The Sarbanes Oxley Act,
the Financial Crisis Inquiry Commission (FCIC), and the Fraud
Enforcement and Recovery Act of 2009 (FERA)
Welcome to the July 2010 edition of the Sarbanes
Oxley Compliance Professionals Association (SOXCPA)
newsletter
Dear Member,
In the middle of the
re-regulation era, we have to understand better the new
regulatory landscape.
Although Sarbanes Oxley is always an
important part of that, we have a new federal commission that is
involved in fraud investigation, accounting practices etc.
Today
we will try to understand better the new Financial Crisis
Inquiry Commission, and the Fraud Enforcement and Recovery Act
of 2009.
We must study carefully the Testimony
Concerning the State of the Financial Crisis by Chairman Mary L.
Schapiro, U.S. Securities and Exchange Commission, before the
Financial Crisis Inquiry Commission (FCIC), January 14, 2010.
We
will learn many important changes in the
regulatory landscape, challenges and the future of regulation. For
example, we read that:
Since
the 2002 passage of the Sarbanes-Oxley Act, the SEC has returned
approximately $7 billion to injured investors.
The
SEC investigates and brings enforcement
actions with respect to a wide range of fraudulent activity,
including accounting and disclosure fraud, fraud in derivatives
and structured products, and illegal insider trading and market
manipulation.
Currently, the SEC's Division of Enforcement
is conducting investigations involving mortgage lenders,
investment banks, broker-dealers, credit rating agencies, and
others that relate to the financial crisis.
To date, the SEC has
reviewed or brought over a dozen actions addressing misconduct
that led to or arose from the financial crisis.
During the
2009 calendar year alone, the SEC
distributed approximately $2.5 billion to harmed investors.
Section 308 of the Sarbanes-Oxley Act of 2002, codified at 15
U.S.C. §7246, enabled the Commission to distribute civil money
penalties to investors in certain circumstances.
In
enforcement actions prior to the passage of the Sarbanes-Oxley
Act, only funds paid as disgorgement could be returned to
investors.
SEC has 3,700
people to oversee approximately 35,000 entities, including 11,300
investment advisers, 8,000 mutual funds, 5,500 broker-dealers, and
more than 10,000 public companies, as well as transfer agents,
clearing agencies, exchanges, and others.
Under these constraints,
the agency can only examine about 10 percent of advisers each
year.
The Financial Crisis Inquiry Commission
In the wake of the most significant financial crisis since the
Great Depression, the President signed into law on May 20, 2009,
the Fraud Enforcement and Recovery Act of 2009, creating the
Financial Crisis Inquiry Commission.
The Commission was
established to "examine the causes, domestic and global, of the
current financial and economic crisis in the United States."
The 10 members of the bi-partisan Commission, prominent
private citizens with significant experience in banking, market
regulation, taxation, finance, economics, housing, and consumer
protection, were appointed by Congress on July 15, 2009.
The
Chair, Phil Angelides, and Vice Chair, Bill Thomas, were
selected jointly by the House and Senate Majority and Minority
Leadership.
The FCIC is charged with conducting a
comprehensive examination of 22 specific and substantive areas
of inquiry related to the financial crisis. These include:
- Fraud and abuse in the financial sector, including fraud and
abuse towards consumers in the mortgage sector;
- Federal
and State financial regulators, including the extent to which
they enforced, or failed to enforce statutory, regulatory, or
supervisory requirements;
- The global imbalance of
savings, international capital flows, and fiscal imbalances of
various governments;
- Monetary policy and the availability
and terms of credit;
- Accounting practices, including,
mark-to-market and fair value rules, and treatment of
off-balance sheet vehicles;
- Tax treatment of financial
products and investments;
- Capital requirements and
regulations on leverage and liquidity, including the capital
structures of regulated and non-regulated financial entities;
- Credit rating agencies in the financial system, including,
reliance on credit ratings by financial institutions and Federal
financial regulators, the use of credit ratings in financial
regulation, and the use of credit ratings in the securitization
markets;
- Lending practices and securitization, including
the originate-to-distribute model for extending credit and
transferring risk;
- Affiliations between insured
depository institutions and securities, insurance, and other
types of nonbanking companies;
- The concept that certain
institutions are 'too-big-to-fail' and its impact on market
expectations;
- Corporate governance, including the impact
of company conversions from partnerships to corporations;
- Compensation structures;
- Changes in compensation for
employees of financial companies, as compared to compensation
for others with similar skill sets in the labor market;
-
The legal and regulatory structure of the United States housing
market;
- Derivatives and unregulated financial products
and practices, including credit default swaps;
-
Short-selling;
- Financial institution reliance on
numerical models, including risk models and credit ratings;
- The legal and regulatory structure governing financial
institutions, including the extent to which the structure
creates the opportunity for financial institutions to
engage in
regulatory arbitrage;
- The legal and regulatory structure
governing investor and mortgagor protection;
- Financial
institutions and government-sponsored enterprises; and
- The quality of due diligence undertaken by financial
institutions;
The Commission is called upon to examine
the causes of major financial institutions which failed, or were
likely to have failed, had they not received exceptional
government assistance.
In its work, the Commission is
authorized to hold hearings; issue subpoenas either for witness
testimony or documents; and refer to the Attorney General or the
appropriate state Attorney General any person who may have
violated U.S. law in relation to the financial crisis.
Frequently Asked Questions about the Commission’s Work
What is the Commission's process for requesting
information?
The Commission is committed to getting the
information it needs to conduct a fair and thorough
investigation.
The law creating the Commission (Section
5 of the Fraud Enforcement and Recovery Act of 2009) says the
following regarding the tools we were given to gather documents
and information:
The Commission
may secure directly from
any department, agency, bureau, board, commission, office,
independent establishment, or instrumentality of the United
States any information related to any inquiry of the Commission
conducted under this section, including information of a
confidential nature (which the Commission shall maintain in a
secure manner).
Each such department, agency, bureau,
board, commission, office, independent establishment, or
instrumentality shall furnish such information directly to the
Commission upon request.
In addition, the Commission has
the power to:
Require, by subpoena or otherwise, the
attendance and testimony of witnesses and the production of
books, records, correspondence, memoranda, papers, and
documents.
The Commission is moving forward expeditiously
to obtain the information it needs to fulfill its mission. In
that vein, the Commission
will treat any delays with the utmost
seriousness.
Therefore, it is the standard practice that
recipients of letters from the Commission requesting information
confirm in writing that they will comply in a timely manner.
In
the event of a failure to provide confirmation of compliance, or
if there is a failure to provide the requested materials in a
timely manner, the Commission is committed to using its subpoena
power to compel compliance.
What is the Commission doing when it is not holding public
hearings?
The Commission has a
full team of investigators
and researchers working to examine the causes of the financial
crisis.
A portion of this work is done out of the public eye
through meetings, interviews and review of public and private
documents and information.
Will the Commission make the
documents it gathers available to the general public?
It
is important to the Commission that the American people are able
to follow what the Commission is doing. If and when it is
appropriate and in the public interest, and when making
documents public will not hinder its ongoing investigation, the
Commission will make them public.
Information important to our
conclusions will be referenced in our report and will become
part of the Commission's records in accordance with federal
archives requirements.
What about the requests for
follow-up information that were referenced in the public
hearing?
We consider these questions to be similar to
requests that are made by the Commission or its staff in the
conduct of its investigation. The information that is received
in response to these questions may include both confidential and
non-confidential information. If and when it is appropriate and
in the public interest, and when making documents public will
not hinder its ongoing investigation, the Commission will make
them public.
The
‘‘Fraud Enforcement and Recovery Act of 2009’’ or ‘‘FERA’’ and the
FCIC
PUBLIC LAW 111–21—MAY
20, 2009
An Act
To improve enforcement of mortgage
fraud, securities and commodities fraud, financial institution
fraud, and other frauds related to Federal assistance and relief
programs, for the recovery of funds lost to these frauds, and
for other purposes.
Be it enacted by the Senate and House
of Representatives of the United States of America in Congress
assembled,
SHORT TITLE.
This Act may be cited as the
‘‘Fraud Enforcement and Recovery Act of 2009’’ or ‘‘FERA’’.
SEC. 5. FINANCIAL CRISIS INQUIRY COMMISSION.
ESTABLISHMENT OF COMMISSION.—There is established in the
legislative branch the Financial Crisis Inquiry Commission (in
this section referred to as the ‘‘Commission’’) to examine the
causes, domestic and global, of the current financial and
economic crisis in the United States.
COMPOSITION OF THE
COMMISSION.—
MEMBERS.—The Commission shall be composed of
10 members, of whom—
3 members shall be appointed by the
majority leader of the Senate, in consultation with relevant
Committees;
3 members shall be appointed by the Speaker
of the House of Representatives, in consultation with relevant
Committees;
2 members shall be appointed by the minority
leader of the Senate, in consultation with relevant Committees;
and
2 members shall be appointed by the minority leader
of the House of Representatives, in consultation with relevant
Committees.
QUALIFICATIONS; LIMITATION.—
IN
GENERAL.—It is the sense of the Congress that individuals
appointed to the Commission should be prominent United States
citizens with national recognition and significant depth of
experience in such fields as banking, regulation of markets,
taxation, finance, economics, consumer protection, and housing.
LIMITATION.—No person who is a member of Congress or an
officer or employee of the Federal Government or any State or
local government may serve as a member of the Commission.
CHAIRPERSON; VICE CHAIRPERSON.—
IN GENERAL.—Subject
to the requirements of subparagraph (B), the Chairperson of the
Commission shall be selected jointly by the Majority Leader of
the Senate and the Speaker of the House of Representatives, and
the Vice Chairperson shall be selected jointly by the Minority
Leader of the Senate and the Minority Leader of the House of
Representatives.
POLITICAL PARTY AFFILIATION.—The
Chairperson and Vice Chairperson of the Commission may not be
from the same political party.
FUNCTIONS OF THE
COMMISSION.—The functions of the Commission are—
(1) to
examine the causes of the current financial and economic crisis
in the United States, specifically the role of—
(A) fraud
and abuse in the financial sector, including fraud and abuse
towards consumers in the mortgage sector;
(B) Federal and
State financial regulators, including the extent to which they
enforced, or failed to enforce statutory, regulatory, or
supervisory requirements;
(C) the global imbalance of
savings, international capital flows, and fiscal imbalances of
various governments;
(D) monetary policy and the
availability and terms of credit;
(E) accounting
practices, including, mark-to-market and fair value rules, and
treatment of off-balance sheet vehicles;
(F) tax
treatment of financial products and investments;
(G)
capital requirements and regulations on leverage and liquidity,
including the capital structures of regulated and non-regulated
financial entities;
(H) credit rating agencies in the
financial system, including, reliance on credit ratings by
financial institutions and Federal financial regulators, the use
of credit ratings in financial regulation, and the use of credit
ratings in the securitization markets;
(I) lending
practices and securitization, including the
originate-to-distribute model for extending credit and
transferring risk;
(J) affiliations between insured
depository institutions and securities, insurance, and other
types of nonbanking companies;
(K) the concept that
certain institutions are ‘‘too-bigto-fail’’ and its impact on
market expectations;
(L) corporate governance, including
the impact of company conversions from partnerships to
corporations;
(M) compensation structures;
(N)
changes in compensation for employees of financial companies, as
compared to compensation for others with similar skill sets in
the labor market;
(O) the legal and regulatory structure
of the United States housing market;
(P) derivatives and
unregulated financial products and practices, including credit
default swaps;
(Q) short-selling;
(R) financial
institution reliance on numerical models, including risk models
and credit ratings;
(S) the legal and regulatory
structure governing financial institutions, including the extent
to which the structure creates the opportunity for financial
institutions to engage in regulatory arbitrage;
(T) the
legal and regulatory structure governing investor and mortgagor
protection;
(U) financial institutions and
government-sponsored enterprises; and
(V) the quality of
due diligence undertaken by financial institutions;
(2)
to examine the causes of the collapse of each major financial
institution that failed (including institutions that were
acquired to prevent their failure) or was likely to have failed
if not for the receipt of exceptional Government assistance from
the Secretary of the Treasury during the period beginning in
August 2007 through April 2009;
(3) to submit a report
under subsection (h);
(4) to refer to the Attorney
General of the United States and any appropriate State attorney
general any person that the Commission finds may have violated
the laws of the United States in relation to such crisis; and
(5) to build upon the work of other entities, and avoid
unnecessary duplication, by reviewing the record of the
Committee on Banking, Housing, and Urban Affairs of the Senate,
the Committee on Financial Services of the House of
Representatives, other congressional committees, the Government
Accountability Office, other legislative panels, and any other
department, agency, bureau, board, commission, office,
independent establishment, or instrumentality of the United
States (to the fullest extent permitted by law) with respect to
the current financial and economic crisis.
POWERS OF THE
COMMISSION.—
HEARINGS AND EVIDENCE.—The Commission may,
for purposes of carrying out this section—
(A) hold
hearings, sit and act at times and places, take testimony,
receive evidence, and administer oaths; and\
(B) require,
by subpoena or otherwise, the attendance and testimony of
witnesses and the production of books, records, correspondence,
memoranda, papers, and documents.
The ‘‘Fraud
Enforcement and Recovery Act of 2009’’ - other important Sections
Section 2 - Amends the federal
criminal code to include within the definition of "financial
institution" a mortgage lending business or any person or entity
that makes, in whole or in part, a federally related mortgage
loan.
Defines "mortgage lending business" as an
organization that finances or refinances any debt secured by an
interest in real estate, including private mortgage companies
and their subsidiaries, and whose activities affect interstate
or foreign commerce.
Extends the prohibition against
making false statements in a mortgage application to employees
and agents of a mortgage lending business. Applies the
prohibition against defrauding the federal government to
fraudulent activities involving the Troubled Asset Relief
Program (TARP) or a federal economic stimulus, recovery, or
rescue plan.
Expands securities fraud provisions to
cover fraud involving options and futures in commodities.
Expands the concept of monetary proceeds, for purposes of
enforcing prohibitions against money laundering, to include
gross receipts.
Expresses the sense of Congress with
respect to the prosecution of money laundering crimes in
combination with other closely-connected offenses.
Requires the
Attorney General to report to the House and Senate Judiciary
Committees on such prosecutions.
Section 3 - Authorizes
appropriations to the Attorney General for FY2010-FY2011 for
investigations, prosecutions, and civil and administrative
proceedings involving federal assistance programs and financial
institutions.
Allocates such funds among various departments
of the Department of Justice (DOJ).
Requires that
an
appropriate percentage of such funds be used to investigate
mortgage fraud.
Authorizes additional appropriations to the U.S.
Postal Service, the Inspector General for the Department of
Housing and Urban Development (HUD), the U.S. Secret Service,
and the Securities and Exchange Commission (SEC), including the
Office of Inspector General, in FY2010-FY2011 for similar
investigations.
Requires the Attorney General, in
consultation with the U.S. Postal Inspection Service, the
Inspector General for HUD, the Secretary of Homeland Security,
and the SEC Commissioner [sic], to submit a report to Congress
identifying:
(1) amounts spent for investigations, with
a certification of compliance that funds have been spent in
accordance with this Act; and
(2) amounts recovered from
criminal or civil restitution, fines, penalties, and other
monetary recoveries.
Section 4 - Amends the False Claims
Act to:
(1) expand liability under such Act for making
false or fraudulent claims to the federal government; and
(2) apply liability under such Act for presenting a false or
fraudulent claim for payment or approval (currently limited to
such a claim presented to an officer or employee of the federal
government).
Requires persons who violate such Act to
reimburse the federal government for the costs of a civil action
to recover penalties or damages.
Modifies and expands provisions
of the False Claims Act relating to intervention by the federal
government in civil actions for false claims, sharing of
information by the Attorney General with a claimant, retaliatory
relief, and service upon state or local authorities in sealed
cases.
Testimony Concerning the State
of the Financial Crisis
by Chairman Mary L. Schapiro, U.S.
Securities and Exchange Commission
Before the Financial Crisis
Inquiry Commission (FCIC), January 14, 2010
I. INTRODUCTION
Chairman
Angelides, Vice Chairman Thomas, Members of the Commission: Thank
you for the invitation to share my personal insights as the
Chairman of the Securities and Exchange Commission into the causes
of the recent financial crisis.
I believe
the work of the Financial Crisis Inquiry
Commission (FCIC) is essential to helping policymakers and the
public better understand the causes of the recent financial crisis
and build a better regulatory structure.
Indeed,
just over seventy-five years ago, a similar Congressional
committee was tasked with investigating the
causes of the stock market crash of 1929.
The
hearings of that committee led by Ferdinand Pecora uncovered
widespread fraud and abuse on Wall Street, including self-dealing
and market manipulation among investment banks and their
securities affiliates.
The public airing of this abuse
galvanized support for legislation that created the Securities and
Exchange Commission in July 1934.
Based on lessons learned from the Pecora investigation, Congress
passed laws premised on the need to protect investors by requiring
disclosure of material information and outlawing deceptive
practices in the sale of securities.
When I became
Chairman of the SEC in late January 2009, the agency and financial
markets were still reeling from the events of the fall of 2008.
Since that time, the SEC has worked tirelessly to review its
policies, improve its operations and address the legal and
regulatory gaps — and in some cases, chasms — that came to light
during the crisis. It is my view that the crisis resulted from
many interconnected and mutually reinforcing causes, including:
The rise of mortgage securitization (a process originally
viewed as a risk reduction mechanism) and its unintended
facilitation of weaker underwriting standards by originators and
excessive reliance on credit ratings by investors;
A
wide-spread view that markets were almost always self-correcting
and an inadequate appreciation of the risks of deregulation that,
in some areas, resulted in weaker standards and regulatory gaps;
The proliferation of complex financial products,
including derivatives, with
illiquidity and other risk characteristics that were not fully
transparent or understood;
Perverse incentives and
asymmetric compensation arrangements that encouraged significant
risk-taking;
Insufficient risk management and risk
oversight by companies involved in marketing and purchasing
complex financial products; and
A
siloed financial regulatory framework that lacked the ability to
monitor and reduce risks flowing across regulated entities and
markets.
To assist the Commission in its efforts, my
testimony will outline many of the lessons we have learned in our
role as a securities and market regulator, how we are working to
address them, and where additional efforts are needed. I look
forward to working with the FCIC to identify the many causes of
this crisis.
II. ENFORCEMENT
Consistent and Vigorous Enforcement Is a
Vital Part of Risk Management and Crisis Avoidance — Particularly
in Times and Areas of Substantial Financial Innovation.
Although we continue to learn more about the causes of
the financial crisis, one clear lesson is the vital importance
that vigorous enforcement of existing laws and regulations plays
in the fair and proper functioning of financial markets.
In light of the FCIC's request for specific
information relating to enforcement actions, I will begin with
some of the efforts made in our Enforcement Division and lessons
learned from these efforts.
Vigorous
enforcement is essential to restoring and maintaining investor
confidence.
Through aggressive and
even-handed enforcement, we hold accountable those whose
violations of the law caused severe loss and hardship and we deter
others from engaging in wrongdoing.
Such enforcement efforts also
help vindicate the principles fundamental to the fair and proper
functioning of financial markets: that investors have a right to
disclosure that complies with the federal securities laws and that
there should be a level playing field for all investors.
The SEC is the singular agency
in the federal government focused primarily on investor
protection. As such, we recognize our special obligation to uphold
these principles.
The SEC has long combated fraud in
the financial markets, and our recent efforts expand this record.
From FY 2007 through FY 2009, the SEC opened 2,610
investigations and brought 1,991 cases charging a variety of
securities laws violations including, and beyond, those related to
the causes of the financial crisis.
Although case statistics cannot tell the whole story,
and I caution against placing undue emphasis on them, they are one
indicator of the agency's efforts. This past fiscal year, the SEC:
Brought 664 enforcement actions
(compared to 671 in FY 2008);
Ordered wrongdoers to disgorge $2.09 billion in
ill-gotten gains (an increase of 170 percent compared to $774
million in FY 2008);
Ordered wrongdoers to pay penalties of $345
million (an increase of 35 percent compared to $256 million in FY
2008);
Sought 71 emergency temporary restraining orders to halt
ongoing misconduct and prevent further investor harm (an increase
of 82 percent compared to 39 in FY 2008);
Sought 82 asset freezes to preserve assets for the
benefit of investors (an increase of 78 percent compared to 46 in
FY 2008); and
Issued 496 orders opening
formal investigations (an increase of over 100 percent compared to
233 in FY 2008).
In addition, where possible and
appropriate, the SEC returned funds directly to harmed investors.
Since the 2002 passage of the Sarbanes-Oxley
Act, the SEC has returned approximately $7 billion to injured
investors.
The SEC investigates and brings
enforcement actions with respect to a wide range of fraudulent
activity, including accounting and disclosure fraud, fraud in
derivatives and structured products, and illegal insider trading
and market manipulation.
Currently, the SEC's Division of Enforcement is
conducting investigations involving mortgage lenders, investment
banks, broker-dealers, credit rating agencies, and others that
relate to the financial crisis. To date, the SEC has reviewed or
brought over a dozen actions addressing misconduct that led to or
arose from the financial crisis.
Transparent Disclosure of Risk and Other Material Information is
Essential. A central question in many of the cases brought by the
SEC is whether investors received timely and accurate disclosure
concerning deteriorating business conditions, increased risks, and
downward pressure on asset values.
Auction Rate Securities.
Beginning December 11, 2008, the SEC entered into a series
of landmark settlements with six large broker-dealer firms for
allegedly misrepresenting to their customers that auction rate
securities (ARS) were safe, highly liquid investments that were
equivalent to cash or money market funds.4 The firms failed to
disclose the increasing risks associated with ARS, including their
reduced ability to support the auctions. When the ARS market
froze, customers were unable to liquidate their securities.
Through these settlements, the SEC and others enabled retail
investors who purchased ARS to receive 100 cents on the dollar for
their investments, resulting in the return of approximately $60
billion to investors.
Reserve Primary
Fund. On May 5, 2009 the SEC charged the managers of the
Reserve Primary Fund for allegedly failing to properly disclose to
investors and trustees material facts relating to the value of the
fund's investments in Lehman-backed paper. The Reserve Primary
Fund, a $62 billion money market fund, became illiquid when it was
unable to meet investor requests for substantial redemptions
following the Lehman bankruptcy. Shortly thereafter, the Reserve
Primary Fund declared that it had "broken the buck" because its
net asset value had fallen below a $1.00. In bringing the
enforcement action, the SEC sought to expedite the distribution of
the fund's remaining assets to investors by proposing a pro-rata
distribution plan. On November 25, a federal judge in New York
endorsed the SEC's approach, which should result in an estimated
return of at least 99 cents on the dollar for all shareholders who
have not had their redemption requests fulfilled, regardless of
when they submitted those redemption requests.
Disclosure of Material Facts. The SEC
has also investigated and brought cases where investors were not
appropriately informed about material items in financial crisis
related mergers or other transactions.
Bank of America/Merrill Lynch. On
August 3, 2009, the SEC charged Bank of America Corporation for
allegedly misleading investors about billions of dollars in
bonuses that were being paid to Merrill Lynch & Co. executives at
the time of its $50 billion acquisition of the firm. The SEC is
currently litigating this case in the Southern District of New
York.
Public Disclosure by Mortgage
Originators and Related Entities. Although originating
risky mortgages does not on its own violate the federal securities
laws, the SEC has charged that some mortgage originators ran afoul
of the federal securities laws in the way they described and
accounted for their businesses to the investing public. Our
efforts in this area have resulted in a number of cases and we are
continuing to investigate potential misconduct by other
publicly-traded mortgage originators.
Countrywide Financial. On June 4,
2009, the SEC charged Angelo Mozilo, the former CEO of Countrywide
Financial, and two other former Countrywide executives with fraud.
The SEC alleged that the defendants deliberately misled investors
about the significant credit risks the company was taking in
efforts to build and maintain market share. In particular, the
SEC's complaint alleges that Countrywide portrayed itself as
underwriting mainly prime quality mortgages, while privately
describing as "toxic" certain of the loans it was extending. The
SEC's complaint also charges Mozilo with alleged insider trading
for selling his Countrywide stock based on non-public information
for nearly $140 million in profit. The litigation is pending.
American Home Mortgage Investment Corp.
On April 28, 2009, the SEC brought actions against three
former executives at American Home Mortgage Investment Corp. for
allegedly engaging in accounting fraud and making false and
misleading disclosures relating to the risk of its mortgage
portfolio. The SEC's complaint alleges that two of the executives
fraudulently understated the company's first quarter 2007 loan
loss reserves by tens of millions of dollar, converting the
company's loss into a fictional profit. One of the executives,
Michael Strauss, settled the SEC's charges, without admitting or
denying the SEC's findings, by paying approximately $2.2 million
in disgorgement and prejudgment interest and a $250,000 penalty,
and agreeing to a five-year bar from serving as an officer or
director of a public company. The litigation is ongoing with
respect to the other defendants.
New
Century. On December 7, 2009, the SEC charged three former
officers of New Century Financial Corporation with securities
fraud for misleading investors as the company's subprime mortgage
business was collapsing in 2006. At the time of the fraud, New
Century was one of the largest subprime lenders in the nation. The
complaint alleges the defendants provided false and misleading
information regarding the company's subprime mortgage business and
materially overstated the company's financial results by
improperly understating its expenses relating to repurchased
loans. In addition, the SEC's complaint alleges that New Century
failed to disclose material facts including dramatic increases in
early default rates, loan repurchases and pending loan repurchase
requests. Further, the complaint alleges New Century materially
overstated its second and third quarter financial results in 2006
by, among other things, overstating pre-tax earnings in the second
quarter by 165 percent, while improperly reporting third quarter
pre-tax earnings as a $90 million profit instead of an $18 million
loss. The litigation is pending.
The
SEC also is reviewing the practices of investment banks and others
that purchased and securitized pools of subprime mortgages.
In addition, we are looking at the resecuritized CDO market with a
focus on products structured and marketed in late 2006 and early
2007 as the U.S. housing market was beginning to show signs of
distress. In particular, we are seeking to determine whether
investors were provided accurate, relevant and necessary
information, or misled in some manner.
Regulators Must Remain Vigilant Against
Fraud. The SEC also has investigated and brought cases
relating to sales practices used by financial professionals buying
or selling complex mortgage-related securities products.
Credit
Suisse. On September 3, 2008, the SEC charged two Wall Street
brokers with allegedly defrauding their customers when making more
than $1 billion in unauthorized purchases of subprime-related
auction rate securities. The SEC's complaint alleges, among other
things, that the defendants misled customers into believing that
auction rate securities being purchased in their accounts were
backed by federally guaranteed student loans and were a safe and
liquid alternative to bank deposits or money market funds.
Instead, the securities that the defendants purchased for their
customers were backed by subprime mortgages, CDOs, and other
non-student loan collateral. The litigation is pending.
Bear Stearns. On June 19, 2008, the
SEC charged two former Bear Stearns Asset Management (BSAM)
portfolio managers for allegedly fraudulently misleading investors
about the financial state of the firm's two largest hedge funds
and their exposure to subprime mortgage-backed securities before
the collapse of the funds in June 2007. The SEC's complaint
alleges that the hedge funds took increasing hits to the value of
their portfolios during the first five months of 2007 and faced
escalating redemptions and margin calls. The complaint further
alleges that, at that point, the two then-BSAM senior managing
directors deceived their investors and certain institutional
counterparties about the funds' growing troubles until the funds
collapsed and caused investor losses of approximately $1.8
billion. In a related criminal action, the defendants were
acquitted of criminal charges. Our civil case, however, has a
different burden of proof and different charges. That litigation
is pending and we expect to go forward.
Brookstreet Securities Corp. On both
May 28 and December 8, 2009, the SEC brought cases involving
Brookstreet Securities Corp., a registered but now defunct
broker-dealer, in connection with sales of allegedly unsuitable
Collateralized Mortgage Obligations (CMOs) to retail customers. In
the December action, the SEC sued Brookstreet and its former
President and CEO, alleging that from 2004 to mid-2007, the
President and CEO helped create, promote, and facilitate a CMO
investment program through which Brookstreet improperly sold
risky, illiquid CMOs to retail customers (including retirees and
retirement accounts) with conservative investment goals. More than
1,000 Brookstreet customers invested approximately $300 million
through the CMO program. Earlier, in the May action, the SEC sued
ten registered representatives of the firm for allegedly making
false statements when marketing the CMOs, receiving $18 million in
commissions related to the investments and causing customer losses
of over $36 million. The litigation is pending.
Consistent Accounting Practices are
Essential to Investor Confidence and Fair Competition. A
key lesson of the financial crisis is that
investor information and confidence is critical to well
functioning markets. Investors must have transparent, unbiased and
comparable information about the companies and funds in which they
choose to invest. Providing investors with this information
assists them in allocating capital to its most efficient use and
is essential to the health of our capital markets. High quality,
consistent accounting standards provide the framework for
investors to make the comparisons of investment opportunities and
perform the analysis necessary to make informed investment
decisions.
Our investigations have revealed possible
failures of public companies and funds to disclose the fair value
of toxic assets and potentially false or misleading disclosures to
investors and purchasers of structured products, including
mortgage-backed securities and CDOs, which have some form of
mortgage as the underlying asset.
Beazer Homes. On July
1, 2009, the SEC charged the former Chief Accounting Officer of
Beazer Homes, a homebuilder with operations in at least twenty-one
states, with allegedly conducting a multi-year fraudulent earnings
management scheme and misleading Beazer's outside and internal
auditors to conceal his fraud. That litigation is pending.
Previously, on September 24, 2008, the SEC issued an order finding
that Beazer Homes, among other things, decreased reported net
income through improper reserves during a period of strong growth
from approximately 2000 to 2005. Then, as Beazer's financial
performance began to decline in 2006, along with the housing
market, Beazer reversed the improper reserves and increased its
net income. The SEC ordered Beazer to cease and desist from
committing or causing fraud and other violations.
Evergreen Investment Management Co.
On June 8, 2009, the SEC charged registered investment adviser
Evergreen Investment Management Company, LLC, and an affiliate,
with allegedly overstating the value of a mutual fund that
invested primarily in mortgage-backed securities. The SEC also
alleged the defendants selectively disclosed problems with the
fund to favored investors, allowing those investors to sell
earlier than other investors and avoid losses. The adviser and its
affiliate settled with the SEC, without admitting or denying the
SEC's findings, by agreeing to pay $3 million in disgorgement and
prejudgment interest and a total civil penalty of $4 million, as
well as make an additional payment of $33 million to compensate
shareholders.
As noted above, the SEC is conducting
investigations involving mortgage lenders, investment banks,
broker-dealers, credit rating agencies and others that relate to
the financial crisis. We will continue to look hard at those that
may have caused or profited from the financial crisis and bring
cases as appropriate.
Enforcement
Agencies Should Continue to Work Together to Address Financial
Crimes. Large financial crimes can often involve multiple
jurisdictions and legal frameworks making it essential for
different agencies to work closely together.
Financial Fraud Enforcement Task Force (Task
Force). To maximize the efficient use of limited resources,
as well as to present a unified and coordinated response to
securities laws violators, the SEC is
enhancing its historically close working relationship with other
law enforcement authorities, including the Department of Justice
(DOJ).
On November 17, 2009, as part of the effort to better
combat financial crime and mount a more organized, collaborative,
and effective response to the financial crisis, the SEC joined the
DOJ, the U.S. Department of the Treasury, and the U.S. Department
of Housing and Urban Development in announcing the President's
establishment of a Financial Fraud Enforcement Task Force.
The Task Force leadership, along with representatives
from a broad range of federal agencies, regulatory authorities,
and inspectors general, will work with state and local authorities
to investigate and prosecute significant financial crimes, ensure
just and effective sanctions against those who perpetrate
financial crimes, address discrimination in the lending and
financial markets, and recover proceeds of financial crimes for
victims.
The Task Force will build upon
efforts already underway to combat mortgage, securities, and
corporate fraud by increasing coordination and fully utilizing the
resources and expertise of the government's law enforcement and
financial regulatory organizations.
Special Inspector General for TARP.
The SEC also has worked closely with the Office of the Special
Inspector General for the Troubled Asset Relief Program (SIGTARP).
For example, in early 2009, the SEC brought an enforcement action
against a Ponzi scheme operator in Tennessee, with assistance from
SIGTARP. In addition, we are currently working with SIGTARP staff
and criminal prosecutors on a number of important investigations.
We have also been an active participant on the TALF/PPIP task
force which has been working diligently to develop strategies to
prevent fraud and abuse in those important programs. Among other
things, we have used our expertise regarding structured products
and other complex securities, as well as hedge funds and other
market participants, to provide training programs for other
participants on the Task Force, including FBI agents, postal
inspectors and other law enforcement personnel.
Internal Changes Can Strengthen and Speed
Enforcement. To improve our enforcement efforts, the SEC is
implementing several initiatives that will make us more
knowledgeable, better coordinated, and more efficient in attacking
the causes of the recent financial crisis. These initiatives also
will better arm us to address current and future market practices
that may be of concern. Highlights of the
current changes include:
Specialization. We
are creating five new national specialized investigative groups
that will be dedicated to high-priority areas of enforcement,
including Asset Management (including hedge funds and investment
advisers), Market Abuse (large-scale insider trading and market
manipulation), Structured and New Products (including various
derivative products), Foreign Corrupt Practices Act cases, and
Municipal Securities and "Pay-to-Play" issues.
Management Restructuring. The
Division is adopting a flatter, more streamlined organizational
structure eliminating an entire layer of middle management;
redeploying staff who were first line managers to the
mission-critical work of conducting front-line investigations.
Streamlining. To facilitate
timely investigations, the agency is streamlining internal
processes and procedures by, among other things, delegating to
senior officers the authority to initiate the issuance of
subpoenas for documents and testimony.
Office of Market Intelligence. We are
creating an Office of Market Intelligence to improve the
Enforcement Division's handling of tips and complaints. This new
office dovetails with the agency-wide effort to revamp the way in
which the SEC handles the large number of letters, emails and
complaints it receives each year. This office will be a key part
of the agency's efforts to collect, analyze, triage, refer and
monitor the information the agency receives. The office also will
draw on the expertise of the agency's various offices to help
analyze the tips and identify wrongdoing while greatly increasing
our communication with other divisions and offices about how to
respond to tips and complaints.
Other
Initiatives. In addition, the agency is enhancing training
and supervision and developing tools to encourage cooperation from
company insiders that will enable the agency to build stronger
cases and file them sooner than would otherwise be possible.
Finally,
the SEC has advocated several
legislative measures to improve its ability to protect investors
and deter wrongdoing.
For example, we have recommended
whistleblower legislation that would provide substantial rewards
for tips from persons with unique, high-quality information about
securities law violations.
We expect this program to
generate significant information that we would not otherwise
receive from persons with direct knowledge of serious securities
law violations.
This legislation, along with our
cooperation initiatives, would increase incentives for persons to
share information quickly while expanding protections against
retaliatory behavior.
III. REGULATION OF COMPLEX
FINANCIAL INSTITUTIONS
Consolidated Supervision
Between 2004 and 2008, the SEC was recognized as the
consolidated supervisor for the five large independent investment
banks under its Consolidated Supervised Entity or "CSE" program.
The CSE program was created as a
way for US global investment banks that lacked a consolidated
holding company supervisor to voluntarily submit to consolidated
regulation by the SEC.
In connection with the
establishment of the CSE program, the largest US broker-dealer
subsidiaries of these entities were permitted to utilize an
alternate net capital computation (ANC).
Other large broker-dealers,
whose holding companies are subject to consolidated supervision by
banking authorities, were also permitted to use this ANC approach.
Under the CSE regime, the holding
company had to provide the Commission with information
concerning its activities and exposures on a consolidated basis;
submit its non-regulated affiliates to SEC examinations; compute
on a monthly basis, risk-based consolidated holding company
capital in general accordance with the Basel
Capital Accord, an internationally recognized method for
computing regulatory capital at the holding company level; and
provide the Commission with additional information regarding its
capital and risk exposures, including market, credit and liquidity
risks.
It is important to note that prior to the CSE
regime, the SEC had no jurisdiction to regulate these holding
companies. Accordingly, these holding companies previously had not
been subject to any consolidated capital requirements. This
program was viewed as an effort to fill a significant gap in the
US regulatory structure.
During the financial crisis
many of these institutions lacked sufficient
liquidity to operate effectively. During 2008, these CSE
institutions failed, were acquired, or converted to bank holding
companies which enabled them to access government support. The CSE
program was discontinued in September 2008. Some of the lessons
learned are as follows:
Capital
Adequacy Rules Were Flawed and Assumptions Regarding
Liquidity Risk Proved Overly Optimistic. The applicable Basel
capital adequacy standards depended heavily on the models
developed by the financial institutions themselves. All models
depend on assumptions.
Assumptions about such
matters as correlations, volatility, and market behavior developed
during the years before the financial crisis were not necessarily
applicable for the market conditions leading up to the crisis, nor
during the crisis itself.
The capital adequacy rules did
not sufficiently consider the possibility or impact of modeling
failures or the limits of such models. Indeed, regulators
worldwide are reconsidering how to address such issues in the
context of strengthening the Basel regime.
Going forward, risk managers and regulators
must recognize the inherent limitations of these (and any) models
and assumptions — and regularly challenge models and their
underlying assumptions to consider more fully low probability,
extreme events.
While capital adequacy is important,
it was the related, but distinct, matter of liquidity that proved
especially troublesome with respect to CSE holding companies.
Prior to the crisis, the SEC recognized that liquidity and
liquidity risk management were critically important for investment
banks because of their reliance on private sources of short-term
funding.
To address these liquidity
concerns, the SEC imposed two requirements:
First,
a CSE holding
company was expected to maintain funding procedures designed to
ensure that it had sufficient liquidity to withstand the complete
loss of all short term sources of unsecured funding for at least
one year. In addition, with respect to secured funding, these
procedures incorporated a stress test that estimated what a
prudent lender would lend on an asset under stressed market
conditions (a "haircut").
Second, each CSE holding
company was expected to maintain a substantial "liquidity pool"
that was composed of unencumbered highly liquid and creditworthy
assets that could be used by the holding company or moved to any
subsidiary experiencing financial stress.
The SEC assumed
that these institutions, even in stressed
environments, would continue to be able to finance their
high-quality assets in the secured funding markets (albeit
perhaps on less favorable terms than normal). In times of stress,
if the business were sound, there might be a number of possible
outcomes: For example, the firm might simply suffer a loss in
capital or profitability, receive new investment injections, or be
acquired by another firm. If not, the sale of high quality assets
would at least slow the path to bankruptcy or allow for
self-liquidation.
As we now know,
these assumptions proved much too optimistic. Some assets
that were considered liquid prior to the crisis proved not to be
so under duress, hampering their ability to be financed in the
repo markets. Moreover, during the height of the crisis, it was
very difficult for some firms to obtain secured funding even when
using assets that had been considered highly liquid.
Thus,
the financial institutions, the Basel
regime, and the CSE regulatory approach did not sufficiently
recognize the willingness of counterparties to simply stop doing
business with well-capitalized institutions or to refuse to lend
to CSE holding companies even against high-quality collateral.
Runs could sometimes be stopped only with significant
government intervention, such as through institutions agreeing to
become bank holding companies and obtaining access to government
liquidity facilities or through other forms of support.
Consolidated Supervision is Necessary but
Not a Panacea. Although large interconnected institutions
should be supervised on a consolidated basis, policymakers should
remain aware of the limits of such oversight and regulation. This
is particularly the case for institutions with many subsidiaries
engaging in different, often un-regulated, businesses in multiple
countries.
Before the crisis, there were many different
types of large interconnected institutions subject to consolidated
supervision by different regulators. During the crisis, many
consolidated supervisors, including the SEC, saw large
interconnected, supervised entities seek government liquidity or
direct assistance.
Systemic Risk
Management Requires Meaningful Functional Regulation, Active
Enforcement & Transparent Markets. While a consolidated
regulator of large interconnected firms is an essential component
to identifying and addressing systemic risk, a number of other
tools must also be employed. These include more effective capital
requirements, strong enforcement, functional regulation, and
transparent markets that enable investors and other counterparties
to better understand the risks associated with particular
investment decisions. Given the complexity of modern financial
institutions, it is essential to have strong, consistent
functional regulation of individual types of institutions, along
with a broader view of the risks building within the financial
system.
Broker Dealer Regulation
Regulators Should Constantly Review and Update Their Tools and
Approaches to Regulation. The Commission is the functional
regulator of U.S. registered broker-dealers and promulgates and
administers financial responsibility rules for broker-dealers.
These include the net capital rule, customer protection rule,
books and records rules, reporting requirements, and early warning
rule for broker-dealers regarding their capital levels.
Under the broker-dealer net capital rule, U.S. registered
broker-dealers are required to deduct the full value of securities
positions that do not have a ready market. Proprietary securities
positions that do have a ready market are subject to either
prescribed haircuts, or in the case of broker-dealers using the
ANC approach, subject to market risk charges calculated under the
firm's mathematical models. Based on the experiences of the past
two years — which included the failure or conversion of the CSE
firms into bank holding companies — the SEC has undertaken a
number of steps to improve its oversight of broker-dealers and
further minimize the risks in these entities.
Enhancing Reporting Requirements.
Since 2008, broker-dealers with significant proprietary positions
now report more detailed breakdown of their proprietary positions.
The primary purpose for this enhanced reporting is to receive
better information on the amount of less liquid positions held by
these broker-dealers. This reporting also provides aggregate
dollar amount of sales for these less liquid positions so that any
further decrease or increase in the liquidity of these markets can
be ascertained.
Additionally, as part of the enhanced
broker-dealer oversight program for large broker-dealers using the
ANC calculation, the SEC now obtains and reviews on a regular
basis more detailed reporting regarding balance sheet composition
to monitor for the build-up of positions in particular asset
classes. This reporting supplements the above and is intended to
be more forward-looking by highlighting concentrations as they
build.
Increasing Capital
Requirements. As part of its oversight, in December 2009,
Commission staff informed the ANC broker-dealers that they will
require that these broker-dealers take standardized net capital
charges on less liquid mortgage and other asset-backed securities
positions rather than using financial models to calculate net
capital requirements. In addition to increasing the capital
required to be held for these positions, this approach will reduce
reliance on Value-at-Risk models. Staff has been reviewing these
requirements and may recommend additional regulatory capital
charges to address liquidity risk.
The Basel Committee presently is revising its approach to
calculating capital requirements to increase charges for market
risk. These standards are expected to address the concentration,
liquidity and leverage concerns that arose in the recent financial
crisis. Once the revised approach is finalized, the SEC will
review those changes to ensure that the market risk charges
applicable to the ANC broker-dealers are at least as stringent as
the Basel market risk charges.
Task Force Review of
Broker-Dealer Regulation. In November 2009, the SEC established a
task force led by its newly-established Division of Risk,
Strategy, and Financial Innovation that will review key aspects of
the agency's financial regulation of broker-dealers to determine
how such regulation can be strengthened.
IV. REGULATION OF FINANCIAL PRODUCTS
Money Market Funds
Money Market Funds Are Not Risk-Free and
Can Be Subject to Runs. As discussed above, in the wake of
the Lehman Brothers bankruptcy in September 2008, the net asset
value of the Reserve Primary Fund, a money market fund, fell below
$1.00 a share, or "broke the buck." At the time of the
announcement of the Lehman Brothers bankruptcy, the Reserve
Primary Fund held 1.2 percent of its assets in commercial paper
issued by Lehman Brothers.
This event, combined with the
general paralysis of the short-term credit markets and a concern
that other financial institutions might fail, revealed the
potential of money market funds to be subject to runs, i.e.,
broad-based and large-scale requests for redemptions that
challenge money market funds' ability to return proceeds at the
anticipated $1.00 value.
This event also revealed the
general lack of appreciation by many investors that money market
funds could return less than the $1.00 per share originally
invested. In addition, the demise of the Reserve Primary Fund and
the money market fund run that followed highlighted the benefit of
halting redemptions once a money market fund has broken the buck.
It also revealed the importance of providing an orderly wind-down
of the fund's operations in order to preserve shareholder value
and avoid a larger contagion in the short term credit markets.
The run on money market funds during the week of September 15,
2008 was stemmed in part by the announcement of the
Treasury Temporary Guarantee Program
for Money Market Funds, which provided a guarantee to money market
fund investors up to the amount of assets they held in any money
market fund as of September 19, 2008. On the same date, the
Federal Reserve Board announced the creation of the Asset-backed
Commercial Paper Money Market Mutual Fund Liquidity Facility
(AMLF). This program also helped to create liquidity and stem the
run on money market funds by extending credit to U.S. banks and
bank holding companies to finance their purchases of high-quality
asset backed commercial paper from money market funds. The
Treasury Temporary Guarantee Program expired on September 18,
2009, and the AMLF is set to expire on February 1, 2010.
The SEC has taken a number of steps to
reduce the risks posed by another money market fund run.
Halting Redemptions from the Reserve
Funds. Following the breaking of the buck by the Reserve
Primary Fund, the SEC issued an order halting redemptions by that
fund as well as other funds within the Reserve family of funds.
This action reduced the need for Reserve Fund management to "dump"
its assets into an already de-stabilized market. It also enabled
the funds in the Reserve fund family to liquidate in an orderly
manner, without causing additional money market fund runs.
Strengthening Money Market Fund
Requirements. In June 2009, the SEC proposed rule
amendments to significantly strengthen the risk-limiting
conditions of our money market fund rules. In particular, the SEC
proposed rules to tighten the credit quality and maturity
requirements for money market funds. In addition, the SEC for the
first time proposed liquidity standards for money market funds
that would mandate that these funds meet both daily and weekly
liquidity requirements.
The rules also would:
require periodic stress
testing of money market fund portfolios to identify potential
problems;
require monthly disclosure of portfolio
information and periodic disclosure of more specific net asset
value information; and
permit funds to halt redemptions if
a money market fund "breaks the buck" in order to stem the
motivation for runs.
Our proposal also requested
comment on a number of other areas relating to the fundamental
structure and disclosure requirements of money market funds,
including whether funds should disclose their daily mark-to-market
net asset value (NAV) (in addition to their $1.00 price); whether
to mandate redemptions-in-kind in times of financial crisis to
reduce run risk; and whether money market funds should have
floating NAVs instead of the current stable $1.00 NAV.
Going forward, we expect to consider adoption of our first set of
money market fund reforms in early 2010, with consideration of
more fundamental changes to the structure of money market funds to
follow. In addition, the SEC has been working closely with the
Federal Reserve Board and President's Working Group on Financial
Markets (PWG) on a report assessing possible changes to further
reduce the money market fund industry's susceptibility to runs.
The SEC will continue to work with the PWG to chart a course
toward further reducing the vulnerabilities of money market funds
to runs while preserving the benefits they provide participants in
the short-term markets.
Asset-Backed Securities
Securitization Requirements Must Be
Strengthened. The financial crisis revealed a number of
gaps in the asset-backed securities (ABS) market. As a result,
staff is broadly reviewing our regulation of ABS including
disclosures, offering process, and reporting of asset-backed
issuers, and is considering several proposed changes designed to
enhance investor protection in this vital part of the market. I
believe changes are critical to facilitating capital formation in
this market, which played a central role in the crisis and has
suffered significant erosion in investor confidence. These
proposals should come before the Commission shortly, which if
approved, would then be subject to public comment.
The
proposals the staff are working on are being designed to address
issues that contributed to or arose from the financial crises —
including a lack of timely information sufficient to enable
investors to adequately assess the investment opportunity. I
anticipate the proposals will include a number of important
disclosure requirements as well as qualitative revisions to the
eligibility standards for "shelf" offerings and an elimination of
the use of credit ratings as an eligibility standard for shelf.
The proposals are also being designed to be
forward looking: to improve areas that may not yet have
caused serious problems, but have the potential to raise issues
similar to the ones highlighted in the financial crisis.
IV. TRANSPARENCY & INVESTOR INFORMATION
Credit Ratings
Too Many Investors and Regulators
Over-Relied on Credit Ratings, Especially for Complicated
Financial Products. Investors have long considered ratings when
evaluating whether to purchase or sell a particular security.
Many investors, however, did not appear to appreciate the risks of
structured financial products and instead relied almost
exclusively on the credit ratings of the securities when making
investment decisions. Market participants, regulators and their
risk models also made assumptions based on credit ratings that
proved incorrect. For example, many regulators — including the SEC
— assumed that AAA-rated securities would remain liquid. Such
reliance was mistaken.
Poor
performance by highly rated securities resulted in
substantial investor losses and market turmoil. One of the reasons
for the poor performance of mortgage related securities was the
relationship between the securitization of mortgages and the
underwriting standards on loan originations. The more loans became
securitized — and the more investors and credit rating agencies
became comfortable with their performance — the more they
purchased and the more underwriting standards deteriorated. This
culminated in the credit rating agencies providing high ratings to
structured products based on very low quality mortgages, which
investors then purchased.
In response to this aspect of the
crisis, the Commission has undertaken to improve ratings quality
by fostering accountability, transparency, and competition in the
credit rating industry.
In February 2009, the Commission
adopted amendments to its rules for
Nationally Recognized Statistical Ratings Organizations (NRSRO).
The amended rules require NRSROs to make additional public
disclosures about their methodologies for determining structured
finance ratings, to publicly disclose the histories of their
ratings, and to make additional internal records and furnish
additional information to the Commission in order to assist staff
examinations of NRSROs. The amendments also prohibited 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.
Last
fall, the Commission adopted further amendments with respect to
the disclosure of ratings histories. In this most recent NRSRO
rulemaking, the Commission adopted new rules that
(1) require a broader disclosure of credit ratings
history information, such as the initial rating and any actions
subsequently taken including, downgrades, upgrades, affirmations
and placements on watch; and
(2) create a mechanism for NRSROs not hired to rate
structured finance products to nonetheless determine and monitor
credit ratings for these instruments.
This would help investors by providing a greater
diversity of ratings and could help foster new NRSRO entrants by
enabling upstarts to build credibility.
The SEC also
proposed the following:
Amendments to the NRSRO application process to
require a credit rating agency applying to be registered as an
NRSRO or an NRSRO providing its annual update to Form NRSRO to
publicly disclose the percentage of (1) net revenue attributable
to the 20 largest users of its credit rating services; and (2)
revenue attributable to its other services and products.
A
new rule that would annually require NRSROs to make publicly
available on their websites a consolidated report of information
regarding each person that paid the NRSRO to issue or maintain a
credit rating, including: (1) the percent of the net revenue
earned by the NRSRO attributable to the person for services and
products other than credit rating services; (2) the relative
standing of the person in terms of the contribution to the net
revenue of the NRSRO for the fiscal year as compared with other
persons who provided the NRSRO with net revenue; and (3) all
outstanding credit ratings paid for by the person.
Requiring disclosure by registrants of information regarding
credit ratings if a credit rating is used in connection with a
registered offering so that investors will better understand a
credit rating and its limitations;
Requiring
disclosure of preliminary credit ratings in
certain circumstances so that investors have enhanced information
about the credit ratings process — including whether there was
"ratings shopping" — that may bear on the quality or reliability
of the rating;
Amendments to the NRSRO application
process to require public disclosure of the percentage of (1) net
revenue attributable to the 20 largest users of its credit rating
services; and (2) revenue attributable to its other services and
products; and
Requiring an NRSRO to furnish the Commission
with an additional unaudited report containing a description of
the steps taken by the firm's designated compliance officer during
the fiscal year to administer the policies and procedures that are
required to be established pursuant the Exchange Act.
Rule 436(g) and Experts Liability. To
address concerns about the accountability of rating agencies and
whether lack of accountability may have negatively impacted the
quality of ratings, the SEC has published for comment a concept
release asking whether NRSROs should continue to be exempted from
"experts" liability under the Securities Act for ratings used by
issuers and other offering participants to market securities
issued in registered offerings. Under Rule 436(g), NRSROs whose
ratings are used to market securities are exempt from liability as
"experts" under the Securities Act, even though investors may rely
on the ratings in making investment decisions in a manner similar
to their reliance on reports or opinions of others who are subject
to experts' liability when their reports or opinions are used to
market securities, such as accountants, property appraisers,
lawyers and engineers. Through the concept release, the SEC is
seeking public views on whether Rule 436(g) should be repealed to
increase the accountability of rating agencies and further
investor protection.
These initial reforms are designed to
promote increased competition in the credit
rating industry and to provide investors with the data with
which to compare the credit rating performance of different
NRSROs. These reforms also will give investors greater insight
into a part of the capital markets that has long been opaque,
fostering greater transparency and accountability among NRSROs by
making it easier for persons to analyze the actual performance of
credit ratings. Further, these rules will give investors greater
ability to account for potential conflicts, allowing them to
better calibrate the degree of reliance that should be placed upon
ratings. Finally, the SEC also is working closely with Congress as
it considers important legislation on the topic.
Policymakers Should Consider the Constraints and Tradeoffs
Associated with Programs that Involve "Voluntary" Oversight and
Regulation. Voluntary oversight programs have a number of
benefits.
They (1) enable some level of supervision where there
might otherwise be none and (2) provide an opportunity to test
particular policy approaches before making them mandatory. These
programs, however, also have substantial downside risks
policymakers should recognize, including:
Limited Rulemaking
Authority. Because participants in these programs can
freely opt-out, regulators can find themselves choosing between
imposing important rules on few, if any, entities, or imposing
weaker rules on the group. This tension can sometimes result in
regulators negotiating key elements of important rules rather than
imposing them; and
Overreliance by
Third-Parties. Once regulation exists, even if only
voluntary, there is a risk that investors, market participants or
others might change their behavior based on the belief that the
new regulation provides more safety than it does.
Taken
together there is a real risk that voluntary oversight programs
can lead to investor and counterparty reliance on a regulatory
regime especially ill-equipped to meet such expectations.
Compensation
Short-term Compensation Incentives Can Drive
Long-Term Risk. Another lesson learned from the crisis is that
there can be a direct relationship between compensation
arrangements and corporate risk taking. Many major financial
institutions created asymmetric compensation packages that paid
employees enormous sums for short-term success, even if these same
decisions result in significant long-term losses or failure for
investors and taxpayers.
In December,
the SEC adopted rule amendments that will
significantly improve disclosure in the key areas of risk,
compensation, corporate governance and director qualifications.
The new rules require companies
to disclose their compensation policies and practices for all
employees (not just executives) if these policies and practices
create risks that are reasonably likely to have a material adverse
effect on the company.
In considering whether a
company's compensation programs create these risks, we expect that
companies will carefully examine their compensation practices and
how they may incentivize risk, which should enable companies and
their boards to more appropriately calibrate risks and rewards.
The new rules also
expand the disclosure
provided to shareholders about the governance structure, the
background and qualifications of directors and director nominees,
and require disclosure of information about the board's structure
and its role in managing risk.
This increased transparency
should increase accountability and directly benefit investors.
In addition, the adopted rules require disclosure about the
fees paid to compensation consultants and their affiliates for
certain additional services. This is intended to provide investors
with information to help them better assess the potential
conflicts of interest a compensation consultant may have in
recommending executive compensation.
Corporate Governance
Management and Boards of Directors
Should be More Accountable. The quality of a board's
oversight of risk management — traditionally viewed as just a
compliance cost — can make an enormous difference in our economy,
and particularly in financial markets.
A fundamental concept underlying corporate
law is that a company's board of directors, while charged with
oversight of the company, is accountable to its shareholders, who
in turn have the power to elect the board.
Thus, boards are accountable to
shareholders for their decisions concerning, among other things,
executive pay, and for their oversight of the companies'
management and operations, including the risks that companies
undertake.
Enhanced disclosure about the
decisions and performance of directors will help shareholders make
informed decisions about the election of directors.
Another tool available to shareholders to hold boards accountable
is the right of shareholders under state corporate law to nominate
candidates for a company's board of directors.
However, shareholders often lack
the resources to effectively run a proxy contest to have their
nominees elected and unseat existing board members. As a result,
over several decades, the Commission has repeatedly considered a
requirement that public companies allow shareholders to list their
nominees for director in the companies' proxy statements and place
their nominees on the companies' proxy ballots.
The
Commission's proxy rules seek to enable the corporate proxy
process to function, as nearly as possible, as a replacement for
in-person participation at a meeting of shareholders. With the
wide dispersion of stock prevalent in today's markets, requiring
actual in-person participation at a shareholders' meeting is not a
feasible way for most shareholders to exercise their rights —
including their rights to nominate and elect directors. Yet those
very proxy rules may place unnecessary burdens on this right, at
the expense of the board's accountability to shareholders. Absent
an effective way for shareholders to exercise their right to
nominate and elect directors, the election of directors can become
a self-sustaining process with little actual input from
shareholders.
In May 2009, the Commission voted to approve
for comment proposals that are designed to facilitate the
effective exercise of the rights of shareholders to nominate
directors. These proposals go to the heart of good corporate
governance.
Under the proposals, shareholders who satisfy
certain eligibility and procedural requirements would be able to
have a limited number of nominees included in the company proxy
materials that are sent to all shareholders whose votes are being
solicited. To be eligible to have a nominee or nominees included
in a company's proxy materials, a shareholder would have to meet
certain security ownership requirements and other specified
criteria, provide certifications about the shareholder's intent,
and file a notice with the Commission of its intent to nominate a
candidate. The notice would include specified disclosure about the
nominating shareholder and the nominee for inclusion in the
company's proxy materials. This aspect of the proposals is
designed to provide important information to all shareholders
about qualifying shareholder board nominees so that shareholders
can make a more informed voting decision.
To
further facilitate shareholder involvement
in the director nomination process, the proposals also
include amendments to Rule 14a-8 under the Exchange Act. That rule
currently allows a company to exclude from its proxy materials a
shareholder proposal that relates to a nomination or an election
for membership on the company's board of directors or a procedure
for such nomination or election. This so-called "election
exclusion" can prevent a shareholder from including in a company's
proxy materials a shareholder proposal that would amend, or that
requests an amendment to, a company's governing documents
regarding nomination procedures or disclosures related to
shareholder nominations. Under the proposed amendment to the
shareholder proposal rule, companies would be required to include
such proposals in their proxy materials, provided the other
requirements of the rule are met.
If adopted, these new
rules would afford shareholders a stronger voice in determining
who will oversee management of the companies that they own.
Strengthening the ability of shareholders to hold boards of
directors accountable to them — including for their oversight of
compensation and risk management — should further empower
shareholders and help to restore investor trust in our markets.
The Commission recently reopened the comment period on the
proposals to seek views on additional data and related analyses
received at or after the close of the original public comment
period. The comment process is a critical component of every
rulemaking, and one that the Commission takes very seriously. I
remain committed to bringing final rules in this area to the full
Commission for consideration early this year.
V. MARKET REGULATION
Markets and Market Regulation Should Promote
Long-Term Investor Confidence, Not Undermine It. There has
been unease, especially since the financial crisis, that markets
designed to enable and encourage investor participation are being
stacked against investors. Investor protection and the confidence
are essential to the efficient flow of capital and the long-term
success of financial markets and the economy. The roots of any
deficiencies in market structure must be addressed head on.
Accordingly, the SEC has taken — and will continue to take — a
fresh look at market structure and trading activities to ensure
that they foster fair, orderly, and efficient markets that are
designed to protect investors. In particular, the Commission will
examine the following issues:
Market Access. The
Commission is considering a proposal to prohibit unfiltered, or
"naked," access to exchanges and alternative trading systems. The
practice permits a customer to directly access the markets using a
broker-dealer's market participant identifier without the
imposition of effective pre-trade risk management controls.
Broker-dealers perform vital gatekeeper functions that are
essential to maintaining the integrity of the markets. Effective
risk management controls for market access are necessary to
protect the broker-dealer, the markets, the financial system, and
ultimately investors.
Large Trader
Reporting System/High Frequency Trading. In the near
future, I also anticipate that the Commission will seek to
implement the Commission's authority under Section 13(h) of the
Exchange Act (which was adopted as part of the Market Reform Act
of 1990) to create a large trader reporting system. A large trader
reporting proposal would not only enhance the Commission's ability
to identify large traders and their affiliates, but also would
provide the Commission with greater ability to gather current
trading information to evaluate the activity of large traders,
particularly during periods of market volatility.
Dark Pools. In October 2009, the
Commission proposed changes to its rules to address concerns about
non-public trading interest in U.S. listed stocks, including
"dark" pools of liquidity. The proposal would increase the
transparency of dark pools by requiring the public display of
actionable indications of interest (IOIs) subject to certain
exemptions applicable to large orders that promote size discovery.
These IOIs are today privately transmitted by dark pools and other
trading venues to selected market participants. The proposal would
also expand the display obligations of alternative trading systems
by lowering the stock trading volume threshold for displaying
best-priced orders from 5% to 0.25%.
Flash Orders. In September 2009, the Commission proposed a
rule amendment that would ban marketable flash orders. A flash
order enables a person who has not publicly displayed a quote to
see orders less than a second before the public is given an
opportunity to trade with those orders. That momentary head-start
in the trading arena could produce inequities in the markets and
create disincentives to display quotes.
Specifically, I am
concerned that, in today's highly automated trading environment,
the flashing of order information outside of the consolidated
quotation data could lead to a two-tiered market in which the
public does not have fair access to information about the best
available prices for a security that is available to some market
participants. In addition, flash orders may detract from the
incentives for market participants to display their trading
interest publicly and harm quote competition among markets.
Short Selling. The issue of short
selling is a matter that the SEC has grappled with for many years.
Beginning in 1938, markets were subject to a short sale price test
restriction known as the 'uptick rule' (former Exchange Act Rule
10a-1) which generally permitted short sales only at the last sale
price after an uptick in the stock's price or above the last sale
price. In 1994, the NASD (now FINRA) established a similar price
test based on the national best bid. In July 2007, after
considerable review, the Commission eliminated all short sale
price test restrictions thereby permitting short selling in any
environment. During the financial crisis, however, concerns led
the agency to issue a number of emergency orders related to short
selling, including a ban on short selling certain financial stocks
which was subsequently permitted to expire.
More recently,
the SEC has attempted to take a fresh look at short selling
through a robust and vigorous process. In particular, the
Commission is examining the following issues:
Fails to Deliver. In
July 2009, the Commission adopted a rule which requires that
"fails to deliver" in all equity securities be promptly closed
out. "Fails to deliver" may, among other things, be indicative of
potentially abusive "naked" short selling. "Naked" short selling,
which is not per se illegal, occurs when a short seller does not
borrow securities in time to make delivery. Sellers may
intentionally fail to deliver as part of a scheme to manipulate
the price of a security or possibly to avoid borrowing costs. Data
indicates that since the fall of 2008, fails to deliver in all
equity securities have declined by 63.4 percent, and fails to
deliver in securities with persistent and large levels of fails to
deliver have declined by 80.5 percent.
Short Sale Transparency. Beginning
August 2009, the SEC, together with several self-regulatory
organizations (SROs), substantially increased the public
availability of short sale-related information. This included
aggregate short selling volume in each individual equity security
for that day and publication on a one-month delayed basis of
information regarding individual short sale transactions in all
exchange-listed equity securities, excluding any identifying
information. In addition, the SEC began providing on its website
more timely "fails to deliver" data.
Short Sale Price Tests. In April 2009 the SEC sought public
comment on whether market wide short sale price restrictions or
circuit breaker restrictions should be imposed and whether such
measures would help restore investor confidence. It also made a
supplemental request in August to solicit additional feedback
regarding an alternative price test which would allow short
selling only at a price above the current national best bid. I
anticipate that the Commission will act next month on a final
rule.
SEC/CFTC Harmonization.
In June 2009, the White House released a White Paper on Financial
Regulatory Reform calling on the SEC and Commodity Futures Trading
Commission (CFTC) to "make recommendations to Congress for changes
to statutes and regulations that would harmonize regulation of
futures and securities." On October 16, 2009, the agencies issued
a report that included recommendations to enhance enforcement
powers, strengthen market and intermediary oversight and improve
operational coordination. The report represented another step
forward in our effort to reform the regulatory landscape to fill
regulatory gaps, eliminate inconsistent oversight, and promote
greater collaboration. These were contributing factors in the
financial crisis.
Facilitating the
Central Clearing of OTC Derivatives. Although limited in
its authority over OTC derivatives, beginning in late 2008, the
Commission, working with the Federal Reserve and the CFTC, issued
temporary orders to facilitate the establishment of several
central counterparties for clearing credit default swaps (CDS).
These exemptions were issued to speed the operation of central
clearing for CDS. They are temporary and subject to conditions
designed to ensure that important elements of Commission oversight
apply, such as recordkeeping and Commission staff access to
examine clearing facilities. In addition, to further the goal of
transparency, each clearing agency is required to make publicly
available on fair, reasonable, and not unreasonably discriminatory
terms, end-of-day settlement prices and any other pricing or
valuation information that it publishes or distributes.
The
SEC is committed to increasing investor protection and reducing
systemic risk by facilitating the development and oversight of
central counterparties to clear CDS. The actions we have taken
should further enhance opportunities to manage the risks related
to CDS and improve the transparency and integrity of the market
for these products.
VI. AGENCY CULTURE
Rethinking the Culture of Securities
Regulation. As discussed above, one theme that flows
through many of the causes and missed opportunities leading up to
the financial crisis, was the culture of financial regulation
itself. During the years leading up to the crisis many viewed
markets as almost always self-correcting. Similarly, many viewed
"deregulation" (particularly in financial services) as an
important part of fostering market growth and ensuring US
competitiveness.
Although a long-term effort, the SEC has
taken a number of steps to transform its culture and approach to
regulation so as to more appropriately calibrate the costs and
benefits of regulation with short-and-longer term risks. Among the
changes are new leadership within our Divisions, streamlining
within the Enforcement Division (as outlined above), significant
expansion of cross-divisional and multi-disciplinary teams, and
the establishment of the Division of Risk, Strategy, and Financial
Innovation in the fall of 2009.
With the establishment of
the new Division, the SEC has brought in a number of well-known
experts in financial innovation, risk management,
derivatives/structured products law, and modern capital market
transactions. The Division uses a multi-disciplinary approach that
integrates economic, financial, and legal disciplines. The
Division's responsibilities cover three broad areas: risk and
economic analysis; strategic research; and financial innovation;
but its impact is agency-wide.
VII.
GOING FORWARD
Although the SEC continues to review
its efforts and make improvements, there are a number of other
lessons that require statutory and other changes to fully make
effective.
Reducing Regulatory
Arbitrage
One central
mechanism for reducing systemic risk and avoiding future crises is
to ensure the same rules apply to economically-equivalent (or
otherwise substitutable) products and participants.
Financial participants now
compete globally, and at the level of micro-seconds and basis
points.
In such an environment, if
financial participants realize they can achieve the same economic
ends at lower costs by taking advantage of a regulatory gap, they
will do so quickly, often massively and with leverage.
We can do much to reduce
systemic risk if we close these gaps and ensure that similar
products are regulated similarly.
Too-Big-to-Fail Problem Should be Addressed.
One of most important regulatory arbitrage risks is the potential
perception that large interconnected financial institutions are
"too big to fail" and will therefore benefit from government
intervention in times of crisis. This perception can lead market
participants to favor large interconnected firms over smaller
firms of equivalent creditworthiness, fueling greater risk. To
address these issues, policymakers should consider the following:
Strengthen Regulation and Market
Transparency. Given the financial crisis and the
government's unprecedented response, it is clear that large,
interconnected firms present unique and additional risks to the
system. To address this issue, I agree with the effort to
establish a mechanism for macro-prudential oversight and
consolidated supervision of systemically important firms.
Moreover, to minimize the systemic risks posed by these
institutions, policymakers should consider using all regulatory
tools available — including supplemental capital, transparency and
activities restrictions — to reduce risks and ensure a level
playing field for large and small institutions.
Establish a Resolution Regime. In
times of crisis when a systemically important institution may be
teetering on the brink of failure, policymakers have to
immediately choose between two highly unappealing options: (1)
providing government assistance to a failing institution (or an
acquirer of a failing institution), thereby allowing markets to
continue functioning but creating moral hazard; or (2) not
providing government assistance but running the risk of market
collapses and greater costs in the future. Markets recognize this
dilemma and can fuel more systemic risk by "pricing in" the
possibility of a government backstop of large interconnected
institutions. This can give such institutions an advantage over
their smaller competitors and make them even larger and more
interconnected.
A credible resolution regime can help
address these risks by giving policy makers a third option: a
controlled unwinding of a large, interconnected institution over
time. Structured correctly, such a regime could force market
participants to realize the full costs of their decisions and help
reduce the "too-big-to-fail" dilemma. Structured poorly, such a
regime could strengthen market expectations of government support,
thereby fueling "too-big-to-fail" risks.
Over-the-Counter Derivatives Should be
Regulated. One very significant gap in the regulatory
structure is the inadequate regulation of OTC derivatives, which
were largely excluded from the regulatory framework in 2000 by the
Commodity Futures Modernization Act. Fixing this weakness is
vital, particularly in the current market environment.
The
OTC derivatives market has grown enormously since the 1980s to
approximately $450 trillion of outstanding notional amount in June
2009. This market presents a number of risks; including
systemic risk. OTC derivatives can facilitate significant
leverage, resulting in concentrations of risk and increased,
opaque interdependence among parties worldwide. Moreover, OTC
derivatives can behave unexpectedly in times of crisis — further
complicating risk management for financial institutions. The
uncertainty surrounding these products and the web of
interconnections created thereby can also affect the willingness
of regulators to allow its major dealers and participants to fail:
adding to the too-big-to-fail risks discussed above.
These
risks are heightened by the lack of regulatory oversight of
dealers and other participants in this market. The combination of
these factors can lead to inadequate capital and risk management
standards and associated failures that can cascade through the
global financial system.
Moreover, OTC derivatives markets
directly affect the regulated securities and futures markets by
serving as a less regulated alternative for engaging in
economically equivalent activity. An OTC
derivative is an incredibly versatile product that can essentially
be engineered to achieve almost any financial purpose. Any number
of OTC derivatives or strategies based on such derivatives can,
for instance, allow market participants to enjoy the benefits of
owning the shares of a company without having to purchase any
shares.
Regulatory arbitrage
possibilities abound when economically equivalent alternatives are
subject to different regulatory regimes. An individual market
participant may migrate to products subject to lighter regulatory
oversight. Accordingly OTC derivatives should be regulated
consistent with their underlying references. This will reduce
arbitrage and better ensure market integrity.
To
address these gaps and regulatory arbitrage dangers, legislation
should bring greater transparency and oversight to OTC derivative
products and major market participants and dealers. Also
counterparty risks can be reduced through such measures as
encouraging the standardization of products and requiring
centralized clearing. The existing regulatory chasm cannot be
allowed to continue.
Congress has made real progress in
this regard. As this process moves forward, however, we must
remain vigilant against even seemingly small exceptions, carve
outs and arbitrage opportunities that might create tomorrow's
risks.
For example, to prevent bad actors from hiding their
trading activities, the SEC needs the tools to effectively apply
the securities laws and police the securities-based derivatives
market. Right now, the SEC is responsible for enforcing the
anti-fraud provisions of the securities laws with respect to
security-based swaps, but lacks the ability to access information
about such transactions without first obtaining a subpoena.
Subpoenas work if the SEC knows about a transaction and is
actively investigating a possible fraud (such as insider trading),
but denying direct access undermines the agency's ability to
identify frauds like insider trading in the first place.
That is why security-based swaps should be subject to at least all
the oversight and transparency that would apply to any other
over-the-counter security, such as an OTC option. This would
ensure that the SEC has the ability to inspect and examine all
relevant market participants — including swap dealers, central
counterparties, trading venues, and swap repositories. Enforcement
staff must have quick access to comprehensive, real-time data on
securities-related OTC derivatives — so that fraudsters cannot
exploit this gap and use securities-based derivatives to engage in
insider trading or market manipulation.
Private Fund Managers Should be Included
Within the Regulatory Framework. Another significant
regulatory gap involves hedge funds and other private pools of
capital, such as private equity funds, venture capital funds and
their advisers that structure their operations to avoid oversight
and regulation by the SEC.
Consequently, private funds and many of
their advisers currently are outside the purview of the SEC and
other regulatory authorities, and we have no detailed insight into
how they manage their trading activities, business arrangements or
potential conflicts-of-interest.
Over the past two decades,
private funds have grown to play an increasingly significant role
in our capital markets both as a source of capital and an
investment vehicle of choice for many institutional investors.
Advisers to hedge funds are commonly
estimated to have almost $1.4 trillion under management.
Since
many hedge funds are very active and often leveraged traders, this
amount understates their impact on our trading markets. Indeed,
hedge funds reportedly account for up to 18 to 22 percent of all
trading on the New York Stock Exchange. Venture capital funds are
estimated to manage about $257 billion of assets, and private
equity funds raised an estimated $256 billion in 2008.
This is a significant regulatory gap in
need of closing. Private fund advisers should be required
to register under the Investment Advisers Act and to report
information that can be used for both systemic risk analysis and
investor protection purposes.
This registration and the resulting
oversight would better protect our markets and would enable
investors, regulators and the marketplace to have more complete
and meaningful information about private fund advisers, the funds
they manage and their market activities.
Broker-Dealers and Investment Advisers
Should be Subject to the Same Fiduciary Standard of Conduct and
Heightened Regulatory Regime When Providing the Same or
Substantially Similar Services. Another area where
regulation should be rationalized involves broker-dealers and
investment advisers, particularly with respect to the services
they provide to retail investors.
The Commission has been closely
examining the broker-dealer and investment adviser regulatory
regimes and assessing how they can best be harmonized and improved
for the benefit of investors.
Many investors do not recognize the
differences in standards of conduct or the regulatory requirements
applicable to broker-dealers and investment advisers. When
investors receive similar services from similar financial service
providers, it is critical that the service providers be subject to
a uniform fiduciary standard of conduct that is at least as strong
as exists under the Investment Advisers Act, and equivalent
regulatory requirements, regardless of the label attached to the
service providers.
Improving the Financial
Regulatory Framework
Regulators Need to Work More Closely Together So That We Can
Better Understand Regulated Entities and Market Risks. The
financial crisis also demonstrated the need to watch for, warn
about, and eliminate conditions that could cause a sudden shock
and lead to a market seizure or cascade of failures that put the
entire financial system at risk.
While traditional financial
oversight and regulation can help prevent systemic risks from
developing, it is clear that this regulatory structure failed to
identify and address systemic risks that were developing over
recent years.
The current structure was hampered by regulatory
gaps that permitted regulatory arbitrage and failed to ensure
adequate transparency. This contributed to the excessive
risk-taking by market participants, insufficient oversight by
regulators, and uninformed decisions by investors that were key to
the crisis.
Given the shortcomings of the current
regulatory structure, I believe there is a need to establish a
framework for macro-prudential oversight
that looks across markets and avoids the silos that exist
today. Within that framework, I believe a hybrid approach
consisting of a single systemic risk regulator and a powerful
council of regulators is most appropriate.
Such an approach would
provide the best structure to ensure clear accountability for
systemic risk, enable a strong, nimble response should adverse
circumstances arise, and benefit from the broad and differing
perspectives needed to best identify developing risks and minimize
unintended consequences.
Resources Are A Key Component of
Effective and Independent Regulation. Although traditionally
independent of the executive branch, unlike most financial
regulators, the SEC lacks an independent source of funding. Most
financial regulators have been established as independent entities
with bipartisan management and dedicated funding sources.
This
structure serves to insulate financial regulators from efforts to
influence inappropriately the supervision of regulated entities or
the pursuit of remedial or enforcement action.
Unlike its
regulatory counterparts, however, the SEC's
funding is subject to the Executive Branch budget process and to
the Congressional appropriations process. As a result, the
SEC has been unable to maintain stable, sufficient long-term
funding necessary to conduct long-term planning and lacks the
flexibility to apply resources rapidly to developing areas of
concern.
This problem has become especially critical with
the enormous complexity of modern capital markets. Many of the
matters central to the financial crisis and its resolution relate
to the derivatives and other financial innovations so important to
modern capital markets.
Pending Congressional legislation
recognizes this and imposes explicit responsibilities on the SEC
in this space. I believe that significant and steady ongoing
resources will be necessary to help ensure that the SEC's human
capital, information technology, and data analytics keep pace with
modern capital markets.
These issues add to a general
funding problem relating to information technology and staffing.
For example, the SEC's funding level was flat or declining during
the 2005-2007 period. The SEC had to cut its staff by 10 percent
and its investments in new IT initiatives by 50 percent — at the
same time the securities markets were growing significantly in
size and complexity.
Since 2005, when these cutbacks began,
average daily trading volume has nearly doubled; the investment
advisor industry has grown by over 30 percent in number and over
40 percent in assets under management; and broker-dealer
operations have expanded significantly in size, complexity, and
geographic diversity.
Today the SEC
has 3,700 people to oversee approximately 35,000 entities,
including 11,300 investment advisers, 8,000 mutual funds, 5,500
broker-dealers, and more than 10,000 public companies, as well as
transfer agents, clearing agencies, exchanges, and others. Under
these constraints, the agency can only examine about 10 percent of
advisers each year.
The current process also makes
funding unpredictable. The SEC rarely receives its annual
appropriation at the beginning of a fiscal year and is often
funded under a continuing appropriation. This dramatically reduces
the agency's ability to initiate new programs and undermines its
ability to engage in long-term planning and contracting that would
provide services in a more cost-effective manner.
Currently, the SEC's collects fees that are completely independent
of, and significantly exceed, its funding level. For example, in
2010, the SEC will collect about $1.5 billion and receive about
$1.1 billion in appropriations. Although this is a significant
appropriation, the agency could receive a substantially different
appropriation next year or any year after, substantially reducing
our ability to plan and make strategic investments.
A
well-designed independent funding structure — for example, one
based on transaction and registration fees already collected —
would provide the agency with a much needed stable funding stream.
This would better enable the investment, modernization and
long-term planning needed to better protect investors and perform
our supervisory mission.
VII.
CONCLUSION
In conclusion, there were many causes and
lessons to be learned from the financial crisis.
The enormity and worldwide scope of the crisis, and
the unprecedented government response required to stabilize the
system, demands a full and careful evaluation of every aspect of
our financial system.
We cannot hesitate to admit mistakes, learn from them
and make the changes needed to address the identified shortcomings
and reduce the likelihood that such crises reoccur. More vigorous
regulation and a new culture or approach are essential. I look
forward to working with the FCIC as its review progresses
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