in a manner that reflects the best interests of their clients, and advisers are fiduciaries of their clients. The federal securities laws were put in place largely to create this ethic because the markets prior to these laws were defined by deception in the pursuit of personal gain. Indeed, the first key federal statute, the Securities Act of 1933, was often referred to as the Truth in Securities Act.

Today, with more investment opportunities available, including increasingly complex financial products, and more investors relying on managers and other intermediaries, the need for honesty and integrity is greater than ever. Investor confidence has been badly shaken, and we need to reestablish stability by returning to the bedrock principle that the capital markets should be known for their integrity and honesty.

As many of you know, I became an SEC commissioner just over five months ago. In my first speech after being appointed, I expressed concern with the potential drop off in large investigations and the dramatic decline in the past few years in the amount of penalties that the Commission seeks and collects. Recently, it has been nearly impossible to turn on a TV or pick up a newspaper without seeing headlines criticizing the SEC and questioning whether the SEC is committed to aggressive and robust enforcement. In my experience, this is not an accurate perception of the dedication of the SEC's staff. However, there is no question that the time is now for the SEC to answer its critics by demonstrating its commitment to be the markets watchdog. To effectively do this — the SEC should undertake some internal shifts in policy and practice.

I will first address the immediate actions that the SEC should take and then what should be done by Congress and others. The SEC has a vital role to play and will need renewed commitment from Congress.

I. Immediate Actions

In my view, in terms of immediate actions, the SEC should:

  • eliminate its penalty pre-authorization pilot program;
  • rebuild and empower its enforcement staff; and
  • concentrate its resources on cases with greater reach into the market.

Eliminate the Penalty Pre-Authorization Program

I believe monetary penalties are a powerful deterrent to those contemplating breaking the law. In fact, in January of 2006, the Commission issued a statement on corporate penalties, in which it reiterated its longstanding view that "corporate penalties are an essential part of an aggressive and comprehensive program to enforce the federal securities laws."1

Although the Commission at the time said penalties were an essential part of an enforcement program, it didn't say anything about how often penalties would be sought or how large those penalties would be. Unfortunately, this strong statement on corporate penalties has been followed by weak action.

As has been well chronicled in the press, the Commission adopted a Pilot Program in 2006 to require the SEC enforcement staff to seek prior Commission approval before negotiating penalties with corporations. Previously, SEC attorneys could enter into settlement talks without obtaining permission in advance. The process worked well for over 70 years.

In my view, requiring Commission pre-approval of corporate penalties has limited the discretion of the dedicated enforcement staff. The passage of time has demonstrated that the Commission has failed to send a strong message of deterrence by imposing meaningful corporate penalties. From the time the program was implemented, penalty amounts in SEC cases against corporate issuers have plummeted.

For example, since the inception of the pilot program, and excluding cases involving the anti-bribery provisions of the Foreign Corrupt Practices Act, cases brought by the SEC against corporate issuers resulted in penalty amounts of $638 million in 2006, $331 million in 2007, and just $96 million in 2008 penalties — as compared to $811 million in 2003. Although year-to-year comparisons always need to be analyzed, by any measure, this is a dramatic drop. Additionally, I believe that this Pilot Program has resulted in cases taking years longer to resolve than they otherwise would have, as the staff's negotiating posture has been compromised.

From what I've experienced in my first five months, the penalty pre-approval pilot program makes the process of seeking a penalty against a corporate issuer more onerous — by increasing the staff's burdens in terms of layers of review, subjecting the staff's recommendation to micro-managing, and tying up resources that could be used to investigate and bring other cases. Thus, in my view, the message that is being sent to the staff is that it should forgo seeking penalties or seek smaller penalties against corporate issuers engaged in fraud in order to have the case approved by the Commission.

This is not the way to run an aggressive and robust enforcement program. I strongly believe that this penalty pre-approval pilot program should be ended immediately. I've recommended as much to the President-Elect's Transition Team and will ask the SEC's new Chair to make it his or her first official action.

Rebuild and Empower Staff

Beyond dismantling the penalty pre-approval pilot program, the Commission should act quickly to rebuild and empower the enforcement staff.

In the last few years, the Enforcement Division of the SEC has been coping with less staff and fewer resources. This is clearly not what has been needed in a time of deregulation and clearly not what Congress had in mind when it enacted Sarbanes-Oxley, specifying an increase in SEC resources in 2002 and stating that enforcement was to be strengthened. By 2006, however, staff turnover was at its highest level in five years. Enforcement groups, normally composed of 15 lawyers, often had only 7 or 8 lawyers during those years and are slowly being built back to the former numbers. The total number of attorneys able to investigate cases has decreased by 10% from 654 in 2005 to just 594 in 2008.

In addition to hiring and staffing at full capacity, the enforcement staff should be fully empowered to aggressively pursue investigations. Approval of formal orders, which are the Enforcement Division's requests to formalize investigations and issue subpoenas, should be streamlined. Currently, formal orders follow the same Commission approval process as every other type of request to the Commission and can often face a logjam due to the time constraints on the members of the Commission. There should be a separate process to streamline and expedite formal orders and assure the public that investigations are undertaken expeditiously.

Cases should also be heard by the Commission within appropriate time periods. I understand that, over the past several years, there has been a tendency for cases that are controversial to languish for years. This is unacceptable. The Commission should enforce an internal timetable so that staff recommendations will be considered in a timely manner.

Concentrate Resources on Cases with Greater Impact for Markets and Investors

As I have said, I 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.

Moreover, it has been reported that federal officials as a whole are bringing fewer cases of fraudulent stock schemes than they did eight years ago. In fact, press reports state that Justice Department officials are on track to bring the fewest prosecutions for securities fraud this year since 1991.

As I said before, our capital markets should be operated at the highest level of integrity, honesty, and professionalism. People who are trying to make a buck at the expense of investors need to know they are not welcome in the capital markets. These downward trends of enforcement need to be aggressively reversed. The SEC, in conjunction with all of you, our state and foreign counterparts, must redouble our efforts.

I agree with those that believe that financial markets are likely to regain investor confidence if they know that authorities are vigilantly overseeing the markets and are ready to crack down on illicit financial activities. We need to work diligently to restore investor confidence.

Improve Communications with NASAA

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.

I think a strong, collaborative relationship between NASAA and the SEC is critical to pursuing robust enforcement efforts. There are many ways to do this. One suggestion would be to consider establishing a standing SEC-NASAA Task Force in order to monitor financial activity across North America, consider the accumulated risk, and share and discuss recommendations for appropriate action. Another suggestion to improve and strengthen this relationship would be to have a NASAA representative at the SEC.

I think either idea, and perhaps others, could substantially improve collaborative efforts and would benefit investors around the nation and North America, as state, provincial, and federal enforcement officials work together to implement regulatory reform and spot fraudulent schemes.

II. Legislative Reform

In addition to the actions that the SEC should take right now, Congress should strengthen the Commission's ability to advance its mission and protect investors.

Regulatory Reform

One suggested reform that has been widely written about is a merger of the SEC and CFTC. This merger makes sense, but only if done in the right way. For many years, market participants and regulators have not been entirely certain about whether certain products were subject to SEC or CFTC jurisdiction. An SEC-CFTC merger would answer the question of "who" regulates financial services, market participants, and products. However, it would not address "how" they are regulated, and this is the key question. The SEC and CFTC have different objectives and have not pursued the same models of oversight — if they had the same models, the question of who regulated certain products and services would not be as important. Personally, I support the SEC's model of regulation, which focuses on investors and markets, and provides for strong and broad regulatory authority and vigorous enforcement, coupled with flexible exemptive power to permit dynamic regulation where needed. Our securities markets have been the world's best in large part because of SEC regulation, which provides for fairness, efficiency and transparency, and robust enforcement of that regulation — 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 is 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.

What we must not do is continue to follow a mistaken belief that efficiency, integrity and honesty will arise naturally from markets. Markets with perfect competition and information can be efficient, but regulation is necessary to prevent anti-competitive behavior and provide transparency where private gains can be obtained through information asymmetry.

For example, an investor's cost in a public securities transaction, even for a few shares, is incredibly small, and this is because of efficient regulation, not in spite of regulation. Public disclosure about the security and the issuer is required by regulation. Market information, such as recent prices and volume, is appropriately regulated, and the SEC has implemented a national market system whereby exchanges, electronic communication networks, alternative trading systems, and securities firms compete to offer the best services to investors, and broker-dealers are legally required to seek the best execution of their customer's transactions.

Our laws should provide for high standards, and those standards need to be vigorously enforced. Investors must have confidence in the integrity and fairness of the securities markets.

One area to watch closely is the regulation of broker-dealers who provide investment advisory services. Historically, broker-dealers that simply effected transactions as directed by their clients generally would not be fiduciaries and had duties focusing on the transaction service they provided. As broker-dealers increasingly provide advice to their clients, the higher standards and fiduciary duties of advisers should also be applied to these broker-dealers.

Independent Source of Funding

I also believe that dedicated, independent financing, such as that enjoyed by the Federal Reserve, is important to enabling the SEC to do its job. Although the SEC is an independent federal agency, the agency is not self-funded. Instead, the SEC's budget is annually appropriated and apportioned. This has led to weaknesses in the agency's ability to perform its mission.

For example, in the past four years, the SEC's budget allocation has been relatively flat, resulting in declining dollars for an agency that is supposed to be the Federal "watchdog" over the world's largest and most complicated financial market. The budget allocations were approximately $888 million in 2005, $888.1 million in 2006, and $881.6 million in 2007, and $906 million in 2008.

By having independent budget authority like the banking regulators, the SEC would have greater control over its own budget and funding levels, allowing the agency to take steps to address its growing workload in an increasingly complicated marketplace, while also recruiting and maintaining quality staff. In fact, the SEC has had to freeze needed hiring as the budget allocations failed to keep pace with year-to-year expense increases for existing staff. Being self-funded would greatly enhance the SEC's ability to advance its mission.

Although the SEC has been criticized a great deal recently, it is important to remember that the return on investment in the SEC is extremely high. In addition to enforcement, the agency administers a valuable review of company offering and periodic disclosures, monitors complex and innovative markets, and regulates a growing number of market participants and intermediaries, among other things.

III. Limiting Risk by Closing Regulatory Loopholes

Regulation of Hedge Funds

An additional area that calls out for Congressional action is the world of hedge funds and hedge fund of funds. 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, the size of their assets, and who controls them. Additionally, because hedge fund 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.

The Commission tried unsuccessfully to act in this area. In December 2004, the Commission promulgated a rule that effectively required hedge fund managers to register under the Investment Advisers Act and comply with adviser regulations, including filing disclosures, 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.

Congress should not hesitate to amend the Investment Advisers Act to clearly provide the Commission with authority over hedge fund advisers.


Congressional action is also needed to address the financial derivatives market. As NASAA members know, the securities laws generally exclude over-the-counter swaps from SEC regulation. That is true even when they can substitute for regulated securities products and affect the regulated securities markets.

As we all know, credit default swaps and other derivatives played a key role in the recent market turmoil, including the concerns about disruptions in the market arising from problems at AIG and Lehman. Estimates of the credit default swap market have come in at over $50 trillion dollars. Yet, notwithstanding their enormous size, these markets have remained opaque and without meaningful oversight.

This exclusion from SEC regulation severely limits the SEC's ability to require appropriate investor protection, such as position and trade reporting, as well as disclosure about the swaps and the counterparties. The SEC is also hindered in its ability to provide for market quality because it cannot require transparent pricing and other transaction information and foster competition.

You may have heard recently about efforts by the SEC, the Federal Reserve, and the CFTC to help establish one or more entities that would clear certain credit default swaps. These entities are referred to as central counterparties, or "CCPs." I want to make absolutely clear that these efforts are a temporary band-aid on the problems in the OTC derivatives markets, not a final solution.

Let me briefly discuss the role of a CCP, provide an overview of our recent action, and then talk about the limitations and what I believe Congress needs to do ASAP.

A CCP's role is to insert itself into the middle of a trade and thereby assume the counterparty risk involved when two parties trade — so an investor who previously entered into a swap with a Lehman or a Bear Stearns would not have to worry about their counterparty risk because the CCP would replace Lehman or Bear. A well-regulated CCP for credit default swaps is a good thing. By centralizing the clearance and settlement of the credit default swap market, offsetting exposures can be netted and the size of the market, and the resulting operational risk, can be reduced.

Unfortunately, the Commission's ability to provide appropriate regulation in this space is limited because of gaps in our authority. Most importantly, the Commission cannot require swap market participants to centrally clear their swaps. Market participants must do so voluntarily.

The Commission recently authorized the London Clearing House as a CCP and is considering authorizing a couple of other entities to operate as CCPs. Our authorization has a sunset period of nine months.

In connection with our work to establish a CCP, it was made clear to our staff that certain market participants would avoid using the CCP, and continue to operate in the opaque over-the-counter market, if the SEC required immediate full application of the securities laws to clearing and exchange listing of swaps. Because market participants cannot be required to centrally clear, they could threaten to continue to operate in the opaque over-the-counter market.

As a result, the staff found itself in the uncomfortable position of having a limited ability to negotiate for what may be considered best for the effectiveness of the markets — and for the protection of participants in those markets.

Because the authorization of the CCP is temporary and expires in September 2009, there is an opportunity to remedy this situation, and I strongly urge Congress to close the loopholes in swap regulation in the interim.

Without Congressional action, the Commission could find itself in nine months again being told that normal SEC regulation would drive market participants back to the unregulated (and dangerous) over-the-counter market, which could give the CCP inappropriate leverage to negotiate reduced regulatory oversight.

Congress must act so that the SEC is able to improve needed oversight to ensure vital public protections.

To address these issues, Congress should make the following two changes. First, Congress should repeal the exclusion of security-based swap agreements from the definition of "security" under the Securities Act of 1933 and Securities Exchange Act of 1934 and expressly include within the definition of "security" financial products that can be economic substitutes for securities. The law should focus on whether the relevance of a financial product arises from the capital markets, and such products should be regulated with an eye towards their effect on the capital markets.

Second, all transactions in securities should be required to be executed on a registered securities exchange and cleared through a registered clearing agency, with an understanding that the Commission would use its existing exemptive authority to permit over-the-counter markets where doing so would be in the public interest (such as where the over-the-counter market is so small or transactions are so infrequent that the risks presented by the market are low and regulatory costs could outweigh the public goods generated through regulation).

The core purpose of the capital markets is to finance the American economy in an efficient manner that allows all Americans to participate. Derivatives on securities or derivatives that can economically substitute for securities should be regulated harmoniously and by the same regulator that regulates the securities markets.

Municipal Securities Disclosure

We should also work to pass legislation requiring stronger disclosure to investors in municipal securities. As the credit crisis and economic slow down reaches state and local municipalities, now more than ever, investors need to have more information and transparency as to their state and municipal securities holdings.

But even in normal times, this multi-trillion dollar market entails many of the same risks of abuses as other parts of the capital markets. Individual investors own nearly two-thirds of municipal securities, directly or through funds, and yet neither the SEC nor any other regulator has the authority to protect investors by insisting on full disclosure. The problems in Jefferson County, Alabama and the multi-billion dollar fraud in the City of San Diego injured investors and taxpayers alike, and are recent reminders of what can go wrong.

That is why the SEC has repeatedly asked Congress for the authority to bring municipal disclosure at least up to par with corporate disclosure. This is an important issue that must be addressed.

IV. Strengthen Enforcement Program

I also would like to see the SEC expand the enforcement efforts to reach criminal violations. As I have already discussed, federal criminal prosecutions of securities law violations have decreased over the years. I believe that Congress could greatly enhance enforcement of the securities laws by authorizing the Commission to prosecute criminal violations of the federal securities laws where the Department of Justice declines to bring an action. The SEC makes a number of criminal referrals every year that DOJ declines to advance because of resource constraints and other reasons. In fact, there are numerous times where the SEC staff is in a holding period, waiting for the criminal authorities to decide whether they are going to bring a case and, in the interim, the evidence is growing older, and the case is less strong. Providing the SEC with this authority would be an effective way to enhance the federal law enforcement of all securities law violations by expanding the amount of cases that may be brought.

Additionally, the SEC could use greater ability to bring cases against people who lie during the course of an investigation. Accordingly, Congress should grant the Commission the power to bring civil and administrative proceedings for violations of 18 U.S.C. 10012 and to seek civil money penalties. 18 USC 1001 is the criminal statute that is violated when someone lies to a government official.

As I end my remarks, I want to commend NASAA and each of you for all your vigilance and efforts in enforcing the securities laws and working toward preserving the integrity of the financial markets. Your role is vital to the well-being of our financial markets — and your efforts are greatly acknowledge and appreciated by your colleagues at the SEC. The SEC looks forward to continuing our collaborative efforts.

In these volatile times, the role of the SEC and NASAA has never been more important. The several thousand men and women who devote themselves to law enforcement and the protection of investors, markets, and capital formation represent this nation's finest. I am both proud and humbled to work side-by-side with them.

Thank you for the opportunity to speak with you today.



Modified: 01/14/2009