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Speech by SEC Commissioner:
Investors Deserve Sustainable Reform — Not More of the Same


Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

The Emerging Regulatory Landscape: A Roundtable Conference
George Washington University Law School and Institute for Law and Economic Policy
Washington, D.C.
November 6, 2009

Thank you for that kind introduction. I am honored to be with you today. The turmoil and pain of the financial crisis demand that we take an in-depth look at reforming our financial services regulatory framework, so I am glad that today's forum brings together recognized leaders to discuss the way forward. For future reforms to be effective we certainly need to have our best thinkers contributing to the debate. Before I continue, and as is customary, I want to make clear that the thoughts I express are my own, and they do not necessarily reflect the views of the other Commissioners or the staff of the SEC.

The challenges we face to the long-term strength of our capital markets are particularly great. It is my hope that the resulting regulatory reform will be one that strengthens, rather than weakens, investor protection, fair and orderly markets and the foundation for long-term economic prosperity.

Clearly, the issues being discussed could very well lead to the largest wholesale regulatory restructuring of the financial services industry since the Great Depression. At the same time, there is a growing concern that we might miss the opportunity to make the transformational changes required to address the realities of today's financial markets — and to prepare for the unforeseen challenges of tomorrow. Moreover, I fear that we may go down the path of piecemeal changes that give the illusion of regulatory reform but leave us in danger of repeating our recent history. This "false comfort" would be a recipe for disaster.

Right now, there many voices clamoring to be heard regarding financial reform. I worry about which voices will most significantly influence the shape of the ultimate legislation that will be adopted. There is no question that the financial services industry and its lobbyists have been quite vocal and effective. As has been reported, for example, the Obama Administration's proposal for a new Consumer Financial Protection Agency has been the subject of an intense lobbying effort to restrict its powers. In addition, there are ongoing efforts to scale back the Obama Administration's proposals to regulate the multi-trillion dollar over-the-counter derivatives industry. Similar efforts have been made to scale back the proposals to regulate the hedge fund industry.

Missed Opportunities

Against this backdrop, my faith in the will and ability of Congress to pass strong reform legislation was severely shaken this week. I am saddened for the American investing public by particular amendments that were included in The Investor Protection Act of 2009 that emerged from the House Financial Services Committee. While the proposed legislation does provide many needed improvements, it unfortunately also contains deregulatory initiatives that would seem to have been thoroughly disproved by the events of the last few years. Let me discuss a few examples.

One late amendment to the bill would reverse a key investor protection forged after the widespread, devastating public company financial frauds from the early part of this decade.

Everyone knows about the Sarbanes-Oxley Act, which contains a set of hard-won reforms made necessary by Enron, WorldCom, and other frauds. One clear lesson learned from those frauds was that many public companies had weak internal controls. The Sarbanes-Oxley Act tackled these problems by requiring the top executives of all public companies to take responsibility for their internal controls, and, importantly, for an independent auditor to come in and examine these controls. In the financial press, this independent audit requirement is referred to as "404(b)," after the section of Sarbanes-Oxley that requires the audit.

The Investor Protection Act of 2009 in its current form would repeal this important requirement of an independent audit for public companies with a market cap under $75 million. Some are describing this repeal of Sarbanes-Oxley as relief for "small businesses." I think people are confused when they hear the words "small business." The companies that would be exempted are not mom and pop neighborhood stores. These are publicly traded companies that offer their shares to all types of investors. And just so you know, this repeal has wide-ranging ramifications and would appear to affect the majority of public companies. Although the SEC generally does not track companies based on market cap, the SEC does have data on companies that generally have $75 million or less in public float, and our staff estimates that over 6,000 public companies may fall under that threshold.

To repeal this part of Sarbanes-Oxley now is to throw away a substantial amount of work done by regulators, companies, and private organizations to make compliance with 404(b) more cost-effective. Since the passage of Sarbanes-Oxley, the SEC has repeatedly deferred smaller public company compliance with the independent internal control audit requirement. During the period of the SEC deferrals, the SEC and the Public Company Accounting Oversight Board (PCAOB) were active in developing rules and guidance to allow 404(b) to be implemented in a manner that would work for both large and small public companies. A central goal of this work focused on making sure that costs for smaller public company were not overly burdensome.

The SEC alone has held roundtables, chartered an advisory committee, and engaged in a number of other regulatory and staff actions targeted at applying 404(b) to smaller public companies, and followed all of that with a staff study which found these efforts made compliance more cost-effective. In addition, private organizations like the Committee of Sponsoring Organizations of the Treadway Commission (COSO) have published guidance on internal control frameworks specifically targeted at smaller public companies. It is particularly ironic that, if 404(b) is undercut now, we will never see the benefits for investors of all the work by the SEC, PCAOB, COSO and others, and the opportunity for smaller public companies to take advantage of the practical lessons learned from companies that are already complying.

In many ways, the current crisis happened because we rejected the hard-earned lessons of the Great Depression, allowed financial institutions to take on too much risk, and left wide parts of the markets entirely unregulated. While we push for reform that improves investor protection and our markets based on the crisis of today, we must not forget the lessons learned historically, whether from the Great Depression or the more recent lessons from just the early part of this decade, and we must not allow important reforms to be undone.

We should remember why 404(b) was passed, recognize the significant positive effects it has had for companies that have complied, and appreciate that a lot of careful work has gone into preparing the standards for use by smaller public companies. When we do so, it is clear that repealing 404(b) as to the majority of public companies would be a mistake, and inconsistent with the objectives of reform that strengthens investor protection. There is still time for this provision to be stripped out the next time this bill is taken up for consideration, and my hope is that the Senate will not include this deregulatory initiative as it develops legislation.

Another provision in the proposed legislation that is very difficult to understand is the one that would transfer oversight of a substantial number of investment advisers from the SEC to an industry self-regulator — in this case it is FINRA (Financial Industry Regulatory Authority Inc.). I am troubled by the proposal to outsource regulatory responsibility from the SEC. There is no doubt in my mind that a government agency subject to Congressional oversight and multiple audits by agencies such as GAO (General Accountability Office) is accountable in ways that an industry organization is not. At a time where there are calls for a new government agency, the Consumer Financial Protection Agency, to buttress protections for consumers, how can the same leaders creating that agency outsource core functions of governmental oversight over a majority of the assets of a $34 trillion industry?

The main argument in favor of putting oversight in the hands of an industry self-regulator is that the SEC lacks resources. The issue of resources masks the real situation. No private organization has the existing resources to expand investment adviser oversight. In other words, the private industry entity in question is not suggesting that it will oversee advisers using the current budget and staff it has in place. Instead, the investment advisers will need to be assessed a bill for this additional oversight. And if advisers have to write a check to someone, as the legislation would require, it makes much more sense for that check to go to the SEC — as the SEC already has the team and expertise in place. This issue really boils down to whether Congress is going to strengthen the SEC by expanding its authority and fortifying its resources, including user fees from advisers, or weaken the SEC by taking away its direct oversight in order to transfer it to an industry organization.

Oversight of the investment adviser community has always been a partnership between state and federal regulators. I don't think this should change. Injecting an industry organization into the mix dramatically changes the oversight structure in ways that do not make sense, particularly given the other provisions in the proposed legislation. Right now the proposed legislation would transfer oversight over a significant amount of advisers to the states by increasing the threshold requirement for federal registration as well as provides for user fees to pay for oversight. These two provisions taken together would significantly strengthen the SEC's oversight framework for advisers. Thus, this legislation is at war with itself because of the significant transfer of oversight responsibility to FINRA. News reports from last night have indicated that Chairman Frank intends to strip this provision out as the bill heads to the House floor. I hope so, for as I said before, the question for Congress is whether it will strengthen the SEC's oversight of advisers or weaken the SEC by outsourcing core responsibilities.

Principles that Should Motivate Reform

On a broader level, in considering the many — and often competing — proposals, I think it is important to step back and think through the principles that should motivate any proposed reforms. As I have said previously, as a regulator standing on the precipice of legislative and administrative action, I think it is important to focus on how things should be rather than how they are. Clearly, smart, effective and forward looking regulations are necessary building blocks if we're to have robust and fair capital markets.

It appears to me that much of the regulatory discussion is not being properly oriented. From the beginning much of the discussion revolved around systemic risk and what to do about companies that are "too big to fail." It seems to me that if you're dealing with a company that's "too big to fail," then regulation has already failed. I agree that there's a need to have resolution authority that can reach all types of systemically important institutions. It is clear that we need the ability to wind down in an orderly way institutions whose failure could endanger the system. I believe, however, that it's more important to have the authority to regulate institutions on their way to becoming systemically significant — as well as to address market-wide impact resulting from the collective action of numerous institutions that may individually not be systemically important. I'll mention one example a little later.

It is my hope that we can shift the dialogue from the discussion of how best to preserve "too big to fail" financial institutions to what is best for investors. Our political leaders, market participants, regulators and other interested parties have to remember that financial services exist to serve investors — and, in turn, our markets. If you're paying attention to the needs of investors you are likely to prevent companies from becoming too big to fail and, at the same time, you will be mitigating potential systemic risk.

The momentum for reform arising out of the crisis presents an opportunity to create a stronger and more robust financial regulatory system, but we have to emphasize the users of the system — investors, not the institutions.

Having the Right Philosophy

As we pursue regulatory reform that strengthens investor protection and promotes market integrity, we must reverse the economic philosophy that resulted in the affirmative decisions that forced gaps in, and otherwise undercut, regulatory protections. This philosophy was driven by the deregulatory principles that market participants could police themselves and that the only way to spur financial innovation was to eliminate all regulatory oversight. These drastic deregulatory policies resulted in large swaths of our financial system having little to no oversight. There are many examples of deregulatory decisions being made with industry's best interests in mind, rather than the investor's interest. In 1999, for example, the Gramm-Leach-Bliley Act formally repealed Glass-Steagall and authorized banks, securities firms, and insurance companies to combine under one umbrella. The repeal of Glass-Steagall was the culmination of years of policies that weakened the protections in place to guard against the development of large financial conglomerates. During this period of banking deregulation the legislation did not emphasize the interests of investors and consumers, or the need to protect investors against the intrinsic risks and conflicts created by these giant entities.

As another example, there is the Commodity Futures Modernization Act, which actually excluded derivatives and swaps from most regulation. This Act resulted from the affirmative decision by Congress to prohibit expert regulators from exercising their judgment as to complex products, such as credit default swaps.

The recent turmoil in the markets illustrate that these and other similar laws did not prioritize investors. Based on some of the current provisions in the proposed Investor Protection Act of 2009, I fear we may repeat these mistakes.

Assessment of Regulatory Reform Proposals

To that end, given our recent history in regulatory policy, it is essential that any reform prioritizes the needs of investors and the market place they depend on. With that as my touchstone, I will discuss my views on some of the recent proposals for reform that are being debated.

Perhaps the most talked about aspect of regulatory reform concerns the need to monitor and manage systemic risk. A term like "systemic risk" is mentioned so often that it is easy to believe that there is a common understanding of the term; however, this is not the case. This lack of a common understanding is important because the definition of systemic risk directly influences one's ideas about how the financial regulatory system is structured.

One view of systemic risk is that government must preserve the viability of institutions that are "too big to fail." But this view can result in a financial regulatory model that focuses too much on specific institutions, not investors. In this system, a government regulator would pick winners and losers among companies at the expense of investors and at the expense of market certainty — as we saw during the events of September 2008.

Instead, by focusing on investor protection, systemic risk regulation should recognize that the various market functions exist to serve investors and other users — and that the focus needs to be on ensuring the continuation of systemically important market functions, not institutions. This orientation toward investors and away from a "too big to fail" philosophy would involve identifying the systemically important market functions that an institution provides, and working to make sure these functions remain available. The objective would be to ensure that the functions would be heavily reinforced against failure, and could be separately maintained within the same institution should other parts of the institution weaken — or that the functions considered systemically important are available elsewhere. For example, if the NYSE-Arca system were to fail, the SEC has designed the market system so that NASDAQ would quickly pick up this important market function.

To that end, systemic risk regulation should facilitate an environment where no institution is indispensable and where other firms can step in to meet the needs of the market.

In addition to the question as to the nature of systemic regulation, there is the question of who the regulator will be. As you know, the debate is ongoing concerning whether to vest systemic risk oversight in a monolithic risk regulator like the Fed or a council of regulators. Moreover, recently a hybrid model has become popular where the Fed would functionally be vested with the powers of the systemic regulator, but would receive input from a council of regulators. This approach is a hybrid but essentially it still vests power in the Fed. While there are advantages and disadvantages to all of these "systemic risk regulator" proposals, I continue to think a stand alone council of regulators seems to offer a more comprehensive and effective option; provided, of course, that it has the sufficient authority, resources and independence to effectively address systemic risk.

The advantages of a council of regulators approach are: first, it reflects the main objective of a systemic risk regulator, which is to identify accumulation of risks. In short, the systemic risk regulator must have the foresight to identify ominous structural imbalances and market trends. Second, it brings together different regulators with different techniques and expertise, providing for a diversity of perspectives that could make it more likely that a risk will be identified. A council would also facilitate the free flow of information among regulators.

Lastly, and most significantly, a council of regulators would avoid the inherent tensions and conflicts that arise when one regulator has combined responsibility over monetary policy, a vested interest in the safety and soundness of particular institutions, and plenary powers to address systemic risk. Any organization with a narrow focus on a particular industry and very broad powers is likely to favor that sector to the potential detriment of others.

Moving forward with a council of regulators approach will present a number of issues to be worked through — not the least of which is selecting the members. With the many existing banking regulators, one member-one vote would create an unworkable imbalance in favor of the banking sector. Other key issues that would need to be considered include: what actual authority the council should have, whether it will it be an independent agency or have political leadership and how it will implement procedural protections on how the council's powers would be exercised.

Being Prepared for Unforeseen Developments

Let me address another important aspect of regulation. As I said earlier, a decade ago there were significant affirmative decisions to deregulate and leave gaps in regulation. I believe that this time around we must make affirmative decisions to empower regulators to not only close today's gaps but to look ahead and give them flexible powers that can be deployed as an unknown future unfolds.

With reform proposals, it is important to solve the problem of today but it is just as important to also build a structure that prepares for the crisis of tomorrow. We can see the drafters of the securities laws did this by granting the SEC significant discretion to promulgate rules, issue exemptions, investigate and enforce the laws.

I firmly hope that the model for new regulation will be one that provides for strong and broad regulatory authority and vigorous enforcement, coupled with flexible exemptive power to permit dynamic regulation where appropriate. This model would grant a regulator the flexibility to better discharge its responsibilities and adapt to future market conditions without having to ask Congress for more authority. For a variety of reasons, as we all know it can take Congress awhile to act. For example, consider the need to regulate OTC derivatives like credit default swaps. There has been widespread agreement for a very long time that credit default swaps need to be regulated. Yet, as we sit here today, the lack of oversight still remains.

One area where I've highlighted that the Commission may miss an opportunity to prepare for the future is in the hedge fund arena. Because it is difficult, if not impossible, to predict today what rules will be required in the future to protect investors and obtain sufficient transparency, especially in an industry as dynamic and creative as hedge funds, the Commission should be actively seeking from Congress broader authority to have additional regulatory flexibility to act in the future. For example, although there are proposals to require advisers of hedge funds and other private pools of capital to register with the SEC, the funds themselves would not be regulated.

In order to be prepared to deal with future developments, Congress could provide the SEC rule-making authority to regulate the funds. One way of doing this would be by conditioning the use of the exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment Company Act. With that authority, should it be necessary, the Commission could impose those requirements that it believes are necessary or appropriate to protect investors and enhance transparency. Having this authority could be useful in addressing the potential market-wide impact resulting from the collective action of numerous funds that may individually not be systemically important. Otherwise, we may find ourselves looking at two trains about to collide — yet being unable to act.

Another example of an area where a grant of broad authority could have helped the SEC protect investors is in the area of asset-backed securities, particularly as related to ongoing public disclosure. Many asset-backed securities are publicly offered, so investors and the SEC receive important disclosures about the securities at the time of the offer. But, after the public offering, these securities often do not meet the thresholds for ongoing reporting and many asset-backed issuers stop providing ongoing disclosure. This harms the ability of the SEC to obtain information about these pools of assets, individually and market-wide. Although the number of offerings of asset-backed securities has decreased significantly since the crisis, it is estimated that the aggregate amount that remains outstanding as of the third quarter of 2009 is over $2 trillion. Information about asset-backed securities can be important to monitoring systemic risk because it can help identify if capital is flowing into a particular area, such as subprime mortgage finance, and taking a broad look at information about payment on loans underlying the securitization could provide some early indication of developing risks. I note that legislation on financial stability working through the House would address the issue of ongoing asset-backed reporting, and I welcome this change.

Granting the SEC with broad authority to regulate will allow it to more quickly deal with unforeseen events. That is a wise and forward looking policy. The SEC has historically used the power to grant and condition exemptions in a responsible and pragmatic way. Take the investment management industry as an example where money market funds and exchange traded funds would not exist today if not for the SEC's use of its exemptive authority.

Reform Proposals Should be Sustainable

As the discussion of regulatory reform continues, it is crucial that the additional regulatory tasks are accompanied by appropriate resources. Reform proposals must be sustainable over the long haul — and, simply stated, unfunded regulatory mandates will not be. In fact, unfunded mandates will give a false sense of security likely to cause more harm.

Make no mistake about it, the SEC is severely under-resourced. With approximately 3,600 staff, the SEC is currently responsible for approximately 12,000 public companies; 11,300 investment advisers; 950 fund complexes with over 8,000 mutual funds; 5,500 broker-dealers (with over 173,000 branch offices); 600 transfer agents; 11 exchanges; 73 alternate trading systems (ATSs); 5 clearing agencies; 10 credit rating agencies; a number of SRO's; and, in addition, has oversight over the MSRB, the PCAOB and the nation's financial accounting standards setter, the FASB. When you compare our responsibility with other regulators you can appreciate how understaffed we are. For example, the FDIC had a staff of over 5,000 to oversee 5,100 FDIC-insured banks. This simple comparison speaks for itself.

To be an effective regulator, the SEC needs to be in the position to set multi-year budgets and respond in real time to a drastically changing market, while also maintaining appropriate staffing and being able to be in a position to upgrade the tools and expertise it needs. To do this, I have long proposed that the SEC be self-funded so it can confidently establish multi-year budgets and execute on long-term technological projects. Currently, the SEC's budget is recommended by the President and annually appropriated and apportioned. This damages the SEC's ability to perform its mission in terms of long-range planning, developing necessary technology and maintaining appropriate staffing levels.

There are a few ways in which self-funding could be implemented, but one option to consider is the SEC retaining the registration and securities transaction fees currently collected. These fees currently go directly to the Treasury and have generally exceeded the SEC's budget by a significant amount. Retaining these fees would be one possibility and one that would not cost the taxpayers.

Being self-funded will not mean that the SEC would use enforcement penalties as part of the funding or that it would have unfettered discretion, two common misconceptions of my proposal. First, I would never contemplate that penalty amounts be considered as a source of funding. Because of the inherent conflict, the penalty amounts are best served by being returned to investors or by going straight to the Treasury. Second, like other self-funded agencies, the SEC will still be subject to rigorous oversight by Congress and a number of other federal entities — such as the Government Accountability Office, our own Inspector General, the Office of Management and Budget, the Office of Personnel Management, and the General Services Administration. In addition, the SEC would still be required to publish its strategic plan and to chart its progress against specific performance measures.

The issue of funding is also particularly acute because the SEC's responsibilities must significantly grow. Currently, Congress is contemplating expanding the SEC's jurisdiction to include hedge fund advisers, and over-the-counter derivatives, among others. These are needed reforms and granting the SEC additional authority is helpful. But without coupling the authority with resources it will not result in sustainable reform.

I have been heartened by the supportive statements made by Senator Schumer and Congressman Kanjorski that the SEC should be self-funded. As Congress contemplates the Consumer Financial Protection Agency as a self-funded entity, it should apply the same principle to the SEC. Being self-funded would put the SEC on the same financial footing as the FDIC, the Federal Reserve, and other financial regulators.

Reforms are destined to fail — and in fact may cause more damage — if no provision is made to accompany the reform with the resources required to make reforms sustainable.


Regulatory reform is upon us. The hope is that we do it in a smart and effective manner. In addition we need to remember that it is not just the laws and rules on the books that matter — it is the will and ability to enforce them. Part of the analysis of what led to the crisis is that many regulators possessed authority to act — but affirmatively decided to sit on the sidelines. Smart, effective and forward looking regulations will not mean anything if they're not enforced.

I, for one, remain optimistic about the on-going discussions of regulatory reform taking place on Capitol Hill. I am hopeful that Congress will soon close many of the regulatory gaps that have been painfully highlighted and that it will provide us with the broad authority needed — and, moreover, set the SEC on a more solid footing by giving us the ability to have the resources necessary to oversee the Commission's ever expanding responsibilities.

I commend all of you for being here today. It is through dialogues such as this one that we can advance the public interest.

Thank you for the opportunity to be here today.


Modified: 11/06/2009