Testimony: Financial Modernization Legislation
TESTIMONY OF
ARTHUR LEVITT, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
CONCERNING FINANCIAL MODERNIZATION LEGISLATION
BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
U.S. SENATE
February 24, 1999
Chairman Gramm, Senator Sarbanes, and Members of the Committee:
I appreciate the opportunity to testify on behalf of the
Securities and Exchange Commission (“SEC” or “Commission”)
regarding financial modernization legislation. I am pleased to
appear before this Committee again to present the Commission’s
views on this important issue.
I. Overview
The Commission has long supported the goal of modernizing
the legal framework governing financial services. As we work
toward this goal, however, we must also preserve principles that
are fundamental to effective oversight of the U.S. securities
markets. Our securities markets today are strong, vibrant, and
healthy. They are relied on by both individual investors who are
increasingly putting their savings in stocks, bonds, and mutual
funds[1] and by American businesses that need to raise
capital.[2] The success of our securities markets is based on
the high level of public confidence inspired by a strong system
of investor protection, and on the entrepreneurial and innovative
efforts of securities firms. As the nation’s primary securities
regulator, it is critical that the Commission be able to continue
to fulfill its mandate of investor protection and to safeguard
the integrity, fairness, transparency, and liquidity of U.S.
securities markets.
The Commission has reviewed the staff discussion draft of
financial modernization legislation that the Senate Banking
Committee released last week. Unfortunately, I believe that, in
its current form, the bill runs the risk of dramatically
undermining investor protection and the integrity of U.S.
securities markets. The Commission understands that the
discussion draft is very much a work-in-progress, but it cannot
possibly support the discussion draft in its current form.
By repealing provisions of the Glass-Steagall Act without
removing the bank exemptions from federal securities laws, this
draft bill would create a dangerously bifurcated system of
regulation. A significant portion of securities activities would
take place outside the protections of the securities laws. The
bank exemptions to federal securities law were, in part, premised
on the very existence of the barriers that the Glass-Steagall Act
had erected. For the sake and safety of our capital markets, we
should not contemplate removing outdated restrictions without
also removing outdated exemptions.
The Commission has outlined below five points it feels
should be addressed by any financial modernization bill.
Specifically, it is crucial that the Commission retain
supervisory and regulatory authority over the U.S. securities
markets, regardless of where securities activities are conducted.
The Commission believes that the following are critical
safeguards in any financial modernization legislation:
* Maintain aggressive SEC policing and oversight of all
securities activities;
* Safeguard customers and markets by enabling the SEC to
set net capital rules for all securities businesses;
* Protect investors by applying the SEC sales practice
rules to all securities activities;
* Protect mutual fund investors with uniform adviser
regulations and conflict-of-interest rules; and
* Enhance global competitiveness through voluntary broker-
dealer holding companies.
These objectives are not novel; they have been central themes to
all of the Commission’s testimony to date. We believe these
objectives can be addressed in a variety of ways -- and certainly
in significantly fewer pages than in previous versions of H.R. 10
-- but they are nonetheless important to investors and the
continued success of our markets.
We recognize and appreciate the Committee’s attempt to
streamline the draft bill. In keeping with this pared-down
approach, we believe that we can offer a simple way to make the
discussion draft’s provisions relating to the securities industry
consistent with sound public policy. You could, along with
repealing section 20 of the Glass-Steagall Act, also repeal the
existing exemptions from the federal securities laws for bank
broker-dealer and bank investment adviser activities. This would
preserve and strengthen investor protections and the vitality of
U.S. securities markets. The Commission cannot ensure the
integrity of U.S. markets if it is only able to supervise a
portion of the participants in those markets. Neither can it
ensure fair and orderly markets if market participants operate by
different rules and investors receive different levels of
protection. [3]
The Commission is eager to work with the Committee to
achieve an appropriate balance in financial modernization
legislation, without compromising these important principles.
II. Background on the Securities Activities of the Banking
Industry
Before discussing the Commission’s objectives in detail, I
would like to summarize the key points that the Commission has
consistently raised in considering Glass-Steagall reform.
The Commission has been the nation’s primary securities
regulator for 65 years. As such, it is the most experienced and
best equipped to regulate securities activities, regardless of
who conducts those activities. The Commission’s statutory
mandate focuses on investor protection, the maintenance of fair
and orderly markets, and full disclosure. Moreover, securities
regulation encourages innovation on the part of securities firms,
subject to securities capital requirements that take into account
risk-taking activities. Significantly, securities regulation --
unlike banking regulation -- does not protect broker-dealers from
failure. It relies on market discipline, rather than a federal
safety net, with an additional capital cushion and customer
segregation requirements to insulate customers from the losses of
broker-dealer firms. Moreover, protection of customer funds has
been further assured by the Securities Investor Protection
Corporation (“SIPC”).[4]
This Committee is well aware of the many securities
activities in which the banking industry now engages. While
these market developments have provided banks with greater
flexibility and new areas for innovation, they have also left
U.S. markets and investors potentially at risk. Because banks
have, to date, retained their exemptions from most federal
securities laws, their securities activities have been governed
in a hodge-podge manner by banking statutes and regulations that
have not kept pace with market practices or needs for investor
protection. As you know, banking regulation properly focuses on
preserving the safety and soundness of banking institutions and
their deposits, and preventing the failure of banks. But,
because market integrity and investor protection are not
principal concerns of banking regulation, the Commission believes
that banking regulation is not an adequate substitute for
securities regulation. Thus, it is crucial that any financial
modernization legislation include a repeal of the bank exemptions
from federal securities law.
In order for banks to be fully liberated from the outdated
Glass-Steagall Act restrictions on their ability to conduct
securities activities, banks must be willing to take on the
responsibility for full compliance with U.S. securities laws,
with which all other securities market participants must comply.
As discussed more fully below, failure to impose such
responsibility on banks would undermine the current safeguards
and investor protections contained in the federal securities
regulatory scheme and would threaten the vitality of U.S.
securities markets. The Commission would vigorously oppose any
final legislation that does not require bank compliance with
federal securities laws.
III. Commission Objectives for Financial Modernization
I will now turn to a more detailed discussion of the
fundamental securities principles that the Commission believes
are necessary elements of a truly effective financial
modernization bill.
A. Aggressive SEC Policing and Oversight of All Securities
Activities
Public confidence in our securities markets hinges on their
integrity. As the Supreme Court recently stated: “an animating
purpose of the Exchange Act . . . [is] to insure honest
securities markets and thereby promote investor confidence.”[5]
The Commission has an active enforcement division, whose first
priority is to investigate and prosecute securities fraud. The
banking regulators, on the other hand, are required to focus
their efforts on protecting the safety and soundness of banks,
which does not consider the interests of defrauded investors.
Detecting securities fraud is a full-time job, and it is a far
cry from formulating monetary policy.
To continue its effective policing and oversight of the
markets, the Commission must be able to monitor all securities
activities through regular examinations and inspections, which
includes access to all books and records involving securities
activities. This unfettered access is currently not available.
For example, during recent examinations of bank mutual funds,
Commission examiners have had difficulty gaining access to key
documents concerning the securities advisory activities of
banks.[6] The Commission cannot vigorously protect the integrity
of U.S. markets and adequately protect investors with one hand
tied behind its back.
B. SEC Financial Responsibility Rules for All Securities
Businesses
Securities positions can be highly volatile. The
Commission’s capital requirements recognize this fact and are,
with respect to protection from market risk, more rigorous than
those imposed by bank regulators. Market exposures and
volatility are risks that the net capital rule was designed to
address, unlike bank capital requirements, which focus more on
credit exposure. Thus, the Commission’s net capital rule better
protects the liquidity of any entity engaging in often volatile
securities transactions.
In addition to promoting firm liquidity, the Commission’s
net capital rule is a critical tool to protect investors and
securities markets because the Commission can also use the net
capital rule to address abusive or problematic practices in the
market. For example, with respect to penny stock market makers,
the Commission can limit their activity by raising capital
requirements for market-making activities. In addition, the
Commission can expand on the margin rules with respect to
particularly risky stocks by increasing capital charges.
Finally, the net capital rule’s 100-percent capital charge for
illiquid securities serves to maintain orderly markets in
securities that have no liquidity or transparency. Without the
ability to uniformly apply its net capital rule, the Commission’s
ability to oversee and influence U.S. securities markets is
severely inhibited.
In addition to detailed net capital requirements that
require broker-dealers to set aside additional capital for their
securities positions, the Commission’s customer segregation rule
prohibits the commingling of customer assets with firm assets.
Thus, customer funds and securities are segregated from firm
assets and are well-insulated from any potential losses that may
occur due to a broker-dealer’s proprietary activities.
Because the Commission’s financial responsibility
requirements are so effective at insulating customers from the
risk-taking activities of broker-dealers, the back-up protection
provided by SIPC is seldom used. Although there have been
broker-dealer failures, there have been no significant draws on
SIPC, and there have been no draws on public funds. In fact,
because of the few number of draws on SIPC funds, SIPC has been
able to satisfy the claims of broker-dealer customers solely from
its interest earnings and has never had to use its member firm
assessments to protect customers. This is in sharp contrast to
the many, often extensive, draws on the bank insurance funds to
protect depositors in failed banks. In addition, during recent
market turmoil in the financial markets, SEC-regulated entities
were well-collateralized and none was ever at risk of failure.
We must continue to protect our markets from systemic risk
by ensuring that there is enough capital to support the market
risk that is inherent in securities transactions. In addition,
we must ensure that customer funds and securities are fully
protected by enforceable requirements to segregate customer
assets from firm assets. To satisfy its quest for effective
financial modernization, Congress should permit the Commission to
set financial responsibility requirements for all securities
activities, in order to better protect investors and U.S.
markets.
C. SEC Sales Practice Rules Applied to All Securities
Activities
All investors deserve the same protections regardless of
where they choose to purchase their securities. Unfortunately,
gaps in the current bifurcated regulatory scheme leave investors
at risk. For example, broker-dealers are subject to a number of
key enforceable requirements to which banks are not, including
requirements to:
* recommend only suitable investments;
* arbitrate disputes with customers;
* ensure that only fully licensed and qualified personnel
sell securities to customers;
* disclose to investors, through the NASD, the disciplinary
history of employees; and
* adequately supervise all employees.[7]
Investors are generally not aware of these gaps in regulation and
the risks that such gaps create.
In addition, federal banking statutes do not provide
customers a private right of action for meritorious claims, and
banking regulators do not routinely fully disclose the details of
any and all enforcement and disciplinary actions against banks to
put customers on alert. Although some customer protections have
been suggested by the bank regulators, they are less
comprehensive than the federal securities laws and serve to
perpetuate the disparities between the bank and securities
regulatory schemes.
Some have suggested a system of parallel securities
regulation by the banking regulators. However, the Commission
notes that the 12(i) model for parallel regulation of bank issuer
reporting has not achieved the objectives of the federal
securities laws. Under section 12(i) of the Securities Exchange
Act,[8] banking regulators are required to adopt rules
“substantially similar” to the Commission’s rules within 60 days
after the Commission’s publication of its final rules. Notably,
one commentator has stated that “final action by the [banking]
regulators in promulgating ‘substantially similar’ 1934 Act rules
has been delayed in some cases over five years after pertinent
SEC amendments have been issued.”[9] In addition, promulgation
of rules alone is not sufficient; banking regulators must also
examine for compliance with any parallel regulatory requirements
and take appropriate enforcement action when violations have
occurred. The 12(i) model perpetuates a complex scheme of
disparate rules offering different protections for investors and
markets and different levels of enforcement efforts.
I would like to briefly discuss two recent Commission
enforcement actions that highlight the need for more universal
application of strict sales practices rules to all entities
engaged in securities activities.
In the first case, the Commission is alleging that the
portfolio manager of two money market mutual funds sponsored by a
bank (i) caused the funds to purchase volatile derivative
instruments, (ii) fraudulently transferred the derivatives at
inflated values between the mutual funds to some of the bank’s
various trust accounts to cover up the mutual funds’ losses, and
(iii) ultimately caused the funds to “break the buck.” The
Commission investigated and has initiated enforcement action
against the mutual fund’s portfolio manager.[10] However,
because of the current bank exemptions from federal securities
law, the Commission was unable to bring charges against the bank
or its personnel for failing to adequately supervise the fund
manager. Under these facts, the Commission ordinarily would have
brought charges against any of its regulated entities for similar
misconduct, and the Commission considers its ability to bring
“failure to supervise” claims to be critical to investor
protection. Securities fraud of this type -- where transactions
occur both in mutual funds and in bank trust accounts --
illustrates the need for securities regulators to have access to
books and records involving all securities activities conducted
by banks.
In the second case, employees of a bank and its broker-
dealer affiliate blurred the distinction between the two entities
and their respective products during sales presentations to
customers and in marketing materials.[11] In addition, the bank
created an environment where the broker-dealer’s employees could
mischaracterize certain products as bank-like conservative
investments when, in fact, they were highly leveraged funds that
invested in interest-rate-sensitive derivatives. These actions
resulted in customers, many of whom were elderly and thought they
were purchasing investments in stable government bond funds,
making unsuitable purchases of high-risk funds. The case is also
evidence of how partial securities regulation split between banks
and their securities affiliates is inadequate to fully protect
investors.
The Commission believes that the protections provided by the
high, uniform standard of the federal securities laws should
benefit all investors purchasing securities.
D. Uniform Mutual Fund Adviser Regulation and Conflict-of-
Interest Rules
Mutual fund investors should always receive the protection
of the federal securities laws. Accordingly, all parties that
provide investment advice to mutual funds should be subject to
the same oversight, including Commission inspections and
examinations. In addition, any type of entity that is affiliated
with a mutual fund should be subject to the strict conflict-of-
interest provisions of the federal securities laws.
For these reasons, the Commission supports what appear to be
non-controversial provisions of previous versions of financial
modernization legislation that would address the increasing
involvement of banks in the mutual fund business and would reduce
potential conflicts of interest. We suggest adding similar
language to the draft bill that this Committee is currently
considering in order to fully protect mutual fund investors by
providing for full bank compliance with the federal securities
laws with respect to their mutual fund advisory activities.
Banks that act as investment advisers currently enjoy an
exemption from the registration and other requirements of the
Investment Advisers Act of 1940. As a result, bank investment
advisers are not subject to the substantive requirements
applicable to registered investment advisers, including:
(i) regulation of advertising, solicitation, and receipt of
performance fees; (ii) procedures to prevent misuse of non-public
information; (iii) books and records and employee supervision
requirements; and (iv) the general anti-fraud provisions.
In addition, as banks increasingly advise mutual funds, the
Commission grows more concerned that its examiners do not have
ready access to information regarding bank advisory activities
that could affect bank-advised mutual funds. Such access is
necessary in order to detect front-running, abusive trading by
portfolio managers, and conflicts of interest (involving, for
example, soft-dollar arrangements, allocation of orders, and
personal securities transactions by fund managers). For example,
as part of its review for conflicts of interest with respect to a
bank mutual fund adviser’s activities, Commission examiners must
be able to compare trading activity in a mutual fund portfolio to
that in the bank’s trust accounts. As discussed above, the
Commission has had difficulty obtaining full access to all
relevant information when reviewing the securities activities of
banks that advise mutual funds.[12] The Commission must be able
to review records relating to all securities activities relating
to mutual fund advisers, just as it does for non-bank fund
advisers.
The Commission is also concerned about the unique conflicts
of interest resulting from increased bank involvement in the
mutual fund business. Currently, the Investment Company Act of
1940 places restrictions on certain transactions between
investment companies and their affiliates. These restrictions
were crafted, however, at a time when Congress could not have
anticipated the dramatic change in the scope of bank securities
activities. Specifically, the Commission is concerned about
conflicts of interest that may arise from:
* bank lending to affiliated mutual funds, possibly on
unfavorable terms, to the detriment of fund investors;
* bank holding company personnel serving on the boards of
directors of affiliated mutual funds;
* personnel of an entity that lends to, or distributes
shares of, a mutual fund also serving on the fund’s
board; and
* bank trust departments that hold shares in an affiliated
mutual fund in a trustee or fiduciary capacity and that
have the power to vote such shares.
Legislation that targets such conflicts of interest is
necessary. Banks that lend to, advise, and/or sell mutual funds
should be subject to rules governing conflicts of interest that
arise when banks act in multiple capacities.
E. Voluntary Broker-Dealer Holding Companies
In order to expand overseas, U.S. broker-dealer firms
generally must demonstrate to foreign regulators that they are
subject to comprehensive supervision on a worldwide basis. Thus,
the Commission strongly supports the ability of U.S. broker-
dealers to voluntarily subject their activities to Commission
supervision on a holding company basis. The Commission’s
“umbrella” oversight would be based on a risk-supervision model
that more appropriately reflects the predominant risk-taking
securities activities of the consolidated entity. Of course, any
regulated subsidiaries of a broker-dealer holding company would
continue to be regulated by the appropriate statutory regulator.
The Commission believes that a supervisory framework for
holding companies substantially engaged in securities activities
would permit securities firms the flexibility to innovate and
keep pace with the rapid changes in today’s capital markets.
This structure would impose risk-based supervision, consistent
with the firm’s principal business, and would help protect market
integrity by ensuring that there are no supervisory gaps.
IV. Conclusions
The Commission has testified many times during the past
decade in support of financial modernization.[13] However, the
legislation as currently drafted perpetuates the broad bank
exemptions from federal securities law regulation. This runs the
risk of grievously threatening market integrity and the continued
strong growth we have seen in the U.S. securities markets.
In the debates surrounding this issue, the Commission’s
primary concerns have been the protection of the integrity of
U.S. markets and those who invest in them. Unfortunately, the
bill as currently drafted would prevent the Commission from
effectively carrying out its statutory mandates, and we could not
support such legislation.
The Commission encourages all involved to step back and look
at the securities issues arising out of financial modernization
with a fresh perspective. We must not lose sight of basic
securities law protections and goals, which have served to ensure
that the U.S. markets are the fairest, safest, most vibrant, most
transparent, and most liquid markets in the world.
We thank you for offering the Commission the opportunity to
present its viewshere today. I would be happy to answer
questions that you may have.
**FOOTNOTES**
[1]: As of December 1998, mutual fund assets totaled $5.5
trillion. Investment Company Institute, Trends in
Mutual Fund Investing: December 1998 (Jan. 28, 1999).
[2]: In 1998, businesses raised a record $1.8 trillion from
investors, $1.31 trillion in 1997, and $967 billion in
1996. (These figures include firm commitment public
offerings and private placements and do not include
best efforts underwritings.) Securities Data
Corporation.
[3]: The Commission recognizes that some bank securities
activities may not give rise to the same investor
protection, market integrity, and fairness concerns.
One simple way to address this issue would be to
provide clear authority for the Commission to exempt
these activities, in consultation with the banking
regulators. However, the Commission has previously
stated in Congressional testimony that it could not
support “a labyrinth of complicated, technical
exemptions from federal securities law regulation.,
See, Testimony of Harvey J. Goldschmid, General
Counsel, U.S. Securities and Exchange Commission,
Concerning H.R. 10, the “Financial Services Act of
1999,” Before the House Comm. on Banking and Financial
Services (Feb. 12, 1999).
[4]: SIPC is a non-profit membership corporation created by
the Securities Investor Protection Act of 1970. SIPC
membership is required of nearly all registered broker-
dealers, and SIPC is funded by annual assessments on
its members. If a broker-dealer were to fail and have
insufficient assets to satisfy the claims of its
customers, SIPC funds would be used to pay the broker-
dealer’s customers (up to $100,000 in cash, and
$500,000 in total claims, per customer).
[5]: United States v. O’Hagan, 521 U.S. 642, 117 S.Ct. 2199,
2210 (1997).
[6]: The Commission and the federal bank regulatory agencies
have worked to enhance coordination of their
examination and inspection programs. See Testimony of
Lori Richards, Director, Office of Compliance
Inspections and Examinations, U.S. Securities and
Exchange Commission, Concerning the Securities and
Exchange Commission’s Examination Oversight of
Securities Firms Affiliated with Banks, Before the
Subcomm. on Financial Institutions and Consumer Credit,
House Comm. on Banking and Financial Services (Oct. 8,
1997). Despite these initiatives, however, the
Commission continues to have difficulty obtaining
access to all appropriate books and records.
[7]: The federal bank regulatory agencies have issued
guidelines that address some bank sales practice
issues. See Board of Governors of the Federal Reserve
System, Federal Deposit Insurance Corporation, Office
of the Comptroller of the Currency, and Office of
Thrift Supervision, “Interagency Statement on Retail
Sales of Nondeposit Investment Products, (Feb. 15,
1994). These guidelines are advisory and therefore not
legally binding, and they may not be legally
enforceable by bank regulators.
[8]: 15 U.S.C. 78l(i).
[9]: Michael P. Malloy, The 12(i)’ed Monster: Administration
of the Securities Exchange Act of 1934 by the Federal
Bank Regulatory Agencies, 19 Hofstra L. Rev. 269, 285
(1990).
[10]: See In the Matter of Michael P. Traba, File No. 3-
9788, Release No. 33- 7617 (Dec. 10, 1998).
[11]: In the Matter of NationsSecurities and NationsBank,
N.A., Release No. 33-7532 (May 4, 1998).
[12]: See note 6 and accompanying text above.
[13]: See, e.g., Testimony of Harvey J. Goldschmid, General
Counsel, U.S. Securities and Exchange Commission,
Concerning H.R. 10, The “Financial Services Act of
1999,” Before the House Comm. on Banking and Financial
Services (Feb. 12, 1999); Testimony of Arthur Levitt,
Chairman, U.S. Securities and Exchange Commission,
Concerning H.R. 10, The “Financial Services Act of
1998,” Before the Senate Comm. on Banking, Housing, and
Urban Affairs (June 25, 1998); Testimony of Arthur
Levitt, Chairman, U.S. Securities and Exchange
Commission, Concerning Financial Modernization and H.R.
10, the “Financial Services Competition Act of 1997,”
Before the Subcomm. on Finance and Hazardous Materials
of the House Comm. on Commerce (July 17, 1997);
Testimony of Arthur Levitt, Chairman, U.S. Securities
and Exchange Commission, Concerning Financial
Modernization, Before House Comm. on Banking and
Financial Services (May 22, 1997); Testimony of Arthur
Levitt, Chairman, U.S. Securities and Exchange
Commission, Regarding H.R. 1062, the “Financial
Services Competitiveness Act of 1995,” Before the
Subcomm. on Telecommunications and Finance and the
Subcomm. on Commerce, Trade and Hazardous Materials of
the House Comm. on Commerce (June 6, 1995); Testimony
of Arthur Levitt, Chairman, U.S. Securities and
Exchange Commission, Concerning the “Financial Services
Competitiveness Act of 1995, and Related Issues, Before
the House Comm. on Banking and Financial Services (Mar.
15, 1995); Testimony of Arthur Levitt, Chairman, U.S.
Securities and Exchange Commission, Concerning H.R.
3447 and Related Functional Regulation Issues, Before
the Subcomm. on Telecommunications and Finance of the
House Comm. on Energy and Commerce (Apr. 14, 1994);
Testimony of Richard C. Breeden, Chairman, U.S.
Securities and Exchange Commission, Concerning
Financial Services Modernization, Before the Subcomm.
on Telecommunications and Finance of the House Comm. on
Energy and Commerce (July 11, 1990); Memorandum of the
Securities and Exchange Commission (under Chairman
David Ruder) to the Subcomm. on Telecommunications and
Finance of the House Comm. on Energy and Commerce,
Concerning Financial Services Deregulation and Repeal
of the Glass-Steagall Act (Apr. 11, 1988); Testimony of
David S. Ruder, Chairman, U.S. Securities and Exchange
Commission, Concerning the Structure and Regulation of
the Financial Services Industry, Before the Subcomm. on
Telecommunications and Finance of the House Comm. on
Energy and Commerce (Oct. 5, 1987).
Last Reviewed or Updated: Feb. 24, 1999