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Speech by SEC Commissioner:
Sustainable Reform Prioritizing Long-Term Investors Requires the Right Orientation

by

Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

SEC Speaks
Washington, D.C.
February 5, 2010

Good afternoon everyone. Thank you for the warm reception. It is astonishing that it has only been a year since the last SEC Speaks. Between the effects and consequences of the economic crisis, the White House and Congressional focus on financial reform, the active Commission agenda, and the press and pundit scrutiny . . . it feels like five years have passed by. Yet, despite the intense focus on financial reform over the last year, very little has changed. Last year, I stood here and spoke about the need for sustainable regulatory reform oriented towards investors. It is clear that the need is even greater today.

John Wooden, the legendary UCLA basketball coach, used to say: "Never mistake activity for accomplishment." This adage perfectly sums up the last year. While there was much activity this past year, very little has actually been accomplished. There have been many speeches given and many preliminary steps taken toward regulatory reform, but for all the activity, reform itself has yet to be achieved. For example, despite the clearly demonstrated need, OTC derivatives, hedge funds, and municipal securities markets still lack appropriate regulation, and our inspection and enforcement efforts in these areas continue to be severely undermined. Moreover, there are those who are using the process of reform as an opportunity to weaken strong investor-focused laws arising from lessons learned in prior crises. In my remarks today, I will highlight the progress we have made and the distance we have to go.

First, I will discuss the continuing need for structural reform;
Second, I will discuss certain of the SEC's reforms to date, with an emphasis on the direction the SEC should take; and
Third, I will discuss the elements needed to make reforms truly sustainable.

Before I continue, and as is customary, let me say that the views I will share today are my own, and do not necessarily reflect the views of the Commission, my fellow Commissioners, or the Commission staff.

Need for Structural Reform

In his quarterly report to Congress, the Inspector General of the TARP program, Neil Barofsky, succinctly stated the need for robust reform when he wrote, "Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car."¹

I worry that, as time passes and the momentum for change is stymied by politics and lobbyists, the passage of comprehensive reform legislation is more in doubt. In this last year, I have seen the memories dim as we hear the arguments for "business as usual." Let's face it, there will always be institutional and political pressure fighting the enactment of robust regulation, particularly if times are good. Thus, it is imperative that financial reform be enacted now, rather than being subjected to more delay.

And I agree with Paul Volcker when he said that "We need to face up to needed structural changes, and place them into law. To do less will simply mean ultimate failure — failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future."²

While steps were made this year toward enacting legislation, concerns remain about how robust the legislation will be. As a first step, last December, the House of Representatives did approve the Wall Street Reform and Consumer Protection Act of 2009. This substantial package contains, among other things, provisions to rein in predatory mortgage lending, enhance enforcement powers at the SEC, and strengthen federal oversight of derivative markets, private fund advisers, and credit ratings agencies.

However, this legislation also contains some loopholes. Many of you know that, at the end of last year, I voiced my concern that the draft legislation would weaken protections developed from the lessons learned about corporate governance after Enron and Worldcom.³ One loophole in the bill that exemplifies this is the provision that would exempt 50% of all US public companies from having an outside audit of their internal controls.

Meanwhile on the Senate side, Chairman Dodd and Ranking Member Shelby issued a joint statement highlighting progress being made and indicated that they hoped to resolve remaining issues early this year.⁴ However, Chairman Dodd made a statement just this morning indicating that bi-partisan talks have reached an impasse and that the Democratic Party will proceed to introduce a bill. As you can see, it is hard to predict if there will be actual legislation.

In short, though there has been activity, we do not — yet — have accomplishment. In fact, trying to read the tea leaves on whether we will have financial reform legislation and, even more importantly, what it will contain, is next to impossible. What is not in doubt is the clear need for smart and effective legislation.

The recent crisis made clear that the financial sector was, and remains, dangerously exposed to firms that are too large and too interconnected to fail without crippling effects throughout the financial system and the real economy. As I have said,⁵ this must be changed.

Casino Capitalism Has Devastating Effects on the Real Economy

There is also a possibly deeper and more troubling observation to be made about our economy and financial markets. As Benjamin Friedman, the noted Professor of Political Economy at Harvard put it, "By now there are few people who do not acknowledge that the major American financial institutions and the markets they dominate turn out to have served the country badly in recent years."⁶

As those in this room know, the essential role of the financial services sector is to facilitate the allocation of capital to economically productive uses.⁷ There has been a clear failure in this regard, with widespread mispricing of assets, trillions in losses, and, perhaps most disheartening, painful levels of unemployment and underemployment — together with an unprecedented concentration of wealth at the top.⁸ In addition, as Professor Friedman stated, "the cost [of the financial crisis] was not just financial losses, but wasted real resources."⁹

Ironically, over the years during which the allocation of capital by the financial sector has been poor, the financial services sector expanded significantly, and the salary and bonuses of people working in financial services grew and continues to grow, outpacing the real economy.¹⁰ It could be said that our society's capital was allocated by financial services, to financial services.¹¹ There was, and continues to be, a disconnect between the lavish bonuses, salaries, and other rewards on the one hand — and the poor job the industry did for our economy on the other. This decoupling of the real economy from Wall Street is also apparent in the growth of equity stock prices compared to GDP.¹²

This contrast between Wall Street and Main Street¹³ — between the financial sector and the real economy — should remind us of John Maynard Keynes's warning that: "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."¹⁴ As many have observed, deregulation in the financial sector ushered in casino capitalism, resulting in a form of capitalism that, in the words of Martin Wolf, the chief economics commentator for the Financial Times, "represents the triumph of the trader in assets over the long-term producer."¹⁵

Today, we live in a world where a significant amount of the profits, and financial market activity, arises from leverage-financed bets on stock prices and credit derivatives, with not enough concern for the fundamentals of the underlying companies. It is clear that the direction of Main Street and Wall Street should be brought back into alignment. Regulatory reform that curtails inappropriate risk taking, such as excessive leverage, could help curb the trend toward casino capitalism.¹⁶ In this way, our financial system will not only be safer, but will better serve its role in the economy.

I support President Obama's recent statement renewing his commitment to robust and effective reforms. In his State of the Union address, President Obama made it clear that he was committed to "a strong, healthy financial market that makes it possible for businesses to access credit and create new jobs."¹⁷ He also emphasized that "if the bill that ends up on [his] desk does not meet the test of real reform, [he] will send it back until we get it right."¹⁸

As Congress returns its attention to financial reform, I urge it to do so with investors and the American public foremost in mind. 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, particularly retail investors, and to our long-term economic growth. Political leaders, market participants, regulators, and other interested parties have to remember that financial services exist to serve investors — and in turn, our economy. To that end, it's important that the focus on "too big to fail" doesn't ignore retail investors by thinking of them as "too small to matter."

SEC Status Update

SEC as The Investor's Advocate

Whether reform legislation comes soon or not, the SEC must continue its own revitalization.

Last year at this time, it would not have been an exaggeration to say that the SEC's very existence was in question. Viable rumors had the SEC being split up, with various parts going to the Federal Reserve Board, the proposed Consumer Financial Protection Agency, and FINRA. As recently as late last year, there was language in the House bill that would have had the SEC outsource its supervisory authority over large investment advisers to FINRA. Thankfully, this idea has been set aside.

Very nearly lost in all of this discussion about restructuring and reshuffling was an appreciation for the vital role that is unique to the SEC. Only the SEC acts as the investor's advocate. And only the SEC is charged with a comprehensive mission tied to the whole of the securities markets: to protect investors, maintain fair and orderly markets, and facilitate capital formation. How would parsing those responsibilities out to competing agencies be beneficial for investors, or facilitate the reduction of systemic risk? If we've learned anything over the past few years, it is that regulating parts of the whole in isolation is fraught with peril.

Fortunately, cooler heads prevailed and recognized that, as I said last year, if you didn't have the SEC, you would need to invent it. The increasingly integrated nature of capital markets and the needs of investors require a regulator with a holistic understanding of the overall system and the inter-connected chain of market participants.

There is no question that the SEC had to start its own transformation in order to restore its reputation as the investor's advocate — a process that continues in earnest. I stood before you last year and said that in the short-term the Commission needed to empower its enforcement and inspection staff and that it also needed to take steps to increase retail investor participation within its processes.

I am particularly pleased to report that two initiatives I advocated last year at SEC Speaks have been launched, and we can already see the positive benefits.

Investor Advisory Committee

First is the Investor Advisory Committee. I am proud to be associated with the formation of this Committee. As the sponsor of the Committee, I can affirm that this Committee has a broad mandate to represent the viewpoints of investors and to make recommendations to the Commission on their behalf. The Committee has reached a stage where the initial logistics are behind it, and its members are hard at work. I can also relay how enthusiastic people are about this Committee, inside and outside of DC. As I travel around the country, I meet people who are energized by its formation and are trying to figure out how best to be involved. As the Committee continues its work, I look forward to the recommendations ahead.

Streamlining The Formal Order Process

The second initiative is that the Commission has streamlined its formal order process by delegating to senior staff the power to issue a subpoena. Under the prior system, it would often take staff many months to pass through all the bureaucratic hoops required to obtain the Commission's approval for a routine subpoena. Because we have streamlined the process, we have seen a huge improvement in the speed and efficiency by which our enforcement staff can conduct an investigation. Last October, staff in San Francisco discovered a fraud and managed to investigate and file the case within a three-week timeframe. This would have been virtually impossible under our prior system.

I have also been greatly heartened by the boost in morale I have seen. By streamlining this process, the Commission has effectively dismantled a regime that micro-managed a routine process and, in turn, has established a process that utilizes Commission resources much more efficiently. The Commission is also sending the message that we support our staff. Consequently, in situations where the staff find themselves being deliberately stonewalled in an inquiry, they can now move quickly and effectively to obtain the necessary information.

I know my forceful advocacy for our Enforcement program has surprised some people, given my life-long career as a corporate and '40 Act lawyer. The stark truth is that when I took office it was obvious that our Enforcement and Inspection programs were in need of serious revitalization and empowerment. I took a keen interest in our Enforcement program and have been very vocal about how to improve its policies and processes. When I was referred to as the "Enforcement Commissioner" in Compliance Week, it was a title that I never expected, but it's one I don't run away from. The continued reinvigoration of Enforcement is essential.

Penalty Guidelines

I also want to flag two issues that would go a long way to truly empowering our staff and removing barriers from their path. We continue to have in place the Commission's Penalty Statement of 2006, a misguided approach to how to weigh factors one considers when deciding whether to seek a corporate penalty.

The 2006 statement was the Commission's first attempt to formally identify penalty factors. Like many first attempts, it can be significantly improved. It certainly does not reflect my views. For example, the 2006 statement prioritizes two factors:

The presence or absence of a direct benefit to the corporation as a result of the violation; and
The degree to which the penalty will recompense or further harm the injured shareholders.

Under this framework, the conduct itself becomes of secondary importance, and the Commission fails to appropriately focus on deterrence. Clearly, this is a serious flaw. The purpose of penalties is to deter and punish misconduct. By penalizing, or not penalizing, corporations based primarily on things other than their misconduct — such as whether the company happened to benefit from a fraud by issuing shares at an inflated price — the 2006 factors misdirect where the focus should be and fail to serve investors. Others, such as the GAO, have also expressed concerns about the Commission's penalty guidelines.

I believe the Commission should promptly revisit the 2006 penalty guidelines because every day these guidelines are in place they adversely impact the cases we are working on.

Uniform Audit Trail

Another initiative that would empower our enforcement and inspection staff is the establishment of a uniform audit trail for securities trading. To effectively monitor and enforce compliance with the securities laws, the staff must have swift access to information regarding trades. As many of you know, the staff currently relies on information obtained from the Electronic Blue Sheet (EBS) system and on information from the self-regulatory organizations (SROs), together commonly referred to as the audit trail. The existing system has resulted from the Commission tacking on new record-keeping and reporting obligations to the many already in place — clearly an outdated, patchwork approach. Accordingly, I believe that a fundamental reworking of the way the staff obtains and analyzes trading information is necessary to improve the staff's ability to detect and investigate complex market-wide transactions, as well as to investigate trade activity in multiple securities during heavy trading periods.

I hope that this year the Commission considers a new approach — replacing the current system with a searchable repository of trading data that would provide the staff with a near real-time view of market activity. The proposed system should be scalable to allow for the inclusion of new products and practices in securities markets, and ideally the derivatives markets. The proposed audit trail system would serve two important purposes: (1) it would provide relevant and timely information to SROs and the Commission staff; and (2) it would reduce the cost and complexity of current record keeping and reporting obligations of market participants.

The establishment of the uniform audit trail system would go a long way toward providing our staff with the basic tools they need to surveil the markets.

E-Proxy

Last year, I also was critical about the effect of e-Proxy, the Commission's rule that allows companies to send shareholders a notice that proxy materials are available online, but not the materials themselves. Under the implementation of e-Proxy so far, the number of shareholders who vote online has been unacceptably low. Informed participation by retail investors, in particular, has plummeted.¹⁹ For many investors, access clearly did not equal delivery. As a result, I called for us to either "fix it or scrap it." So I am happy to report that soon the Commission will take action designed to improve e-Proxy, by establishing educational efforts to help investors understand e-Proxy and their rights, as well as amending our rules so that the process is less confusing to investors. But nevertheless I remain concerned, and I will be watching to see if the amendments result in real improvement.

Elements of Sustainable Reform

Stepping back from specific initiatives and looking at the bigger picture, the Commission's agenda is bursting at the seams. This is a direct response to the turmoil and issues that currently confront investors and our capital markets. However, as we move forward it is important that the Commission engage in sustainable reform, both for itself and those it regulates.

Self-Funding

As I have consistently advocated, the single most transformational act that Congress could do is to allow the SEC to be self-funded. Unlike almost every other financial regulator, the SEC remains without a stable funding stream. Self-funding would enable the SEC to set multi-year budgets and respond promptly to drastically changing markets, while also maintaining appropriate staffing.

No matter what additional authority the SEC may receive, without appropriate long-term self-funding, the SEC will risk being just a "paper tiger."

Regulatory Oversight is More than Approving New Rules

Beyond the viability of the agency, the other required piece of sustainable reform is to recognize that regulation is more than the laws on the books. A regulatory structure should be dynamic, and it must be robust from every angle. Although the Commission is in an active rulemaking period, that does not by itself equal strong regulation. Regulatory oversight is robust only if the rules are implemented fully and enforced. For example, the Commission recently adopted proxy enhancement rules that, among other items, require greater disclosures to investors about board member qualifications. The usefulness of this disclosure to investors will depend on how well these rule requirements are implemented. To that end, I commend those who will work to meet not only the letter of the law, but the spirit as well.

SEC and Casino Capitalism

To ensure that our reforms are sustainable, it is important that the SEC move in the right direction. As I said earlier, many have noted that there has been a shift in the nature of financial services toward casino capitalism — or, toward profiting on bets about price movements, rather than a company's ability to make money by producing goods and services. This has led many, including Senator Maria Cantwell, to call for policy makers to "embrace productive capitalism, not casino capitalism."²⁰ These concerns may affect not just regulatory reform, but also SEC regulatory action more generally, in at least two ways. First, as Lord Turner, chairman of the Financial Services Authority in the United Kingdom has observed:

"In the aftermath of the crisis, we must therefore be willing to challenge two assumptions:

that all markets are by definition self-correcting and in some sense rational; and
that financial innovation resulting from market competition is by definition useful."²¹

In addition, the SEC may need to consider whether existing and upcoming regulatory action encourages or discourages productive investment. For example, the Commission's concept release on market structure stated, "it is important to assess more broadly the performance of the market structure, particularly for long-term investors and for businesses seeking to raise capital."²² Sustainable reforms are reforms that prioritize long-term investors.

Conclusion

I firmly believe that the SEC, as the country's capital markets regulator, must be on the front lines of responding to the economic crisis, its causes, and its consequences. Our expertise and dedication to serve as the investor's advocate is vital to our economy's success. I am committed to a broad inquiry into how the capital markets and financial services can be made to — once again — work for the real economy and for shared prosperity.²³

I also want to commend my colleagues at the SEC. I believe deeply that the SEC has been an important factor in the development of our capital markets and the confidence of investors. The several thousand men and women who devote themselves to the protection of investors, markets, and capital formation are among this nation's finest public servants. I am proud to work at their side, and, as they work tirelessly in the best tradition of public service, I too will work tirelessly to make sure they have the tools to do their job.

Thank you.

Endnotes

⁶ Benjamin M. Friedman, William Joseph Maier Professor of Political Economy, Harvard University, The Failure of the Economy & the Economists, New York Review of Books (May 28, 2009) (observing that, "By now there are few people who do not acknowledge that the major American financial institutions and the markets they dominate turn out to have served the country badly in recent years. The surface evidence of this failure is the enormous losses—more than $4 trillion on the latest estimate from the International Monetary Fund—that banks and other lenders have suffered on their mortgage-related investments, together with the consequent need for the taxpayers to put up still larger sums in direct subsidies and guarantees to keep these firms from failing. With nearly 9 percent of the labor force now unemployed and still more joining their ranks, industrial production off by 13 percent compared to a year ago, and most companies' profits either falling rapidly or morphing into losses, it is also evident that the financial failure has imposed huge economic costs.") http://www.nybooks.com/articles/22702

⁸ See, e.g., Robert Reich, Professor of Public Policy, University of California, Berkeley, former Secretary of Labor, Wall Street bailout — the great sideshow of 2009, L.A. Times, December 27, 2009 (stating, "The real problem was on Main Street, in the real economy. Before the crash, much of America had fallen deeply into unsustainable debt because it had no other way to maintain its standard of living. That's because for so many years almost all the gains of economic growth had been going to a relatively small number of people at the top. � In truth, most Americans did not spend too much in recent years, relative to the increasing size of the overall American economy. They spent too much only in relation to their declining portion of its gains. Had their portion kept up — had the people at the top of corporate America, Wall Street banks and hedge funds not taken a disproportionate share — most Americans would not have felt the necessity to borrow so much.")

⁹ Friedman, supra note 6 (stating that "As in past financial declines, what is sorely missing in this discussion is attention to what function the financial system is supposed to perform in the economy and how well it has been doing it. Today attention is mostly focused on banks' and other investors' losses from buying mortgage-backed securities at inflated prices. What is neglected is the consequence: if the prices of the securities were too high, this meant that the underlying mortgage rates were too low, and so too many houses were built, and too many Americans bought them. In just the same way, when the 1990s stock market boom crashed, everyone talked about investors' losses on their telecom stocks, not the fact that if the stocks' prices were too high, the cost of capital to the firms that issued the stocks was too low, and so communications companies laid millions of miles of fiber-optic cable that nobody ended up using. In both instances, the cost was not just financial losses but wasted real resources.")

¹⁰ See, e.g., Simon Johnson, Professor of Global Economics and Management, Sloan School of Management, MIT, former Chief Economist, International Monetary Fund, The Quiet Coup, The Atlantic, May 2009 (noting that "From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.") http://www.theatlantic.com/doc/200905/imf-advice

¹¹ See, e.g., Louise Story, On Wall Street, Bonuses, Not Profits, Were Real, N.Y. Times, December 17, 2008, ("Pay was tied to profit, and profit to the easy, borrowed money that could be invested in markets like mortgage securities. As the financial industry's role in the economy grew, workers' pay ballooned, leaping sixfold since 1975, nearly twice as much as the increase in pay for the average American worker. 'The financial services industry was in a bubble,' said Mark Zandi, chief economist at Moody's Economy.com. 'The industry got a bigger share of the economic pie.'") http://www.nytimes.com/2008/12/18/business/18pay.html

¹² J. Stephen Landefeld, Director, and Shaunda M. Villones, Economist, Bureau of Economic Analysis, Dept. of Commerce, GDP and Beyond: Measuring Economic Progress and Sustainability (noting that "For most of the post-WWII era, the S&P stock price index rose at roughly the same rate as GDP and corporate profits. This makes sense because over time growth in stock prices must come from growth in the economy or a higher rate of return to capital investments. However, after the mid-1990s, U.S. stock prices—even after accounting for the cyclical drop in profits in 2000—soared relative to GDP and corporate profits. Part of the rise was based on the perception that the United States had entered a period of higher economic growth driven by technology. And � while there was a bump-up in economic growth above the slower growth experienced since the early 1970s, it was not sufficient to explain "irrational exuberance" seen in financial market expectations, nor was it particularly high in the context of long-term growth.") http://www.bea.gov/papers/pdf/RevisedBeyondGDP.pdf

¹³ Cf., Barack Obama, President, United States of America, Remarks by the President on Financial Reform (January 21, 2010) ("When I see soaring profits and obscene bonuses at some of the very firms claiming that they can't lend more to small business, they can't keep credit card rates low, they can't pay a fee to refund taxpayers for the bailout without passing on the cost to shareholders or customers — that's the claims they're making. It's exactly this kind of irresponsibility that makes clear reform is necessary.") http://www.whitehouse.gov/the-press-office/remarks-president-financial-reform

¹⁵ Martin Wolf, chief economics commentator at the Fin. Times, Unfettered finance is fast reshaping the global economy, Fin. Times, June 18, 2007 (observing that "Much of the institutional scenery of two decades ago — distinct national business elites, stable managerial control over companies and long-term relationships with financial institutions — is disappearing into economic history. We have, instead the triumph of the global over the local, of the speculator over the manager and of the financier over the producer. We are witnessing the transformation of mid-20th century managerial capitalism into global financial capitalism. � The new financial capitalism represents the triumph of the trader in assets over the long-term producer. Hedge funds are perfect examples of the speculative trader and arbitrageur.") http://www.ft.com/cms/s/2/518482b4-1dc5-11dc-89f7-000b5df10621.html

¹⁶ However, imposing leverage limitations on traditional banking entities alone may not fully address the problem. As noted in 2007 by Timothy Geithner, "U.S. financial institutions now hold only around 15 percent of total credit outstanding by the nonfarm nonfinancial sector: that is less than half the level of two decades ago. For the largest U.S. banks, credit exposures in over-the-counter derivatives is approaching the level of more traditional forms of credit exposure. Hedge funds, according to one recent survey, account for 58 percent of the volume in credit derivatives in the year to the first quarter of 2006." Timothy Geithner, Secretary of the Treasury, former President and Chief Executive Officer of the Federal Reserve Bank of New York, Credit Markets Innovations and Their Implications, Remarks before the Credit Markets Symposium hosted by the Federal Reserve Bank of Richmond, (March 23, 2007). http://www.newyorkfed.org/newsevents/speeches/2007/gei070323.html

¹⁹ See Dominic Jones, Investorrelationships.com, ("Statistics collected by Broadridge during the first year of notice-and-access meetings also present a dismal picture. First, only 1.1% of notice recipients bothered to ask companies to mail them paper documents. Meanwhile, just 0.5% of all recipients viewed the materials when they visited the URL provided in the notices. According to Broadridge, notice-and-access has resulted in a 96% reduction in information access by investors, which arguably has led to greater levels of voting without viewing proxy information.")

http://www.sec.gov/news/speech/2010/spch020510laa.htm

Speech by SEC Commissioner: Sustainable Reform Prioritizing Long-Term Investors Requires the Right Orientation

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