Speech by SEC Commissioner:
Remarks at the 14th Annual SEC Regulation Outside the United States Conference
Commissioner Elisse B. Walter
U.S. Securities and Exchange Commission
London, United Kingdom
June 10, 2010
Thank you very much, Mark, for that kind introduction. I appreciate the opportunity to be here this morning to speak in this wonderful city. From a look at the conference agenda, you and others have done an excellent job putting together a comprehensive and useful program.
Although I have been a Commissioner of the U.S. Securities and Exchange Commission for nearly two years, this is the first time I am speaking in that capacity outside the United States. So, it seems only fitting that I have been asked to focus my remarks today on issues relating to reform of the American financial regulatory system. However, as you all know, in today’s age, economies and markets of all types are increasingly linked, and regulatory reform in a single country often (perhaps more often than not) has an impact that extends beyond that nation’s borders.
As I give you my thoughts on this topic today, please keep in mind that I speak only for myself and not for my fellow Commissioners or the SEC’s staff.1
REGULATORY REFORM IN THE U.S.
Efforts to reform the U.S. financial regulatory system have ebbed and flowed over the past several years, but the legislation currently pending before our Congress has been propelled by the financial crisis that began in late 2008. After months of hearings and debate on the issues, last December our House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173). The effort then moved on to our Senate, which recently passed its own version of regulatory reform, the Restoring American Financial Stability Act of 2010 (S. 3217).
Although both chambers of our Congress have now passed a bill, the legislative process has not yet been completed. There are important differences between the House and Senate bills and, as you undoubtedly know, both chambers of our Congress must agree on a piece of legislation before it is sent to our President for signature and it becomes law. Thus, our focus and attention has now turned to a Congressional conference committee, which is tasked with finding mutually agreeable provisions for a consolidated bill. The process continues even as I speak to you this morning, with the Conference committee scheduled to begin meeting today. So, I will focus today as much as possible on the versions of the legislation already passed by the House and Senate, with the understanding that there could be significant changes made during the conference committee process.
In my remarks today, I cannot hope to cover all aspects of the bills, let alone the many initiatives outside the United States to reform the structure of financial regulation. Given my position as an SEC Commissioner, what I would like to do instead is to focus on the issues in the legislation that relate most directly to our agency’s mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
The legislation now pending will bring needed change to financial regulation. The reactions to it vary. In part that is because, as Sydney J. Harris, a journalist who was born in London and raised in Chicago, once said, “Our dilemma is that we hate change and love it at the same time; what we really want is for things to remain the same but get better.”
Regardless of how you feel about the legislation, it is clear that the changes it will bring are extensive and will require significant implementation time and effort on the part of the Commission and other U.S. regulators. It has been estimated that the legislation may require the SEC to undertake about 70 rulemakings and 20 studies.
The first area covered in the regulatory reform bills I would like to mention is systemic risk. The financial crisis has taught us that there is a constant need to watch for, warn about, and eliminate conditions that could cause a sudden shock leading to a market seizure or a cascade of failures that could put the entire financial system at risk.2 While traditional financial oversight and regulation are part of what is needed to prevent systemic risks from developing, it is clear that our current regulatory structure failed to identify and address systemic risks that developed over recent years. One of the weaknesses of our current regulatory system in the United States is its siloed structure, which fails to provide regulators with all the authority and all the real-time information they need.3
One of the central goals of the financial reform bills in the United States is to address systemic risk by identifying and regulating financial firms that are so large, interconnected, or risky that their collapse would threaten the entire financial system. The House bill would address systemic risk and the silo problem, in part, by creating a new Financial Services Oversight Council (“Council”), which includes the heads of federal financial regulatory bodies, including the SEC, and chaired by the Secretary of the Treasury. The Council would identify financial firms as so large or otherwise important that their distress could cause a threat to financial stability or the economy. Such firms would be subject to increased oversight and regulation, including stricter capital and other prudential standards. In certain circumstances, the Council could even force a systemically significant firm to discontinue or place limits on certain of its activities or force it to divest business units or other assets. Although there are certain differences from the House bill, the Senate bill would also establish a Council of Regulators authorized to identify certain systemically important firms that require additional regulatory oversight.
I am pleased that the Commission’s voice will be heard on the Council as a voting member, and that we will serve together with other agencies in this important role. And, I fully support the efforts reflected in systemic risk components of the bills to remove the silos that exist today and address systemic risk in a manner that looks across the markets.
I also strongly believe, however, that such efforts should not be allowed to override or erode the central role that the SEC plays in protecting investors or to confine the SEC's role to a retail sales perspective. More generally, it is my hope that new systemic risk rules add to, rather than undercut, needed consumer and investor protections.
Let me explain. The SEC’s investor protection mission differs from the missions of other financial regulators. Banking regulators, for example, are primarily concerned about the safety and soundness of financial institutions and the financial system. As SEC Chairman Schapiro has stated, "The vision of the Congress when it created an independent SEC was to make sure that there was one agency of government focused single-mindedly and without dilution on the well-being of America's investors." She went on to say: "Congress made [the SEC] independent precisely so we can champion those who otherwise would not have a champion, and, when necessary, take on the most powerful interests in the land. Regulatory reform must guarantee that independence in the future."4
A good example of how a concern for systemic risk could undercut the protection of investors is enforcement. Bringing an enforcement action against a financial institution for violations of the federal securities laws undoubtedly causes reputational harm, and yet vigorous enforcement is essential to protecting investors. Investors will be better able to make sound investment decisions if they understand the failings of a company that is subject to an enforcement action; yet, in some cases, publicizing that action could undercut the continuing viability of that entity or at least make it more difficult for it to conduct its business. A regulator that is focused almost exclusively on safety and soundness of the financial system and of the institutions that it regulates may well favor prudential measures over enforcement actions, and be less inclined to support making enforcement actions and their underlying facts public, even if that is in the interest of investors.
The legislation establishes a framework that could support the desirable balance between protecting against systemic risk and investor protection. In implementing the legislation, it is critical that, in our zeal to address systemic risk, we make sure that the voice of investor protection is not muted.
The next area I would like to address is the regulation of OTC derivatives. Financial derivatives played an important role in the recent market crisis. As you may know, the Commodity Futures Modernization Act of 2000 ("CFMA") explicitly prohibited the SEC and Commodity Futures Trading Commission ("CFTC") from regulating much of the OTC derivatives market, including credit default swaps. As a result, we at the SEC cannot adopt reporting and other prophylactic measures to prevent fraud, manipulation, and insider trading with respect to any security-based swap agreement. Nor can the SEC require the disclosures, such as position and trade reporting, as well as information regarding counterparties, needed to surveil the market.
Overall, in my view, the House and Senate bills represent an important step forward in bringing transparency to this largely opaque market. The bills would bring currently unregulated swaps, swap dealers, major swap participants, and swap markets under a fairly comprehensive regulatory framework. They would improve transparency and regulatory oversight. They would facilitate the standardization and centralized clearing of swaps, which would reduce counterparty risk, a significant source of instability in our financial system.
There remain, however, a few meaningful limitations in the bills, particularly as they relate to real transparency and the Commissions’ ability to regulate central counterparties who trade both swaps and security-based swaps. I also believe that the bills could be stronger in several other ways. The regulation of the securities and futures markets currently is split between the SEC and CFTC. As financial products have become increasingly indistinguishable in economic function and purpose, however, it often is quite difficult to determine their correct regulatory treatment. For example, is a new product a futures contract, subject to CFTC jurisdiction, or a security, subject to SEC jurisdiction? This ambiguity can lead to protracted interagency disputes over products that straddle regulatory boundaries. These disputes serve neither the interests of investors nor the efficiency and competitiveness of our financial markets. Instead, they just waste valuable regulatory resources. Moreover, a jurisdictional split no longer makes sense today since trading conduct and positions taken in these “split” markets are often part of the same overall strategy.
For these reasons, I—and others—have expressed the view that Congress should seek to merge the regulatory oversight responsibilities of the SEC and CFTC to provide more comprehensive oversight of the increasingly interrelated futures and securities markets.5 I formed this opinion from experience working on the staff at both agencies. But neither the House bill nor the Senate bill would merge the two bodies.
Indeed, the bills add unnecessary complications to the regulation of the swap markets by dividing jurisdictional responsibility for swaps in a way that can only be described as "jurisdictional gerrymandering." Under the House and Senate bills, a securities-related swap based on nine or fewer securities would be regulated by the SEC, while a securities-related swap based on 10 or more securities would be regulated by the CFTC. In my view, dividing jurisdictional responsibility in this manner is illogical and arbitrary and only invites abuse, regulatory arbitrage, and gaming.
Also, this jurisdictional divide would make it much more difficult for the SEC to oversee the whole securities-related marketplace. Market participants could choose whether to buy and sell cash securities or engage in synthetic transactions using securities-related swaps in order to fall within the jurisdictional authority of a particular regulator. Certainly, business choices should not be made on the basis of an evaluation of which agency is perceived to be weaker or more permissive.
Even if Congress mandated that the SEC and CFTC adopt uniform rules governing securities-related swaps that fall within their respective jurisdictions, nothing guarantees that over time one agency or the other will not become less rigorous in oversight, or less vigorous in enforcement, or that regulatory interpretations would stay in alignment.
Swaps are just economic substitutes for the asset or event underlying a contract. And, securities-related swaps have a significant impact on the debt and cash equity securities markets. Thus, the most sensible approach in an environment with bifurcated jurisdiction would be to have all securities-related swaps regulated by the SEC and all commodities-related swaps regulated by the CFTC. This simple regulatory approach—one in which the same regulator can impose similar requirements on similar products—would prevent regulatory arbitrage and gaming, as well as provide regulators with the best chance of detecting and deterring fraud, manipulation, or other abuses.
I was disappointed that the bills did not take this approach, which would simplify and rationalize, and they instead just add further complication.
Hedge Funds and Hedge Fund Advisers
Next, I’d like to speak out on the regulation of hedge fund advisers. The SEC currently lacks basic data about hedge funds and hedge fund advisers. As you may know, in 2004, the SEC sought to remedy this problem by requiring hedge fund advisers to register with us, only to have that action overturned by the courts.6 As a result, these entities remain virtually unregulated. Yet, they are important and influential participants in the financial markets. In fact, according to a recent report, the global hedge fund industry has about $1.4 trillion in assets under management.7
Although the House bill and the Senate bill have their differences, they take the same basic approach to U.S. hedge fund advisers by narrowing the exemptions from registration that are currently available. Today the only regulatory tool we have with respect to unregistered hedge fund advisers is to sue them if they commit fraud; that single, and rather blunt, instrument is insufficient. The legislation would require many larger hedge fund advisers to register with the SEC, and thus subject them to the full investment adviser regulatory regime. The bills also contain recordkeeping, reporting, and information-sharing provisions that are important to effective examination of these entities.
But, there are two ways in which I think the bills could be improved.8 First, the Senate bill would provide exemptions from registration for venture capital and private equity fund advisers, while the House bill would do the same for venture capital fund advisers. Since most rules under the Advisers Act apply only to advisers that are registered, this could open new regulatory gaps. I am not convinced that the different goals and strategies employed by venture capital and private equity fund advisers are so different from the goals and strategies of hedge fund managers to justify "partial regulation," although I recognize that there are important benefits these funds provide, notably seed capital for start-up businesses.
Second, the House bill and the Senate bill would increase markedly the assets-under-management dollar threshold for U.S. investment advisers that register with the Commission. Advisers below the threshold would be prohibited from registering with the Commission, and would instead be regulated by state authorities. Even though, as a result of other changes under the bills, new private fund advisers would have to register with us, the net effect of increasing the threshold would actually mean that more advisers would leave SEC oversight than come under it.
If the decision to raise the threshold is motivated by legitimate concerns about the SEC's limited resources, Congress should consider the fact that the states may well not have the resources to handle this substantial increase in workload. Indeed, some of our states have no inspection program for advisers. State regulation would just be moving a problem from one place to another.
Rather than changing jurisdictional lines to address a resource question, we should instead tackle funding head-on. Congress should allow the SEC to be self-funded. Unlike most other U.S. financial regulators, the SEC remains without a stable funding stream because it depends on yearly appropriations from Congress. The SEC's 3,800 employees oversee approximately 35,000 entities—a nearly 10 to 1 ratio that is only growing larger.9 Self funding would allow the SEC to better protect millions of investors by enabling us to maintain appropriate staffing. It also would have other absolutely critical advantages, including enabling the SEC to plan for and fund multi-year technology initiatives. Technology demands the ability to look several years into the future.
I believe that self funding is critical to the Commission's future effectiveness and fully support the statements made by Chairman Schapiro on its importance.10 Although there is a self funding provision in the Senate bill, no such provision exists in the House bill. I would very much like to see it be a part of what is ultimately passed by the U.S. Congress and signed into law.
In addition, I believe that Congress should have authorized a self-regulatory organization, or SRO, for investment advisers. The presence of an additional national regulator or regulators, particularly one not dependent on funding by taxpayers, would enhance investment adviser oversight. That suggestion is quite unpopular in some circles, but it would be a step forward in my view.
Harmonization of the Standards for Investment Advisers and Broker-Dealers
Another important area touching on the investment management industry relates to the regulatory inconsistency with which U.S. law governs financial professionals providing virtually identical services to retail investors. When your elderly Aunt Millie walks into the local financial professional to ask for advice, she has no idea—nor should she—which set of laws governs the conduct of the person on the other side of the table. For this reason, I believe that every financial intermediary that offers a comparable product or service should be regulated in a substantially similar way. The House bill would make important progress in this direction by requiring the SEC to adopt rules requiring that the standard of conduct for a financial professional giving personalized investment advice about securities to retail customers would be to act in the best interests of the customer without regard to the interests of the professional. It would prescribe that the standard shall be no less stringent than the fiduciary standard applicable to investment advisers under the antifraud provisions of the Advisers Act. Personally, I strongly support a fiduciary duty for all financial professionals offering personalized investment advice.
The Senate bill, in contrast, would only call for the SEC to conduct a study regarding the effectiveness of existing legal and regulatory standards of care for brokers, dealers, and investment advisers. I believe that just mandating the SEC to conduct a study would be a mistake. For one thing, a study has already been conducted. In 2008, the SEC hired the RAND Corporation to do this, and RAND found that trends in the financial services market since the early 1990s had blurred the boundaries between investment advisers and broker-dealers, and that firms were constantly evolving and bundling diverse products and services in response to market demands and the regulatory environment.11 The RAND Report also found that retail investors were confused about the differences between investment advisers and broker-dealers.
We do not need another study to tell us again that investors are confused. Instead, it is time to move forward with substance. As I have said many times, what I would prefer to see is a legislative approach that goes further than simply imposing a fiduciary duty. In my view, we should harmonize the regimes governing investment advisers and broker-dealers comprehensively, taking into account the strengths and weaknesses of both regimes. Unfortunately, both bills fall short of proposing this comprehensive solution. But it is my hope that at least the House approach makes it into the bill that becomes law.
Credit Rating Agencies
Next, I’d like to turn to credit rating agencies. They played a key role in the recent financial crisis, and it is clear that their importance to the markets far outstripped the amount of oversight they received. And, too often even highly-sophisticated investors failed to use their own judgment and simply relied on the credit rating agencies.
Before considering the current legislation, let me briefly explain the action that the Commission has already taken, using its current authority. After obtaining authority in September 2006, the Commission moved quickly to establish a registration and oversight program for credit rating agencies that want to be treated as nationally recognized statistical rating organizations (or “NRSROs”) for purposes of U.S. laws that use that term. Moreover, during the last two years, the Commission has taken steps to address conflicts of interest and improve ratings quality. The SEC has adopted rules requiring NRSROs to make additional public disclosures about their methodologies for determining structured finance ratings, to disclose publicly the histories of their ratings, and to make additional internal records available to the SEC. The amendments also prohibit NRSROs and their analysts from engaging in certain activities that could impair their objectivity, such as recommending how to obtain a desired rating and then rating the resulting security. Furthermore, we created a mechanism for NRSROs not hired to rate structured finance products to nonetheless determine and monitor credit ratings for these instruments in order to provide investors with a greater diversity of ratings and help foster new entrants into the ratings business. And, we have proposed further rules to enhance conflicts of interest disclosure, highlight ratings shopping, and provide the SEC with reports of compliance reviews. Finally, we issued a concept release soliciting comment on whether the Commission should subject credit rating agencies to "expert" liability in connection with a public offering.
In the legislative arena, both the House bill and Senate bill would provide greater accountability for credit rating agencies and improve the SEC's regulatory oversight of credit rating agencies. Both bills would make it easier for investors to sue credit rating agencies, require rating agencies to have an independent board of directors, and establish a new Office of Credit Rating Agencies at the SEC to strengthen regulation (with the House bill also calling for the establishment of an outside Advisory Board to the Commission). Both bills also would mandate improvement in internal controls, require greater transparency of rating procedures and methodologies and management of conflicts of interest, reduce reliance on credit ratings, and enhance the SEC’s enforcement tools (although to differing extents).
For example, both bills would clarify that the limitation prohibiting the Commission from regulating the substance of credit ratings or the procedures and methodologies used to determine credit ratings is not a defense in a Commission proceeding to enforce the antifraud provisions. Only the House bill, however, would enhance the Commission’s enforcement authority by enabling it to sanction persons associated with NRSROs, and make changes preventing an NRSRO from arguing that it could not be sanctioned for making material misstatements in its application or other required reports because they were not “filed” with the Commission.
Another important area that will be affected by regulatory reform is the $2.8 trillion market for U.S. sub-national debt—which we call “municipal securities.” I think we need to do more in this arena than either bill would require, however. With the focus in regulatory reform on the gaps and weaknesses in our existing regulatory framework, I've frankly had a hard time understanding the relative lack of attention paid to this area. The U.S. market for municipal securities is enormous and operates with a high-level of participation by retail investors. Also, as former Chairman Arthur Levitt put it last year, "[t]he opacity of this market is unrivaled and thus presents a significant threat to our economy."
I spoke in depth on this topic last year,12 but I want to reiterate my strongly-held view that this is an area where we need to act. Despite its obvious size and importance, the municipal securities market lacks many of the protections customary in many other sectors of the U.S. capital markets. Investors in municipal securities are, in certain respects, afforded only "second-class treatment" under current law, and that needs to change.
Our principal goal should be to improve the quality and timeliness of information available to those who buy the municipal securities that are critical to state and local funding initiatives. Among other things, while our options seem to be limited absent legislation, we should further leverage our current antifraud authority to improve the quality and timeliness of disclosures. The Commission staff is actively at work on that. I would also like to see us continue our close work with the Municipal Securities Rulemaking Board (“MSRB”) to enhance the usefulness of its EMMA system with respect to electronic collection and availability of information in the secondary market. Regulators and the industry also need to work together to provide critically needed pre-trade transparency in this market.
As important as these steps might be, to reform regulation of the municipal securities market fully, I would have wanted to see Congressional action in a number of areas. First, let’s take a look and see what Congress is contemplating.
Both the House and Senate bills address municipal securities. The House bill provides a regulatory framework for the regulation of municipal advisers to issuers of municipal securities under the SEC, and mandates that the advisers have a fiduciary duty to the issuers for which they act. Another important provision of the House bill provides that the MSRB Board must have a majority of independent members.
For its part, the Senate bill contains provisions imposing fiduciary duties on swap dealers and major swap participants who provide swaps to municipal entities. It also provides for a regulatory framework for municipal advisers, but vests authority primarily with the MSRB and would not impose an express fiduciary duty on advisers. The Senate bill also reconstitutes the MSRB’s board, but does not require that Board members be independent—only that they not be directly affiliated with broker-dealers, municipal dealers, and municipal advisers. It also provides that the MSRB may collect fees relating to its EMMA system in certain circumstances, and formalizes within the SEC an Office of Municipal Securities whose head reports directly to the Chairman. The Senate bill requires the U.S. Government Accountability Office (“GAO”) to study the municipal markets generally, the value of enhanced municipal disclosure, and the possible repeal of the Tower Amendment legislative restrictions on the MSRB and SEC with respect to issuer disclosure.
I am pleased to see some of these provisions address concerns that I have raised about municipal securities regulation in the past.13 I generally prefer the House bill because it vests authority over municipal financial advisers primarily with the Commission. I would have preferred, however, to have joint SEC–MSRB authority over municipal financial advisers.
I am also pleased to see that both bills would reconstitute the MSRB board, but believe that the House language is preferable, as it requires that a majority of the members of the board to be independent of those it regulates and makes the board truly independent. I have also been concerned about the separation of the enforcement and regulatory functions between the MSRB and the Financial Industry Regulatory Authority (“FINRA”), and I would like to have seen changed this inefficient allocation of duties.
There are other aspects of regulatory reform in this area that I would have liked to see in the bills. In the U.S., a private entity engaging in certain activities may benefit from a tax-exemption for interest on its bonds—resulting in dramatically lower interest costs to the private entity—if it borrows with the assistance of a state or local government acting as a conduit to the municipal market. I would have liked to see the legislation include authority for the Commission to apply the registration and disclosure standards to non-governmental conduit borrowers that would apply if they issued their securities directly without using municipal issuers as conduits to reach the public markets.
Even with these legislative efforts in regulatory reform, there is more to be done. Chairman Schapiro recently asked me to lead an effort through which we will hold field hearings across the country. Through these hearings we will elicit the analyses and opinions of a broad array of municipal market participants. At the conclusion, a report will be provided to the Commission that will recommend specific changes—to statutes, rules, and private sector best practices—to better protect municipal securities investors. I look forward to these hearings and the discussions on this very important topic.
I would now like to focus briefly on the Commission’s enforcement powers. As we continue to learn more about the causes of the financial crisis, one clear lesson is the vital importance that enforcement of existing laws and regulations plays in the fair and proper functioning of financial markets. Through vigorous and even-handed enforcement, we can hold accountable those whose violations of the law caused severe loss and hardship, recoup investor losses, and deter others from engaging in wrongdoing.
Time does not permit me to address enforcement in any real depth. However, I would like to mention that I am pleased to see the legislation includes several measures advocated by the SEC to improve its ability to protect investors and deter wrongdoing. For example, new whistleblower legislation would provide authority for substantial rewards for tips from persons with unique, high-quality information about securities law violations. This legislation, particularly the stronger House version, combined with our own cooperation initiatives, would increase incentives for persons to share information quickly while expanding protections against retaliatory behavior. We expect this program to generate significant information that we would not otherwise receive.
Both bills authorize the SEC to impose so-called “collateral bars,” permitting us, where appropriate, to bar a regulated person who violates the securities laws in one part of the industry (e.g., a broker-dealer who misappropriates customer funds) from serving as a regulated person in another part of the industry (e.g., as an investment adviser). Both bills also would permit the SEC to use penalties obtained from a defendant for the benefit of victims even if we do not also obtain disgorgement.
Other critical provisions are found only in the House bill. These include clarifying the application of Section 106 of Sarbanes-Oxley regarding document production and service of process with respect to foreign auditors, authorizing nationwide service of subpoenas in civil actions, penalties for aiding and abetting Advisers Act violations, aiding and abetting in the Securities and Investment Company Acts, and clarifying that SEC authority to pursue aiders and abettors extends to reckless conduct. These changes and others are important to our enforcement program, and it is my hope that all of these provisions are included in the legislation that eventually becomes law.
There is one critical topic outside of regulatory reform that I want to mention before I conclude my remarks today. That topic, of course, is IFRS. There always seems to be some kind of rumor going around that the SEC is not committed to a single set of global standards.14 That rumor is false; this is absolutely a priority for us. We continue to drive towards that goal. The announcement last week by the Financial Accounting Standards Board and International Accounting Standards Board that they will modify their timetable for and prioritization of standards being developed under those boards’ joint agenda should not affect our staff’s analysis under the Work Plan. Indeed, the Boards’ adjustment is intended to enhance the quality of the accounting standards. Thus, I echo Chairman Schapiro’s recent statement regarding the announcement and her confidence that we continue on schedule for a 2011 determination about whether to incorporate IFRS into the financial reporting system for U.S. issuers. 15
I appreciate the opportunity to be with you this morning and share my thoughts on regulatory reform and IFRS. These are critical topics, both for us in the United States, and for the global economy.
Please know that you should feel free to call me or send an e-mail if you have any thoughts on these or other topics. My door is open to you, and I am always interested in your perspectives, thoughts, and ideas. Thank you again for asking me to be with you this morning.