Dissenting Statement Regarding Adoption of Regulation SDR and Regulation SBSR
Commissioner Daniel M. Gallagher
Jan. 14, 2015
Thank you, Chair White. At the outset, I would like to thank the staff in the Division of Trading and Markets for all of the hard work that went into today’s adopting releases. In particular, on Reg SDR, I’d like to recognize the efforts of Jo Anne Swindler, Richard Vorosmarti, Angie Le, and Kevin Schopp who stepped in to take on this rulemaking at a time when the Commission was just starting to digest the behemoth that is Dodd-Frank. I commend you for seeing this through and immersing yourself in the issues all while continuing the outstanding work you do in your “day jobs.”
And on Reg SBSR, I’d like to thank Michael Gaw, Natasha Cowen, Yvonne Fraticelli, George Gilbert, David Michehl, Geoffrey Pemble, and Mia Zur. I’d also like to thank DERA and the Office of the General Counsel for all of their work on these rulemakings.
Reg SDR is just one rule from one title of Dodd-Frank, but it is unfortunately emblematic of many Dodd-Frank rules. The rules take what are already overly prescriptive statutory mandates and add on a number of intrusive and counter-productive requirements. And to make matters worse, the Commission today is doing so through ill-defined additional requirements that it did not propose and that will chill communications among SDR employees and the Chief Compliance Officer. As a result, I do not support their adoption.
We have seen a steady trend towards the increased federalization of corporate governance over the last couple of decades. As with many things, corporate governance is something traditionally and better overseen by the states. The camel’s nose is already under the tent in this area. But, that does not mean the Commission should continue push further — or, even worse — open the door and invite the beast in. Rather, we should be pushing it back and leaving corporate governance to the states.
In Reg SDR, the Commission is subjecting SDR Boards and their Directors to second-guessing against the standard of whether their judgment is “sound.” And unfortunately, the rules do not provide SDRs with any semblance of predictability and certainty regarding how the Commission will interpret this provision. Throwing out vague requirements that can be used in an after-the-fact “you should have done ‘x’ instead of ‘y’ scenario,” which I believe these types of provisions are ripe for, is bad government, bad process, and ultimately bad for investors and our markets.
In explaining what SDRs should consider in effectuating the “sound judgment” requirement, the Commission has unfortunately re-entered the realm of regulating thoughts. For SDR policies and procedures to address sound judgment, the rule suggests requiring that individuals “consider fairly all relevant information and views without undue influence from others.” Again, the Commission is aiming at what management and directors think without regard to whether any action has been taken.
And to further prescribe SDR internal operations, today the Commission will be requiring SDRs to provide market participants, including end-users, the right to petition for alternate candidates on its Board of Directors. Fair representation and the opportunity to participate in the nominating process may be one thing, but the right to petition for alternative candidates goes too far.
SDR also includes prescriptive requirements for Chief Compliance Officers. As I have ardently stated for years, the work of Chief Compliance Officers — and indeed all compliance professionals — is key to enhancing the Commission’s ability to protect investors and ensure that the markets in which they work remain fair and efficient, a result which all of us should want. In fulfilling their role, CCOs must remain independent so that they can assess whether policies and procedures are followed while also being actively engaged with senior management and others at the regulated entity so that they can understand the purpose of its policies and procedures. Fulfilling this role involves a delicate balance. But, a compliance team that is cordoned off from the rest of the organization or insulated from constructive advice or criticism will not be able to effectively assess compliance and recommend alternative approaches.
Today’s rule poses too high of a risk that the CCOs of SDRs will be isolated and that communication between them and others at the SDRs will be chilled. Rather than allowing the SDR to determine how best it can structure itself to allow the CCO to find this balance, the Commission is mandating that the Board — and only the Board — can hire and fire the CCO. Dodd-Frank requires many things for the CCOs of SDRs, but this is not one of them.
The Commission also has made it a violation of the securities laws to, among other things, indirectly manipulate the CCO. This provision would prohibit officers, directors or employees from “directly or indirectly tak[ing] any action to coerce, manipulate, mislead, or fraudulently influence” the CCO. I am unsure how such activity would not be a securities law violation under existing law, but I do know that the Commission did not actually propose this language. The proposing release asked one question about whether the Commission should prohibit such actions, to which one commenter responded in the affirmative. I fail to see how one question in a release and one commenter’s response amounts to a proposal under the APA. This final rule as commonsensical as it may seem, is the result of a “shadow proposal” and as such should not be promulgated.
And, the Commission has further dissuaded SDR employees from criticizing or rejecting any changes the CCO recommends to its policies and procedures as a result of the CCOs annual review. Because, if it does, the CCO is required to report to the Commission what those recommendations were and whether the policies have been or will be modified.
This will inevitably chill communication between the CCO and management. If a recommendation is not implemented, having raised questions about the recommendation or opposed its implementation will inevitably subject SDR employees to scrutiny based on this open-ended and vague standard.
For CCOs to fulfill their purpose, they must be both independent and effective. I believe the rules being adopted today do nothing to advance the independence of CCOs that cannot be done through less intrusive means. And what they will do is make CCOs of SDRs less effective by isolating them from the rest of the SDR and insulating them from questioning and criticism.
One last point, Form SDR requests information on the business experience of the CCO, officers, and directors. With respect to the CCO, the release provides that the Commission will not judge the competency of the CCO and that the rule does not create a competency standard. All of that raises the question of why the Commission is requesting information in the first instance that it claims it will not use.
These requests for information on Form SDR continue a disturbing trend of the Commission slipping into registration forms requests for information not germane to any of the requirements of Commission rules. This back door method of “regulation by form” is inappropriate. And never mind that it does not comply with the APA.
If the Commission wants to re-think how it goes about registering entities and considering qualification issues, it could employ an effort championed by my former colleague Elisse Walter, namely, a concept release.
Such a concept release would be the proper avenue to address this important policy issue.
With respect to the adoption of Regulation SBSR, I would like to again thank the staff for all of their hard work and dedication. I appreciate the time in which they responded to my questions and comments; however without burying the lead, I unfortunately cannot support it for the following reasons.
First, these rules just aren’t ready for prime time. The release is replete with references to anticipated future rulemaking related to the implementation and completion of Reg SBSR. There are so many unanswered questions as to how Regulation SBSR will work moving forward. The release signals — sometimes in great detail — anticipated rulemaking, and I cannot help but feel that something is amiss. A more appropriate approach would have been to complete the work on open issues and the companion proposing releases.
Second, the adopting release is also incorporating a new and troubling reference — an “internationally recognized standards-setting system,” (“IRSS”) and recognizes the Global LEI System as an internationally recognized standards-setting system. As many of you know, I am a supporter of LEI. I worry, however, that IRSS will become the new “NRSRO.” The Commission is creating a new term that will require future Commission action to recognize any other “IRSS”, and there is little guidance on the standards and process by which the Commission will do so.
Third, I cannot support two new requirements that are being adopted without ever being proposed. The Commission did not propose to require counterparties to a security-based swap transaction to obtain an LEI to comply with Reg SBSR reporting requirements yet it is in the final rule. And separately, the rule mandates identification of so-called “execution agents.” And this notion was never proposed and received no comment. Rule 900, as adopted, provides that the execution agent ID is the “UIC assigned to any person other than a broker or trader that facilitates the execution of a security-based swap on behalf of a direct counterparty.” The rule is trying to capture entities that could act as agents in a security-based swap transaction, such as an asset manager acting as an agent on behalf of a fund counterparty. Now it is all well and good if the Commission wants to require the reporting ID of such an entity. However, we should have proposed it. This takes me back to my first point — if there are holes that need to be remedied by finalizing new concepts, then Reg SBSR is not ready for adopting. To be clear, I think it is appropriate to prioritize Title VII rules as the markets and market participants need clarity due to the competing rule set already put in place by the CFTC. We should not, however, push forward rules that aren’t ready.
Lastly, I must note that the concepts I take issue with in adopting Reg SBSR, and to some extent Reg SDR, carry through to the proposed amendments to Reg SBSR. Therefore, I also cannot support the proposal before me. However, I want to reiterate that my position today in no way diminishes the hard work of the staff.
 See Daniel M. Gallagher, Dissenting Statement at SEC Open Meeting on Nationally Recognized Statistical Rating Organizations (Aug. 27, 2014), available at http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370542775101 (“This new prohibition is solely based on state of mind — there is no requirement that any action be taken. Even if the rating process is effectuated without any abuse, we could theoretically still pursue the analyst unfortunate enough to display evidence that a stray thought related to sales and marketing considerations crossed his or her mind. Remember, the rating process, much less the rating itself, does not have to be influenced by such considerations to violate this new rule.”)
 See Daniel M. Gallagher and Harvey L. Pitt, When ruler-makers don’t follow the rules, The Washington Times (June 9, 2014); available at http://www.washingtontimes.com/news/2014/jun/9/gallagher-pitt-when-ruler-makers-dont-follow-the-r/.
 See Rule 900(m).